The tail risk of a Sino-US trade war is getting fatter. Both Chinese President Xi Jinping and US President Donald Trump are nationalistic leaders who have emphasised their strength and resolution. Neither can afford to look weak in a confrontation with a large sovereign power.
If patriotism were to get the upper hand on rationality, the two sides may misjudge each other’s intentions and push themselves into a spiral of attacks and retaliation. The resulting damage would be negative for risk assets.
Let's put aside both the question of 'who’s right and who’s wrong' and speculation about possible irrational policy responses from Beijing (these might include devaluing the renminbi and/or dumping US Treasuries).
Instead, in this post, I would like to assess how, if push comes to shove, Beijing would fight a Sino-US trade war. Should a large scale trade conflict break out, China’s potential “nuclear option” for retaliation is to hit the US companies operating in China using regulatory and non-trade barriers.
"This nuclear option is ultimately an example of the arrogance of power". Joe Biden
As I have previously argued, this would potentially be very damaging to the US, which has invested much more in China than China has in the US. In principle, no US product sold in China or US company invested in China would be considered safe from this sort of retaliation.
Continued escalation of trade war
After announcing 25% tariffs on USD 50 billion worth of Chinese imports on 15 June, matched tit-for-tat by China, President Trump instructed his trade officials to find another USD 200 billion of Chinese imports for 10% tariffs and threatened another USD 200 billion if China continued to retaliate.
The US administration is also set to prepare investment and export restrictions to block China’s access to US technology.
A negotiated settlement seems to be out of reach at this point. In my view, Beijing will never agree to the US demand for it to abandon its “Made In China 2025” industrial policy. Beijing considers this to be essential to its national security and development strategy. The escalating tensions also underscore a point I have made previously namely: the gulf between China’s developing-country industrial policy approach and the US’s developed-country industrial competition approach is too wide to bridge in the medium term.
Senior Chinese policymakers originally considered Trump to be simply a deal-maker. They now think Trump seeks dominance over China and that Beijing should fight back rather than make concessions. Beijing’s change of view, together with a mercurial Trump, is aggravating the trade-war risk.
Multinationals caught in trade war crossfire
China will not be able to match the US tariffs if they keep spreading. The US bought USD 500 billion of Chinese goods in 2017, while China imported only USD 150 billion of US goods. But the operations of US multinationals in China offer a much bigger target for Beijing’s retaliation. Total sales of US-invested companies in China was estimated at around USD 480 billion in 2015 and are now likely to be more than USD 500 billion.
Beijing has recently started identifying non-tariff measures that could limit investment or market access for US firms. There are a large number of regulatory tools it could deploy. Evidence from previous economic conflicts shows that restrictions on trade and/or tourist flows imposed on Japan, South Korea, Norway, the Philippines, Taiwan and Mongolia inflicted economic damage on these economies at little cost to China. The US economy is much bigger and has deeper ties with the Chinese economy, so the potential economic damage to China would also be larger. Thus, the first targets of Chinese retaliation are likely to be US products of less consequence and easier to replace.
Potential retaliation targets
US airplanes are a major target. But since rewriting multi-year contracts with Boeing would be costly, disruptive and possibly affect China’s bargaining power with Airbus, Beijing is likely to tread carefully with this sector.
Hollywood is a much easier target as earnings from the massive Chinese market are increasingly important for US movie makers. Beijing can easily instruct the two state-owned distributors to halt or delay distribution of US films or tell video-on-demand companies to reduce the number US TV shows they stream. It could also tighten censorship requirements, delay the release dates of films in China, shorten theatrical release periods or keep movies off screens during lucrative holiday periods. Such non-trade barriers have already been in place for a while and have been the object of many complaints from US movie producers.
US pharmaceutical companies are also an easy target. China is currently reviewing 201 applications to sell new drugs from the US, Europe and Japan. Beijing can easily use targeted regulations to slow approval of drug applications by US companies, hurting their market share in China.
Agriculture is a sector where the Chinese authorities have enormous regulatory discretion. Excuses such as health and sanitation concerns have already been used to prolong customs checks and quarantine periods to restrict US agricultural imports. The barrier can easily be raised and extended to include US genetically modified (GMO) crops sold in China, which have faced delays in an approval process that is already taking years.
The market is rightly concerned about US carmakers being targeted in Chinese retaliation. China’s car market is now the world’s largest and one of the most competitive. US marques account for only about 12% of passenger-car sales in China. Since substitutes from both domestic and foreign manufacturers are readily available and marques are usually tied to national identity, cars have been a favourite target in previous disputes.
South Korean and Japanese carmakers saw their sales and market share drop sharply in China when their relations with China soured in 2017 and 2012, respectively. In both cases, Beijing said consumer outrage, not government action, was the cause of the boycotting. But who really knew. Beijing could also easily limit the growth of US carmakers by withholding or slowing approvals for new factories, models or distribution licences.
Technology companies are potential targets for regulatory retaliation. Take Apple Inc., which has USD 40 billion in sales in China. Beijing could delay issuing network license for iPhones and, thus, hurt Apple’s launches of new smartphones and sales revenues. Although such action would also hurt the revenues of Chinese suppliers and mobile carriers, Beijing may see that as a price worth paying since it would help Chinese smartphone makers.
As far as M&A activity goes, China has still not cleared US semiconductor company Qualcomm’s takeover of Dutch competitor NXP Semiconductors despite a lengthy review process and the approval of other global regulators. Other deals waiting for Chinese approval include United Technology Corp.’s acquisition of avionics maker Rockwell Collins and the merger of Marvell Technology and Cavium, both California-based semiconductor companies. Delaying or denying approvals for such deals would incur costs and efficiency losses for those US technology companies operating in China, but would involve few economic costs on China.
China’s regulatory and non-trade barriers would largely operate free of constraints. They could virtually hit any sector and any company, according to Beijing’s discretion. Chinese officials would be happy to comply with Beijing’s implicit requests to carry out the retaliation as they see it as their patriotic duty to make life hard for US companies.
If China deploys such a “nuclear option”, no one will likely benefit and market risk aversion looks set to soar. Given the change in the views of China’s senior leaders on Trump’s trade tactics and his readiness to escalate tensions, the risk of a large-scale trade war appears to be rising. Let’s hope that rationality will prevail and the Chinese “nuclear option” will not be used.
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