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Sino-US trade war risk – a reality check

The trade war between China and the US has moved into a second stage, in my view, with tail risk of a currency war in the short term and possible de-globalisation leading to fragmentation of global financial and technology linkages in the longer term. 

  • Stage one - from July 2018 when the US imposed the first tariffs on some USD 34 billion Chinese imports to May 2019 when the Chinese leadership decided on a national strategy to fight a prolonged trade war even at the cost of slower economic growth
  • Stage two - dragging out the trade fight to exhaust the Americans
  • There are “nuclear options” Beijing can use to hit American firms if it chooses to

Trade war - Mark I

In starting the trade war, US President Donald Trump had two primary goals:

  • to cut the US trade deficit, in particular with China
  • to force relocation of supply chains and production out of China presumably to weaken China’s global influence in the long-term (at least from the Chinese view).

Until May 2019, the Chinese seemed to be playing defensive, trying to minimise the damage to supply chains and maintain access to US markets.

The trade war has already resulted in trade diversion from China to other economies. As Exhibit 1 shows, exports to the US have been booming in Vietnam, and have picked up strongly in Taiwan and other Asian economies.  However, Chinese and Hong Kong exports to the US have contracted noticeably.

Exhibit 1: Changes in exports to the US by exporting country (breakdown in %, 3-month moving average, year-on-year)

Exhibit 1: Export growth to the US

The US trade deficit with China has fallen, but not its deficit with the rest of the world (Exhibit 2).  The stubborn deficit reflects an imbalance between savings and investment in the US.  If this disequilibrium is not corrected, the deficit will likely remain and the trade war would only change the composition of the countries with which the US has a deficit.

Exhibit 2: Change in the US trade balance with China and with the rest of the world (on the basis of a 12-month rolling total)

Exhibit 2: US trade balance*

US imports from China have dropped sharply, while imports from its other key trading partners have risen, including

  • Mexico and Vietnam, which have benefited from trade diversion as the US replaces Chinese imports with goods from these countries
  • Japan, Taiwan and South Korea, which have benefited from the re-shoring of tech and capital goods that are exported directly to the US.

Trump’s strategy not working out

Precedents for using ad-hoc trade policies to pare the US trade deficit with a top trading partner do not look encouraging for Mr. Trump. Between 1984 and 1994, the Reagan administration enforced a quota-like voluntary export restraint (VER) covering Japanese cars in an attempt to reduce the US-Japan trade deficit. It did not work.

Evidence does not support Mr. Trump’s claim that his strategy had forced massive relocation of foreign firms from China to other countries. There is anecdotal evidence for some production relocating out of China, notably to cheaper developing countries such as Vietnam and Mexico, and some re-shoring to Taiwan, Korea and Japan. However, overall foreign direct investment in China is still rising at around 3.0% annually, roughly the same pace as in the previous five years.

Foreign firms have left China for various reasons. Some realised that their China strategies had failed. Others that thrived for many years by exporting labour-intensive goods left China for cheaper production bases, such as Vietnam and Bangladesh, when Chinese wages continued to rise.

It remains to be seen how many firms will ultimately leave China and how many of these will relocate to the US. But relocation is easier said than done, except for those labour-intensive low-skill industries. A large number of foreign, including US, firms in China primarily produce for its huge domestic market. These firms have little incentive to leave.

Meanwhile, foreign affiliates operating in China draw on an extensive local supply chain that has been built up over the decades. They have hired about 25 million Chinese workers, including many skilled technicians and managers who are not readily available in other developing countries.

Trade war - Mark II

This May, China’s leadership came to a consensus on dragging out the trade fight to exhaust the Americans. Note that this strategy was decided way before recent media reports on Beijing’s shift to a dragging negotiation tactic prompted by the emergence of Mr. Trump’s impeachment risk.

As the second stage unfolds, the relative negotiating positions of the two sides have changed; and the impeachment enquiry has turned the timetable against Mr. Trump. While China is not eager to reach a trade deal, Mr. Trump is under pressure to get at least a temporary deal done to help his re-election bid before impeachment risk rises and the US economy weakens further.

Under these circumstances, China’s rotating tactic of fighting and negotiating (see Appendix) may give it the upper hand and result in a temporary, watered-down agreement that is light on the structural reforms and compliance monitoring mechanisms that Washington has been demanding. Time will soon tell.

The risks

In the short term, a further rise in trade tensions may prompt China to scale back on its currency intervention and allow the renminbi to weaken further under market forces as part of the negotiation tactic[1]. This does not mean that China has a devaluation policy, but it does imply that the tail risk of the trade war igniting another round of a currency war has risen.

In the longer term, as I argued recently[2], the US effort to decouple from China by breaking up the global supply chains could be quite disruptive to the world’s production ecosystem. The broken supply chains will be inefficient, turn the clock back on globalisation and reverse the trend of disinflation.

De-globalisation could also result in financial fragmentation, which would disrupt the global technological landscape. Restrictions on technology transfers and linkages, justified on the national security basis, would give rise to competing and non-compatible standards, leading to excessive or cut-throat competition, hurting innovation and pushing up costs, slowing adoption and even resulting in inferior products.

Background on China's strategy[3]

In a series of meetings in May 2019, senior Chinese leaders agreed to hardening the trade-war position. President Xi Jinping’s visit to rare earth mining and processing facilities on 20 May constituted a veiled threat to cut rare earth exports to the US. Then, on 29 May, the People’s Daily, the Communist Party’s mouthpiece, explicitly warned the US in its editorial: “Don’t say we didn’t warn you!” This phrase has been used only twice before, in 1962 before China’s border war with India and in 1979 before the China-Vietnam war.

This warning came amid rallying calls by senior leaders for national support in fighting a prolonged trade war. What most observers ignored was the leadership’s emphasis, via the national media, on the Battle of Triangle Hill, or the Shangganling Campaign, in the Korean War. This was fought over a piece of land of no more than 3.7 sq km, which the US thought it could take in a couple of days. China won the 1952 battle after 42 days of fighting. Casualties totalled over 40 000 soldiers, but the ratio of deaths was skewed with 1.6 US/Korean deaths per Chinese casualty.

Even at the cost of more pain to the domestic economy, the new trade war strategy was to exhaust the opponent, much like the Shangganling Campaign: after each round of fighting, China would negotiate, and if the negotiation failed, it would fight again, and so forth. Beijing would up the ante after each round to make the settlement conditions tougher. The cycle would go on until the US agreed to a deal.

Granted, Beijing was betting on its ability to sustain this fight. News on 31 May that China would establish a list of “unreliable" entities to target foreign firms it deemed to damage China’s national interest appeared to underscore Beijing’s commitment to this strategy. And as I  have argued before, there are “nuclear options” that Beijing can use to hit US firms if it chooses to[4].

[1] See “Chi Flash: The Renminbi Conundrum – External Surplus Jumps but the Exchange Rare Falls, Why?  How Long and How Far Will the Exchange Rate Fall?” 14 August 2019

[2] See “Chi Flash: US Mulling to Limit Portfolio Flows to China”, 30 September

[3] This analysis appeared on 31 May 2019 as “China Not Named Currency Manipulator, FTSE Russell Adds A-shares, But Trade War Risk Rises Further

[4] Chi Flash: China’s “Nuclear Option” in the Trade War”, 3 July 2018

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