24 September 2018

The US and China Dig in on Trade

By Phillip Orchard

The trade war will only get bloodier from here.

The U.S.-China trade war isn’t going away. Last week, U.S. Treasury Secretary Steven Mnuchin reportedly invited China to Washing to give talks another go, ostensibly to avoid another escalation. Sure, political calculations may lead to symbolic concessions or a temporary truce. Yet both sides have basically given up on trying to strike a comprehensive deal anytime soon and appear to be digging in for the long haul, Mnuchin's outreach notwithstanding. The U.S. thinks it’s in prime position to strike on trade issues and strategic matters alike. To China, the U.S. is demanding nothing less than an abandonment of the state-led economic model underpinning its rise – and the Communist Party’s hold on power. It believes the costs are not yet high enough for a dramatic overhaul. Put differently, the trade war is will only get bloodier from here. How it plays out, though, will depend on which of the two different types of trade wars the U.S. decides to fight.

State of Play

The U.S. currently has 25 percent tariffs targeting around $50 billion in imports from China in effect. On Sept. 6, the public consultation period on another $200 billion in U.S. tariffs, now expected to be 10 percent, came to a close, meaning the White House can order implementation at any time. (The Wall Street Journal reported that the order will go ahead once the administration can make revisions based on the public feedback it received.) On Sept. 7, President Donald Trump threatened tariffs on yet another $267 billion worth of Chinese goods – effectively meaning all Chinese exports to the U.S. would be taxed.

China has responded dollar to dollar thus far, but with China’s imports of U.S. goods last year amounting to just $154 billion, it won’t be able to continue if the White House follows through with the third round. (It has pledged to retaliate against as much as $110 billion, or 85 percent of U.S. exports.) China will have to try to level the playing field in other ways, such as filing complaints with the World Trade Organization, encouraging consumer boycotts of U.S. goods, and making life miserable for U.S. firms operating in China. A new survey by the American Chamber of Commerce in Shanghai, for example, found that more than half the U.S. firms in the country are already facing non-tariff barriers such as increased regulatory scrutiny and customs delays. (There are limits to what China can do without alienating foreign investors.)

The U.S. is sticking to its guns for three main reasons. First, the White House thinks it's in position to push for far more than a modest deal that narrows the U.S. trade deficit and perhaps brings about some measure of reform in China. Such a deal could have been reached months ago and given Trump a tangible victory. In fact, Chinese negotiators reportedly thought such a deal had been reached in May, when China agreed to dramatically boost agriculture and energy imports, only to see it fall apart less than a week later because of disagreements within the White House. Meanwhile, the U.S. trade deficit has only grown, rising by 9.5 percent month-over-month in July alone.

The White House thinks it can fundamentally restructure the U.S. trade relationship with China. Numerous aspects of the Chinese model are in the crosshairs, from market protections to state support for rival industries to alleged support for forced technology transfer and outright theft. And even though Trump’s focus on the trade deficit – which is, in many ways, a measure of the strength of the U.S. economy – isn’t exactly popular, these other components have substantial bipartisan support. The fight over them will continue regardless of the outcome in the next two elections.

Second, near-term political and economic pressures are not forcing the White House to compromise. China’s original strategy rested on the hope that the pain from the trade war would make it politically untenable for Trump. This strategy involved targeting politically sensitive districts and industries in swing districts with Chinese counter-tariffs and informal trade barriers. As China’s consumer base has grown, U.S. exports have as well, with goods to China alone surging by 86 percent over the past decade (compared to 21 percent for the rest of the world). Beijing also expected that U.S. tariffs would create some friendly fire. According to a study by the Peterson Institute for International Economics, for example, the first $50 billion in U.S. tariffs would harm foreign firms in China – many of them American – more than Chinese firms. Costs of component parts that U.S.-based manufacturers relied upon would go up. New U.S. tariffs targeting finished goods would make the sticker shock more apparent, reminding voters that tariffs are a tax shouldered primarily by consumers. The interconnectivity of multinational supply chains today simply makes it difficult to target one country without hitting others.

Some degree of political backlash in the U.S. is certainly taking place. There is a growing chorus of warnings from trade groups, industry associations and anxious lawmakers about the economic fallout to come. A group representing thousands of companies known as Tariffs Hurt the Heartland is the latest to raise a stink. The decision to reduce the next round of tariffs to 10 percent, rather than 25 percent as ordered by Trump in July, may hint at a degree of concern about exposing U.S. consumers to steep price hikes so close to a pivotal election. Yet, at this point, there’s little evidence to suggest that trade, inherently an esoteric issue, will dominate the midterms. The U.S. economy is too strong, and the pain from the trade spat either too sectoral or too theoretical at this point, to have a tangible impact on most voters’ lives in the next few months. (Besides, some sectors and communities stand to benefit.)

Finally, there are much bigger strategic issues at play, from North Korea to the South and East China seas to the broader aim of curbing Chinese influence. And with trade, the White House thinks it has Beijing on the ropes. It’s hitting China at a precarious time, forcing Beijing to fight a two-front war against Washington on trade and against deeply embedded economic problems. Beijing is scrambling to help small exporters, particularly through boosted lending and tax relief. In China, the stakes of an economic slowdown are an order of magnitude higher than in the United States. The White House has good reason to think it has the upper hand.

China Shifts to a Containment Strategy

China just doesn’t have much room to give. The biggest reason is it can’t meet the United States’ demands on issues like structural changes and market reforms. Doing so would be tantamount to abandoning its core industrial and development models – the way it asserts central authority across the country, its means of addressing imbalances between the coasts and the interior, its state-led drive to move up the manufacturing value chain and compete in high-tech industries, and so forth. Chinese officials say these issues account for as much as 40 percent of U.S. demands. If anything, the trade war is convincing Beijing that it needs to accelerate its plans to boost domestic industry and reduce dependence on the West.

Nor can China agree to measures that would do real damage to the trade imbalance, particularly liberalizing its currency. Japan’s “Lost Decades” – themselves partly the result of similar U.S. pressure to strengthen a currency – taught China a lesson in how detrimental it can be to give into sweeping U.S. trade demands. Japan has the societal cohesiveness to survive a 20-year slump without major social upheaval. China cannot be sure it does.

Ultimately, Beijing may get pushed to the point where it has to start conceding on things it thought it never would. But doing so now might be premature for two main reasons. The first is the state of U.S. politics. Even though the pressure on issues like technology theft won’t go away with the next U.S. administration, Beijing has reason to believe the U.S. will struggle to maintain that pressure if there's political chaos in Washington. Second, Beijing thinks that the economy is on solid enough footing to ride out the storm for now – and that it has enough tools available to offset some of the pain. (It can quickly channel credit to and ease tax burdens on affected industries, its ability to modestly weaken the yuan, etc.) The economy is relying less and less on exports and more on state-directed investment and domestic consumption.

Still, the trade war is making Beijing nervous. Even without the trade war, Beijing has been walking a tightrope as it attempts massive reforms to restructure the economy amid slowed growth, without sparking mass social unrest. Losing exports to the U.S. will give it a lower margin for error. Moreover, there’s only so much Beijing can anticipate. It’s impossible to comprehensively map out the effects of the trade war, in part because it’s unclear what new tariffs will be implemented, what exceptions either government will carve out and what measures either side will take to offset the pain. Global supply chains will shift at varying speeds. As China’s retired central bank chief noted this week, perhaps the biggest unknown is the potential for panic. So Beijing has little choice but to prepare for worst-case scenarios.

For China, that scenario is that other major economies – especially Japan and Europe – form a united front with the United States. Beijing believes it can withstand lost exports so long as business can continue as usual with the rest of the world. If the world gangs up on China, that's a different story. Indeed, there are some signs that Japan and Europe are putting aside their own trade differences with the U.S. to, for example, join U.S. cases against China at the WTO and adopting measures to to restrict Chinese investment in local firms. As a result, Beijing has opened a major charm offensive, taking several steps to ease tension with Tokyo and going hat in hand to Europe.

Thus, to an extent, how the trade war plays out boils down to what kind of trade war the U.S. chooses to fight. If the goal is to contain China – economically but also strategically by diminishing its ability to modernize its military and buy friends and allies – then Beijing will find itself in a serious fix. If the goal is to bring back manufacturing jobs lost to foreign competition, then Trump can’t stop with China. Labor-intensive manufacturing operations in China would simply move to other low-cost destinations rather than home to the U.S., while higher-end manufacturing would still face stiff competition from Europe, Japan and South Korea. A united front will be more difficult to form, and China might just be able to find a way through unscathed.

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