The U.S.-China “Cold War”

 

Until recently, China and the United States had a convenient symbiotic relationship whereby China supplied cheap consumer goods to the U.S. consumer in exchange for dollars which it then invested in U.S. treasury bills. The relationship was perceived to be largely benign and mutually beneficial. For China, access to the U.S. market allowed it to follow the path followed in the past by its Northeast Asia neighbors (Japan, Korea and Taiwan), gradually moving up the value chain from toys, to textiles to electronics…etc. For the U.S., cheap Chinese goods increased consumer purchasing power at a time of stagnant wages. Geo-political strategists in Washington imagined that as China prospered it would start to act more like a Western liberal democracy.

However, since the arrival of Trump the relationship has frayed, and the two countries are now on the verge of a full-fledged “cold war.” Though Trump’s  anti-globalization and protectionist rhetoric may have galvanized opposition to China, the change in Washington is deep-rooted and largely consensual. Today, China-bashing is one of the few things that unite republicans and democrats, and the Washington establishment has made a remarkable about-face and now actively demonizes China. What was once seen as a “win-win” relationship is now perceived to be heavily skewed in favor of Beijing.

The current line of thinking in Washington is that China has abused American goodwill. While the U.S. opened its markets for Chinese exports and investments, China gamed WTO rules, restricted access to its market for trade and investments and sponsored the theft of intellectual property. Moreover, it has suddenly dawned on the Washington intelligentsia that China does not intend to become a liberal democracy. This makes China very different from previous beneficiaries of the “Pax Americana,” such as Germany, Japan and the Asian tigers. China is also different because of its huge scale and a growing economy that may, if it follows its current growth path, surpass the U.S. economy over the next decade. For the first time ever, China is now seen as a potential hegemonic rival that must be thwarted.

Washington’s new-found condemnation of China grew in tandem with the ascendency of Xi Xinping, his consolidation of power and his “coronation” in October, 2017 as “leader for life.”  Prior to Xi, Chinese leaders had projected  diffidence and humility. This was best expressed by Deng Xiaoping who advised: “Observe calmly; secure our position; cope with affairs calmly; hide our capacities and bide our time; be good at maintaining a low profile; and never claim leadership.”  However, Xi has come to symbolize a new more militant, arrogant and ambitious China, with pretentions of global leadership. Most emblematic of this are Xi’s two core policy initiatives: One-Belt-One-Road, which seeks to project Chinese influence and investments outside of China, particularly along the old “Silk Road” and international shipping routes; and the “Made in China 2025” industrial planning policy which aims to move Chinese manufacturing up the value chain into frontier technologies.

The U.S. is critical of both of these initiatives because they are seen as anti-market products of a command economy, made possible by state subsidies and state companies. These policies and Xi’s stated objective of strengthening state capitalism and the role of the Communist Party are seen by Washington as indicative that China is a non-market economy that operates by different rules than Western economies. Topping off Washington’s grievances is the perception that Xi is taking China down a new path of military expansionism which threatens Asian stability.

With Trump at the helm, there is a very high probability of further deterioration in the relationship with China. As JPMorgan strategists wrote last week  “a full-blown trade war becomes our new base case scenario for 2019.” It is increasingly likely that a 25% tariff will be imposed on all Chinese goods early next year.

Currently, the two countries are at an impasse. Trump believes that the Chinese will surrender on his terms as the Chinese economy deteriorates. Xi believes the state-run Chinese economy is resilient, and China can wait patiently for changes in the U.S. political and economic cycles. China is convinced that the U.S. is now undermining the post-war economic order because it is determined to thwart China’s economic rise. Its response has been to act as a responsible member of the rules-based international community, gradually adapting to the legitimate demands of its commercial partners. An example of this is China’s recent elimination of joint-venture requirements in the auto sector (this week BMW announced it is taking full control of its JV with Brilliance China).

The two countries are probably underestimating each other’s resolve, which means that the quarrel with have long-term consequences. What may be these be?

  • Tariffs and disruption of supply chains will boost inflation in the U.S. and bring the late-cycle U.S. economy closer to recession. Over the short term, little can be done to substitute Chinese imports, and tariffs will act as a large tax on consumers. Over the medium term, countries like Vietnam, Bangladesh, and Mexico can replace China as manufacturing bases for the U.S. consumer. Over the long-term robotics may change everything and allow a contraction of manufacturing supply chains.
  • European and Asian firms will take advantage of the trade war to take market share from U.S. firms in the Chinese market.
  • As indicated by the poor performance of the stock market, the Chinese economy may become less stable. China already faces big challenges dealing with high debt levels and malinvestment, while it moves from an investment and export driven economy to one based on consumption. A trade war with the U.S. can only make this transition more difficult, and this may have significant negative consequences for the global economy. Given that EM stocks are mainly driven by events in China and the U.S., the disruption of the China-U.S. relationship will surely have very serious consequences.
  • Over the medium term, there may be a retrenchment in globalization and an acceleration of regional blocs and multipolarity. Firms will have to think about operating in increasingly separate ecosystems, each with its own supply chains and technological platforms: one supply chain will serve the U.S. market; another will be structured for the Chinese market. This process is in full acceleration: Huawei and ZTE have been banned from the U.S.; the U.S. is accusing China of hacking supply-chain components sourced in China; China is determined to become self-reliant in key components for the high-tech sector.
  • Initially, one of the few clear winners of this “Cold War” may be Mexico. The Mexican government smartly outmaneuvered Trump and secured the basics of NAFTA in exchange for a new name (USMCA). The deal allowed Trump to say that “the worst trade deal ever” has now become “a great deal, the most important trade deal we have ever made.” The new deal may make Mexico the manufacturing base of choice for firms seeking the combination of easy access to the U.S. market and cheap labor.

Macro Watch:

  • The weak fundamentals of the global economy (Project Syndicate)
  • Trump’s poison pill for China (Yardeni)
  • U.S. tariffs on China are not short term strategy (WSJ)
  • The decline of the dollar standard (Project Syndicate)
  • The U.S. will win this trade war (Gary Shilling)
  • New NAFTA is a relief (The Economist)
  • Brazilian democracy on the brink (Project)
  • The Tyranny of the US dollar (Bloomberg)
  • Trump’s rebranded NAFTA (Bloomberg
  • New NAFTA shows limits of “America First” (WSJ)
  • NAFTA to USMCA – What in a name? (Lowy)

India Watch

  • India’s Russia arm deal (WSJ)
  • India’s game-changing healthcare plan (Lowy)
  • Measuring Indian equities (S&P)
  • Modi is no populist (Foreign Policy)

 

China Watch:

  • Chinese actress to pay $129 million tax-evasion fine (WIC)
  • A strategy for dealing with China (PIIE)
  • China and Islam ( Hoover)
  • Gloves off in China-US conflict (Axios)
  • The garlic war (AXIOS)
  • Chinese U.S. investments plummet (SCMP)
  • China-U.S. ties now driven by conflict and containment (CSIS)
  • VP Pence’s cold war China speech (NYtimes)
  • U.S.-China trade relations forever broken (SCMP)
  • The U.S. will lose its trade war with China   (Project Syndicate)
  • Hong Kong mainland bullet-train link opens (WIC)
  • China’s embracement of Russia (SCMP)

China Technology Watch

  • BMW takes control of China venture (WSJ
  • China aircraft sector slow take-off (SCMP)
  • How the US halted China cyber-attacks (Wired)
  • Huawei’s new chips (WSJ) and (Tech Review)
  • Most Chinese patents are worthless (Bloomberg)
  • Chinese provinces keen to attract EV investments (Caixing)
  • How China sustematically steals technology (WSJ)

Brazil Watch

  • Brazil’s Bolsonaro (New Yorker)
  • In Brazil, campaign promises but no money (WSJ)
  • Emerging markets’ lost decade (Blackrock)
  • Brazil’s gene-edited angus cow (WSJ)
  • Brazil’s social media election (FT)
  • How to fix Brazil’s economy (Project Syndicate)

EM Investor Watch

  • Indonesia’s bullet-train is stalled (Caixing)
  • Russia’s missed tech opportunity (Hoover)
  • Emerging markets’ lost decade (Blackrock)
  • SPIVA Latin American Scorecard (S&P)

Tech Watch

  • The plan to end malaria with CRSPR (Wired)

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