The China-U.S. trade war of attrition

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1 July 18, 2018 The China-U.S. trade war of attrition U.S. President Donald Trump has finally made good on his threat. He recently imposed tariffs on $34 billion worth of merchandise imports from China, targeting primarily products central to the Made in China 2025 initiative, a policy intended to transform China into a world leader in several cutting-edge sectors. China immediately retaliated by levying tariffs on an equivalent amount of American imports. Another $16 billion more in tariffs could be imposed by the U.S. later this month. Soon after, the White House announced that it was also considering a 10% tariff on an additional $200 billion worth of Chinese goods. Owing to a number of procedural requirements that must be completed beforehand, the earliest this measure could take effect is in September. If implemented, this tariff together with those already in place would raise the price of nearly half of everything that the United States buys from China. The delay before the earliest possible implementation of this tariff gives the two sides time theoretically to start a new round of talks. However, agreeing to more than a temporary truce in the short term is easier said than done because they are essentially in a high-stakes battle over which country will control the world s next cutting-edge technologies and emerge as the dominant global power. China accused of not playing fair At the heart of the dispute are U.S. accusations that China engages in predatory practices to grant its companies an unfair advantage over foreign rivals. These include stealing trade secrets, extending government subsidies, and demanding that foreign companies share their intellectual property in exchange for market access. The United States claims these tactics have led to the creation of domestic monopolies that generate enough cash in their vast local market to finance aggressive expansion abroad all the while denying foreign firms access to Chinese markets. The battle for dominance in the IT sector While China has made impressive gains in the IT sector, it still trails the United States in key areas like microchips and software design. Though China manufactures most of the world s smartphones and computers, it imports the vast majority of the semiconductors needed to run these gadgets. Last year, China imported about $260 billion worth of semiconductors, which is 60% more than it spent on oil imports. 1 Sources: Trump tariff salvo triggers anxiety for US chip makers, Financial Times July 4, 2018, and China's upstart chip companies aim to topple Samsung, Intel and TSMC, Nikkei Asian Review, April 25, Taiwan s Technology Secrets Come Under Assault From China, The Wall Street Journal, July 8, 2018

2 This strategic vulnerability was thrown into sharp relief when the United States threatened to bar China s second largest telecom equipment maker, ZTE, from buying American IT components after it violated trade sanctions against North Korea and Iran. This had the effect of nearly putting the company out of business until President Trump agreed to allow ZTE access to U.S. components in exchange for a $1 billion dollar fine and increased regulatory surveillance. This episode has only reinforced the view in China that it must become less reliant on foreign technology by whatever means necessary. Chinese President Xi Jinping, as the following quote illustrates, considers technological prowess the key to becoming a global power. Advanced technology is the sharp weapon of the modern state. An important reason that Western countries were able to hold sway over the world in modern times was that they held the advanced technology. China is also uneasy about relying on foreign technology to guard the nation s secrets, particularly after Edward Snowden revealed in 2013 the extent to which U.S. intelligence services had involved U.S. IT firms in spying on China and other countries. Dominating the semiconductor sector, however, will require purchasing foreign companies in possession of valuable intellectual property something that has become much harder to do politically not only in the United States but also in many other countries. This increased scrutiny also extends to Chinese nationals. On fears of espionage, the Trump administration recently instructed U.S. embassies to issue visas valid only for one year (as opposed to the previous common practice of several years) to Chinese graduate students studying in fields such as robotics and high-tech manufacturing. This directive also calls for Chinese citizens working for companies on a U.S. Commerce Department list of entities requiring higher scrutiny to obtain special clearance before being granted entry to the United States. 2 Strong U.S. bipartisan support for taking a tougher stance on China Another factor driving trade tensions between the two is that while many U.S. lawmakers have been critical of tariffs imposed on the European Union and other countries, many Democrats and Republicans feel that a tougher line needs to be adopted against China. Indeed, Trump s decision to overturn a Commerce Department decision to block U.S. firms from supplying IT components to Chinese-owned ZTE met with widespread criticism from both sides of the political divide. Senate Democrat Minority Leader Charles Schumer reacted to Trump s ZTE compromise with the following tweet: [ ] his policy is now designed to achieve one goal: make China great again. On June 19, the Senate voted to reinstate the ban on selling U.S. parts to ZTE. If the House of Representatives votes in the same manner, Trump s decision to throw ZTE a lifeline would be reversed, as the president cannot veto a vote that passes with at least two-thirds majority support in both houses of Congress. 2 AP sources: US to impose limits on some Chinese visas, Associated Press, May 29,

3 Even more importantly, the House of Representatives voted 400 to 2 in late June to broaden the powers of the Committee on Foreign Investment in the United States to block more types of deals, including overseas mergers and ventures. This includes reviewing whether overseas joint ventures are improperly transferring critical technologies to foreign companies. A similar measure has already passed the Senate and the two versions now need to be reconciled. This bill, which primarily targets China, will likely become law in the next few months. Such a high level of bipartisan support for legislation is nearly unheard of in today s polarized political climate. How will China respond to U.S. tariffs? China s capacity to impose tariffs on U.S. imports is limited by a very important fact: China exports nearly four times as much goods to the United States as it imports from it. The logical move by Chinese government would be to target Chinese subsidiaries of U.S. firms. Companies such as Apple, Nike, GM and Starbucks derive substantial revenue from Chinese-based operations, while retailers like Wal-Mart benefit from importing low-cost electronics, clothes and furniture from China. These companies could be subjected to increased regulatory scrutiny and/or made to suffer longer delays at ports. In fact, it has been reported that ships carrying U.S. agricultural products are already having to wait longer to have their cargo unloaded. However, if China pushes back too hard on this front, U.S authorities could retaliate with similar measures against Chinese firms in the United States and/or encourage U.S. firms to migrate to lower-cost countries at a faster pace than is already occurring. Even though China is trying to move up the value chain, it is still heavily reliant on the production of cheap goods to employ its vast population of low-skilled workers. Though China has made impressive progress in reducing poverty, the World Bank estimated in 2017 that nearly 500 million Chinese still earned less than $5.50 per day. 3 Does China have an authoritarian advantage? An authoritarian government has the ability to support targeted industries immediately without congressional approval, to crack down on dissent, and to shape public opinion via its control of the media. For example, the Chinese government recently warned journalists not to cite the trade conflict as a reason for the recent decline in the stock market. In contrast, the Trump administration has to contend with strong opposition to its policies from business, the media, and certain members of congress. Further, blunting the impact of Chinese tariffs on U.S. exports requires following a set of procedures that often involves obtaining congressional approval. With mid-term congressional elections looming, China and other countries have decided to inflict maximum political pain on Trump by targeting regions that voted for him in In an effort to avoid a political backlash, the Trump administration is considering the use of Depression-era programs, which permit borrowing as much as $30 billion from the Treasury to shield farmers from trade-related losses. 4 Was launching trade war on multiple fronts, as opposed to focusing on China, a strategic error? On a side note, many analysts have argued that by attacking the trade policies of the EU (and Canada, for that matter), the United States has lost out on a valuable opportunity to forge an international alliance against China s trade practices. Like the United States, the EU has long complained about China s closed economy. Indeed, the worst-case scenario for China would be for other major trading partners to join forces with the United States against its trade practices. The EU reportedly declined China s offer of a trade alliance against the United States. Despite the Trump administration s recent protectionist moves, the EU is painfully aware that China s market remains much more closed than America s. A heavily publicized study by the German-based Mercator Institute for China Studies concluded that 75% of the major acquisitions by Chinese companies in Europe since 2000 would not have been allowed had existing Chinese rules regarding foreign acquisitions been in place. 5 Distrust of China is perhaps the single most important reason why the EU is reportedly considering zero tariffs on EU-U.S. trade in cars as a means of easing trade tensions with the United States. 3 Xi Jinping Vows No Poverty in China by That Could Be Hard, New York Times, October 31, Trade Fight Threatens Farm Belt Businesses, Wall Street Journal, July 2, Chinese Expansion Has Germany on the Defensive, Spiegel, May 24,

4 Conclusion Despite growing trade tensions, we feel both sides will ultimately step back from a full-blown trade war and negotiate for the simple reason that they both have too much to lose from things spiraling out of control. The United States also does not want any major geopolitical headwinds to disrupt its economy and financial markets, especially before the upcoming midterm congressional elections. As for China, it can ill-afford a full-blown trade war at a time when it is trying to implement major structural reforms. It is also dealing with the challenges of rising wages, high debt levels, a rapidly ageing population, and significant air/water pollution. Complicating matters further is the widely held view among leading nations that China must change its unfair trade practices. However, whether or not a trade agreement is struck between China and the United States, heightened trade tensions between the two countries is likely to be the new normal for the foreseeable future. Their intense competition to be the dominant power in the world s next cutting-edge sectors means the stakes are too high for either side to give up easily. It is important to note, also, that today s trade tensions with China are very different from past commercial disputes the United States has had with many other countries. Historically, the United States has, up to a certain point, tolerated large trade deficits with Germany, Japan, and South Korea because they are close allies and democratic states. In stark contrast, China is viewed as an authoritarian geopolitical rival intent on reducing America s global geopolitical and economic influence. It is also a competition between two very different economic models: one market-oriented, the other state-driven. The gradual unwinding of supply chains between the two countries The fact that the United States and China see one another more and more as geopolitical rivals means that a certain unwinding of the supply chains between the two countries is inevitable over the long term. This is being driven by barriers placed on each other s companies. To cite but one example, in early July, U.S. authorities blocked an application from China Mobile, which has more than 900 million customers, to serve the U.S. market owing to national security concerns. As for China, western firms have long been denied access to the Chinese telecommunications sector. Over the longer term, U.S. firms will increasingly relocate some of their supply chains to the United States and/or low-cost countries such as Vietnam, Malaysia, Mexico, and Thailand. China, for its part, will try to buy high-tech inputs from other countries, such as South Korea, Canada, Australia, and Germany. Not surprisingly, these growing restrictions have caused Chinese foreign direct investment in the United States to plummet from a high of $46 billion in 2016 to $27 billion in 2017 and to only $1.8 billion in the first half of Angelo Katsoras 6 Arrested Development: Chinese FDI in the US in 1H 2018, Arrested Development, Rhodium Group, June 19,

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