Economy

The US–China Trade War

Analysis 2 March 2019
The US–China Trade War

The US has weathered its trade war with China better than many observers had predicted. Unless Trump’s advisers persuade him to demand major Chinese concessions on broader structural issues, a deal in the next few weeks remains likely.

Expectations have risen in recent weeks that China and the United States may soon broker an ‘interim’ deal to end the trade war which began when US President Donald Trump announced tariffs on Chinese imports last year. On 24 February, Trump declared that he would postpone an increase of tariffs from 10% to 25% on US$200-billion worth of Chinese imports that had been planned for 1 March and, assuming continued progress in negotiations, would hold a summit with Chinese President Xi Jinping in Florida.

The following day, he suggested that Washington and Beijing were ‘very, very close’ to a trade deal. Those within the Trump administration who support a deal, including Treasury Secretary Steven Mnuchin, White House Economic Advisor Larry Kudlow and Chairman of the Council of Economic Advisors Kevin Hassett, appear to have regained their political voice. Their position has been strengthened by the increasing uncertainty felt by US business and financial communities in the wake of market volatility in late 2018.

While loud voices within the administration, such as Trade Representative Robert Lighthizer, National Security Advisor John Bolton and Commerce Secretary Wilbur Ross, remain sceptical of any interim accord and favour continued efforts for a far more ambitious deal than currently appears possible, market and political factors are pulling both Trump and Xi towards such an agreement. Both leaders are aware that failure to reach a deal could trigger a negative market response and a global recession, from which they would both stand to lose greatly.

The US has weathered the economic confrontation with China better than many observers had predicted, and there is growing evidence of a Chinese economic slowdown. China’s efforts last year to exert influence over US economic policy by targeting some of Trump’s key domestic constituencies appear to have failed. Trump, however, is keen to declare victory in the trade war. Beijing is calculating that Trump would be willing to accept an agreement narrower in scope than his more hawkish advisers would prefer, so long as it substantially reduced the bilateral trade imbalance, his main metric for fair trade. Unless these advisers persuade Trump that Washington’s advantages in the trade war allow him to demand major concessions from China on broader structural issues, a deal in the next few weeks remains likely.

An emerging consensus

The Trump administration’s trade war against China began in mid-2018, in the aftermath of a series of high-profile and aggressive efforts to reshape US trade relations with the European Union, Canada and Mexico, and Japan and Korea. Within the US political and foreign policy communities, the initial trade actions against China were far less controversial than the pressures placed on US allies. Assertiveness towards Beijing was bipartisan and enjoyed widespread support from US allies and partners. Several senior officials from the Obama administration had published high-profile articles expressing regret for not adopting a stronger stance against China in both the security and economic spheres. Indeed, the criticism often made of Trump’s early trade policy was that by confronting allies, he had weakened the basis for a coordinated effort against Beijing, whose strategy of aggressively fostering exports, promoting industrial ‘national champions’ and coercing technology transfer from foreign firms investing in China had generated broad international concern.

Confronting China’s trade policy is the first of three legs of a new, more aggressive US approach to commercial relations with Beijing. The second concerns foreign investment in the US. In 2018, the Trump administration worked with both congressional Republicans and Democrats to strengthen the government’s ability to block a broader range of inward investments on national security grounds. While cast in general terms, this effort chiefly targeted Chinese activity. In August 2018, Trump signed into law the Foreign Investment Risk Review Modernization Act, which had enjoyed bipartisan support. The third leg of the US approach is challenging the growing influence of Huawei and other Chinese technology companies, especially concerning 5G platforms and networks in Western and developing states.

Perceptions of leverage

When Trump began the rapid series of tariff announcements in the spring and summer of 2018 that sparked the trade war, both Washington and Beijing were confident that they would possess ‘leverage dominance’ over the other. This perception produced a quick ‘tit-for-tat’ escalation in the volume of exports subject to restrictive trade measures. On 17 September, the US announced that its 10% tariff on US$200bn-worth of Chinese goods would begin on 24 September 2018, and increase to 25% by the end of the year. It also threatened tariffs on an additional US$267bn-worth of imports if China retaliated. Yet China did exactly this the following day, imposing 10% tariffs on US$60bn of US imports. China has either imposed or proposed tariffs on US$110bn of US goods, representing the vast majority of its US imports.

The Trump administration believed that China’s much greater dependence on exports to the US – China’s exports to the US average just over 4% of overall GDP, while US exports to China represent only around 0.6% of its GDP — would give Washington significant leverage. This would be reinforced by strong US public support for an aggressive trade policy towards Beijing. In a November 2018 Pew poll, 58% of respondents viewed China’s increasing economic strength as a ‘serious concern’. Moreover, Trump possessed great confidence that his negotiating skills would allow him to strike a deal with Xi.

In Beijing, however, there was also optimism about leverage dominance. China’s leadership believed that Trump’s low favourability ratings with the US public, usually hovering around 40%, combined with the impending midterm elections, made him politically vulnerable. By economically punishing key constituencies associated with Trump, especially in agriculture, they hoped to force him to back down. They also believed that due to the state-led nature of the Chinese economy, the US economy would be far more vulnerable to market pressures resulting from tariffs. A substantial proportion of global observers of the US–China trade war shared these perceptions, believing that the US was more exposed to Chinese pressure than vice versa.

Chinese vulnerabilities and US resilience

As 2018 wore on, however, it became increasingly clear that Beijing’s efforts to undermine Trump politically were having little effect, while Washington’s expectations of Chinese economic vulnerability were coming to fruition. Several indirect indicators suggested a slowdown in the Chinese economy and diminished market confidence. Both of these trends were reinforced by US trade measures.

In the late summer and early autumn, Beijing sought to conceal this unfavourable economic news. Yet by November and December, news of negative trade reports, further stock-market deterioration and very weak consumer spending dominated China’s economic media. In 2018, car sales in China were 2.8% lower than during the previous year. In December, China’s imports — a better indicator of domestic economic strength than exports – were 7.6% lower than a year earlier. Ironically, postponing the release of negative economic news probably served to over-emphasise the causal relationship between the trade war and the downturn, at least among China’s consumers and business community.

China would have encountered negative economic conditions in 2018 regardless of the trade war. Since mid-2017, Beijing’s main economic goals had been to stabilise expectations over the renminbi exchange rate, to reform the ‘shadow banking’ sector and to reverse the dramatic rise in debt, especially that owed by provincial and local governments. Each of these policies put downward pressure on growth. Strong economic headwinds therefore made China much more vulnerable to the negative effects of US trade actions.

At the same time, China’s strategy of generating domestic political pressure on Trump had failed. Trump and the Republicans sustained substantial losses in the midterm elections, losing the House of Representatives as well as their dominant position with suburban voters. Yet the expected backlash against Trump’s China trade policy from agricultural constituencies never came. If anything, Trump’s tough stance on China helped him politically. Polling suggests that farmers blamed China, not Trump, for their reduced access to Chinese markets: a December 2018 poll recorded support for Trump in major US agricultural states at 76%.

Furthermore, in contrast to China, in late 2018 the US economy appeared to be booming. At 3.7%, unemployment was at its lowest rate in decades and the stock market continued to rise (until December). Although many individual US firms were adversely affected by US tariffs, during the autumn of 2018 it was difficult to discern any substantial negative macroeconomic effects in US economic data. Differing cyclical dynamics in the two economies were an important part of the reason why the trade war seemed to affect China more than it did the US. Yet the viability of Trump’s aggressive trade policy also demonstrates that despite recent attention paid to Beijing’s growing economic power, the US retains unique capabilities of economic coercion due to its size, openness to foreign investment, its large trade deficit and the dollar’s continued status as the unrivalled global reserve currency.

Market pressures and shifting strategies

After the US midterm elections, political strategies in both Washington and Beijing began to shift, as did the market pressures on both Trump and Xi. For most of the first two years of his presidency, the markets ignored Trump’s steady stream of often provocative tweets and his penchant for brinksmanship in international negotiations. This pattern shifted rapidly in late autumn 2018, as Trump took rhetorical aim at Federal Reserve Chairman Jerome Powell and trade with China, and dismissed Secretary of Defense James Mattis. The market’s fluctuations in December, in which it fell by almost 15%, were partly due to the strengthening conviction that the end of a long growth cycle is approaching, and reflects investor squeamishness about remaining in the market for too long. It also appears, however, that US markets have finally become sensitive to Trump’s statements and actions.

Market pressures in both countries are pushing towards de-escalation of the trade war. In recent weeks, the Chinese stock market has regained momentum after a grim 2018, in which its performance ranked last among major markets worldwide. While Chinese authorities are no doubt pleased by this development, they are aware that it is not driven by positive economic news at home but rather by the expectation of a trade deal with Washington. Similar expectations have driven the US market’s recovery from its December losses. Around a decade ago, the commentators Niall Ferguson and Moritz Schularick coined the phrase ‘Chimerica’ to refer to the real economy linkages – China as producer, US as consumer – that bound together the two countries’ economies. The ‘Chimerica 2.0’ moment may be beginning: one driven less by real economy linkages and more by the shared political needs of both Xi and Trump to avoid the market disruptions engendered by their failure to reach at least a preliminary agreement.

As with his approach to trade issues with Europe, Japan, Korea, Mexico and Canada, Trump himself has publicly stressed that he sees pressure on China as the path to a deal. For his part, Xi has pivoted China’s strategy away from the failed attempt to mobilise domestic pressure against Trump towards seeking an interim agreement that would prevent the US increasing its 10% tariffs to 25% as scheduled. The first phase of this strategy was the 30 November summit between the two presidents on the sidelines of the G-20 meeting in Buenos Aires. Trump and Xi agreed to initiate 90 days of ‘framework negotiations’ intended to reach an interim agreement on lowering the bilateral trade deficit and freezing existing tariff levels rather than increasing them to 25%. Trump’s recent decision to postpone the increase in tariffs suggests that Xi’s strategy is bearing fruit.

Measuring success

Since the Buenos Aires summit, Beijing has exploited the differences between Trump and his trade advisers over how to measure success in the trade war. Beijing is aware that for decades, Trump has described the bilateral trade balance as the appropriate measure of trade ties between countries, even though most economists consider bilateral trade balances essentially irrelevant. Trump’s trade advisers, on the other hand, have focused on the structural disadvantages China imposes on the US, such as lack of intellectual property rights, forced technology transfers and China’s use of industrial policy (exemplified by Xi’s ‘Made in China 2025’ initiative). China has therefore concentrated its efforts on dramatically lowering its bilateral trade deficit with the US.

The Chinese seem to have calculated that a substantial reduction of the bilateral trade imbalance would placate Trump. They believe that a significant increase in US imports would more or less suffice for a deal, and that Trump would agree to defer the broader, structural issues to a future negotiating round. This calculation is probably correct. For Trump, the political benefits of campaigning for re-election on a reduced trade deficit with China are straightforward and substantial. Wrangling over intellectual property and industrial policy may appear to him as abstract and esoteric.

Sensitive to US perceptions, China appears to be dealing with the issue of Canada’s detention of Huawei CFO Meng Wanzhou via a back-channel, so as not to undermine chances for a deal. At the time of her detention, Beijing remained silent about US demands for her extradition and restricted its retaliation to target Canadian interests: a strong signal of its intent to reach a trade agreement with Washington. The probable outcome is that, following a trade agreement, the US will drop the extradition request, allowing Meng to return to China. The recent US indictments against Huawei will remain, making it easier for Trump to defend a narrowly focused trade deal against charges that he is going soft on China.

Outlook

The biggest obstacle to any agreement is the possibility that perceived US advantages over China might harden Trump’s negotiating position. Should his more hawkish advisers persuade him that Xi is desperate for a deal, Trump may insist that any agreement address additional, structural issues, which in turn could make the deal unpalatable to Xi. Yet Trump’s record of negotiations so far – for example, concerning NAFTA or US trade with Europe, Japan and South Korea – suggests he will not push Xi to extremes. While he often adopts a bombastic or threatening tone towards negotiating partners, he typically becomes more accommodating in final discussions. It is also unlikely that Xi would definitively reject US requests on structural issues. Instead, he will argue that these questions will be more amenable to creative compromise in the afterglow of a successful interim agreement.

A trade deal between the US and China therefore remains likely in the next few weeks. If one is brokered, it will demonstrate two points: firstly, that Beijing has moved on from its failure to mobilise US domestic discontent and instead exploited Trump’s desire for headline victories that he can deploy in his re-election campaign; and, secondly, that the consensus in the US around ‘getting tough with China’ is constrained by both markets and politics.

Published in cooperation with IISS.

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