The U.S.-China trade war is in full swing, and it’s not going away anytime soon. The U.S. is beginning to see it more as a strategic opportunity to contain Chinese assertiveness than as a play to invigorate U.S. manufacturing. What the White House is demanding in negotiations, Beijing cannot concede without abandoning the state-led economic model that the Communist Party of China thinks it needs to address a staggering range of political and economic problems at home – ones that it’s been grappling with even before the trade war began. Thus, the trade war is only going to get bigger from here.
This Deep Dive looks at the potential fallout in China. Ultimately, it concludes that for Beijing, the economic cost of the trade war will be real but likely manageable if considered in isolation. China has ample tools at its disposal to ease the pain, and it’s been gradually reducing its dependence on the U.S. market anyway. The problem for Beijing is that it’s contending with much bigger political and economic problems already – problems that reflect a profound internal weakness that has bedeviled Chinese leaders for thousands of years.
Counting the Costs
Last year, exports accounted for around 20 percent of China’s gross domestic product. Of these, 18.6 percent went to the United States. If U.S. buyers for all of these goods abruptly disappeared and firms in China were unable to find replacements, it would dent China’s annual GDP by at least 3.5 percent – and presumably more when accounting for the accompanying loss of investment, the hit to consumption that comes with job losses and so forth. Chaos would ensue.
Of course, not all Chinese exports to the U.S. will come to a grinding halt, and some that do will find buyers elsewhere. A continued weakening of the yuan alone could offset much of the tariffs (particularly 10 percent duties), albeit at the risk of raising the cost of critical imports that Chinese industry needs to keep humming and spurring capital flight by spooked investors. Moreover, the bulk of the value of many goods exported from China is actually produced elsewhere (e.g., Japanese semiconductors manufactured in Malaysia that go in a laptop merely assembled in China), so what’s billed as a $200 billion package of tariffs is actually quite a bit less for China. All told, most estimates put the current hit to China in the range of 0.2-0.6 percent of GDP. (Officially, at least, China grew by 6.9 percent last year and set a target of 6.5 percent this year.)
In reality, making any sort of precise estimate of how tariffs will hurt China is nearly impossible. There are simply too many variables in play. To start, it’s unclear how much the U.S. will expand the tariffs (and at what rate). We know that the latest round (10 percent on $200 billion) is set to increase to 25 percent on Jan. 1 if a deal isn’t reached before then (we doubt one will be). But we don’t know how serious President Donald Trump is about following through with his repeated threats to tax another $260 billion – effectively, all Chinese imports. Similarly, the size of China’s retaliatory measures against the U.S. will matter as well, since tariffs amount to a tax on one’s own citizens, and in China’s case will dampen consumption without benefiting comparable Chinese domestic industries (which already largely dominate the Chinese market). It’s also unclear what exceptions either government will carve out to ease the pain. U.S. firms had made more than 37,000 requests for exclusions from steel tariffs alone as of last week, according to the Commerce Department, which had processed less than 12 percent of them. The exemption process from the new round of tariffs on China has reportedly not yet been implemented.
How much of the increased costs will be borne by consumers and how much by producers, meanwhile, will differ from one product to the next, depending on factors like elasticities in supply and demand. China has already lowered tariffs on imports it can’t easily get elsewhere, for example. Global supply chains for different products will shift at varying speeds; just how fast depends on the medium-term planning decisions of thousands of businesses, not to mention other governments. Some exporters in China will merely find ways to become more efficient, and the closing of some will support Beijing’s ongoing reforms aimed at reducing industrial overcapacity. China will also try to reroute some products through neighboring markets not facing U.S. tariffs, particularly Vietnam, but doing this adds its own costs to the exports, and the U.S. will be on close watch for such activities, meaning they may end up taxed anyway. Where pain can’t be avoided, Beijing has some tools with which to soften the blow for the domestic market, such as targeted tax relief, subsidies, monetary and fiscal stimulus, and so forth.
All this is just scratching the surface. But in short, there’s no small amount of uncertainty about how far, and with how much force, the tariffs will ripple outward in China. This uncertainty is itself a problem for Beijing, whose historically poor oversight and data collection capacity put it at risk of getting blindsided by a crisis bubbling up in remote corners of the country. Uncertainty also has a way of breeding panic – perhaps the most unpredictable factor at play, whether in the stock markets, among foreign firms operating in the country or among Chinese consumers – that could make an otherwise manageable situation markedly worse.
Most important, though a 0.2-0.6 percent hit to China’s GDP from the tariffs would likely be manageable in isolation for a nearly $14 trillion economy, the trade war is far from China’s only problem. Rather, it will intensify three challenges, in particular, that China is already grappling with. The first is the effort to clean up the mess left behind by the 2008 financial crisis and the internal structural dysfunction it exposed. The second is its quest to find a more sustainable path to growth. The third is deep-rooted regional divides between the wealthier coasts and the interior – a fundamental threat to China as we know it.
The Immediate Crisis
Breakneck growth in China was always going to be difficult to perpetuate. As economies become larger, high growth rates naturally get harder to sustain. And China is running out of the sort of easy gains – in particular, cheap exports, investment and the one-time gains of land and resource privatization – that fueled its rise, and domestic consumption has not increased quickly enough to allow the economy to stand on its own. The problem for China is that it cannot tolerate the social risks that would result from a massive increase in unemployment, and so it has generally been unwilling to stomach a major slowdown, much less a sudden shock to the system. Thus, to sustain employment, it has generally sacrificed profitability to keep some exports competitive and made up for the rest with credit and fiscal stimulus, leading to any number of distortions. This was laid bare following the 2008 global financial crisis. Beijing’s response – massive infrastructure spending, unchecked lending and an even greater reliance on public investment – compounded the long-term challenge by flooding the economy in debt, nonperforming loans and industrial overcapacity. Today, the country is dotted with unprofitable “zombie firms,” smog-choked “ghost cities” and marauding “gray rhinos” (over-leveraged conglomerates considered too big to fail).
Painful reforms could not be avoided forever. To contain the fallout, the Communist Party recentralized and re-embraced authoritarianism in the form of President Xi Jinping, who launched a sweeping reform drive to address systemic risks – from asset bubbles to overcapacity to shadow lending to pollution – during his first term. This is a work in progress, at best, and one that is a considerably bigger drag on growth than the trade war itself. Thus, China expected 2018 to be a rough year even before Trump went guns blazing with tariffs. For the year, Beijing has set a GDP growth target of just 6.5 percent, after hitting 6.9 percent (officially, at least) in 2017.
Still, the more trade pressure the U.S. applies, the more it will complicate Xi’s best-laid plans. Over the summer, Beijing grappled openly with the question of whether it should be attempting to fight a two-front war – against the U.S. on trade and against China’s internal dysfunction. There’s been pressure on Beijing to ease off its deleveraging campaign, in particular, and focus instead on stimulating growth as the trade war intensifies. But the trade war is precisely the sort of potential external shock that has fueled Beijing’s sense of urgency to get its own house in order. And thus far, Xi has continued to prioritize deleveraging and derisking. Beijing has adopted some modest expansionary policies to calm markets and guard against panic – for example, expanding local government bonds for infrastructure projects and making regular injections of capital into state-run banks. These are a far cry from the money cannons Beijing used to blast away at the crisis in 2008, when China unloaded some 4 trillion yuan ($590 billion) in new spending.
But reform would be a high-wire act for Beijing even in more favorable economic circumstances, forcing the government into a high-stakes game of whack-a-mole to contain unintended consequences and prevent a cascading crisis. One notable example of this dynamic is the crackdown on shadow lending, which has reportedly choked off credit to many small and medium-sized enterprises that had relied on over-leveraged smaller banks. Those banks are now under pressure to rein in speculative lending, forcing Beijing to scramble to find ways to force larger, healthier state-owned banks to lend to parts of the economy they’re ill-suited to. It just so happens that SMEs, which account for around 60 percent of China’s GDP, are likely to be the hardest hit by the tariffs. Their employees shop for things and have mortgages to pay. It’s not hard to see how matters can spin out of control. The trade war gives Beijing just ever so much less room to maneuver.
The Middle Kingdom and the Middle-Income Trap
Even if Beijing is able to defuse its present debt troubles and stave off an immediate crisis, it’ll still be wrestling with another problem stemming from slowing growth: what’s known as the “middle-income trap.” This is what happens when a country’s economic growth stagnates once it fails to replace low-wage growth drivers with new sources of labor productivity and growth common among fully developed economies, such as robust consumption and high-value exports. China’s unfavorable demographics make its challenge here particularly problematic. According to China’s National Development and Reform Commission, China’s working-age population (those aged 16 to 59) will fall more than 23 percent to around 830 million by 2030 and 700 million by 2050. By then, a full third of the Chinese population will have reached retirement age, compared to around 15 percent today. This is likely to push labor costs up further, while diminishing its capital base and tying up a greater share of resources in caring for the elderly. In short, the country is primed to get old before it gets uniformly rich. Beijing’s recent abandonment of the one-child policy is too little, too late.
China has some room to continue to boost productivity. The country’s rapid urbanization, in particular, is likely to bring about ample efficiency and consumption gains. But this approach has diminishing returns. Over the long term, it’s trying to push through to high-income status by pouring resources into moving up the manufacturing value chain, particularly in high-end technological sectors dominated by the West, South Korea, Taiwan and Japan (and that, incidentally, would also help China get by with a smaller workforce). The trade war strikes at the heart of Beijing’s plans on this front.
China’s state-led industrial blueprint, known as “Made in China 2025,” outlines steps to leapfrog the U.S. as a technological innovator in the industries that will matter most over the coming century (for both commercial and military applications), such as semiconductors, robotics, aerospace, artificial intelligence, green energy and biotech. Unfortunately for Beijing, the plan has also set off alarm bells across the West, not just in the U.S., and given the White House something around which to rally support for its trade war both at home and abroad (to the point where Beijing has banned mentions of Made in China 2025 in state-run media). Naturally, the U.S. tariffs focus heavily on the industries included in the plan, as do tightening controls on Chinese investment in the United States. Ending state-support for them makes up a sizable share of U.S. negotiating demands. Beijing isn’t going to budge on this front; it can’t without abandoning its core, state-led economic model. Rather, the trade war is likely to only reinforce Beijing’s sense that it needs to dramatically reduce its dependence on foreign technologies – and that the White House’s underlying goal with the trade war is to blunt China’s very rise.
It’s hard to say how much the trade war will hurt this effort. Tariffs alone are unlikely to do much. Made in China 2025 is being executed primarily through Chinese state-owned enterprises, which Beijing is better equipped to protect from the tariffs than it is the private conglomerates and SMEs hurting the most thus far. On the other hand, Beijing has relied heavily on technology transfers from Western firms (if not, as alleged by dozens of U.S. firms, outright tech theft) for its progress on tech development thus far. If tariffs make U.S. firms less inclined to enter into the joint ventures often required to operate in China, and if restrictions on investment keep Chinese firms out of the U.S. and Europe (which has been following suit on foreign investment), Beijing will be stuck doing tech development the slow and hard way.
The Long-Term Threat: A Return to Regionalism
The third problem is that the pain from tariffs is likely to be highly concentrated in a handful of export powerhouse regions along the coasts: Guangdong, Jiangsu, Shanghai and Zhejiang provinces in particular. Exports dominate each of these regional economies – as much as 50 percent in Guangdong, and between 20 and 45 percent in the others – and collectively, they accounted for more than half of China’s total exports last year. Jiangsu has the highest dependence on U.S.-bound exports, at around 27 percent. (Guangdong, which routes a sizable share of its exports across the border through Hong Kong, may be more dependent on the U.S. market.) These areas are the primary hubs of China’s electronics and machinery sectors, which as we mentioned are a core focus of the U.S. trade offensive. (In 2016, these sectors accounted for more than a third of Guangdong’s output.) And they are home to the majority of foreign firms, which will be mulling an exodus from China. In Jiangsu, Guangdong and Shanghai, for example, between one-half and two-thirds of exports from each in 2016 came from enterprises with foreign investment. This concentration may seem like a good thing; the coastal economies are by far China’s strongest and most modernized (with the largest consumer bases), giving them greater resiliency. And it means the interior masses are less likely to be directly harmed by the tariffs. Beijing won’t have to try to find awkward one-size-fits-all solutions for the entire country. But there’s a bigger issue at stake: the country’s very territorial integrity.
China’s history is one of cycles – it unifies, it fragments, then it unifies again. And when it fragments, it often does so along deep fault lines between the wealthier coasts and the less-developed interior. The coastal-interior divide isn’t just about the steep disparities in wealth, though this is certainly a big part of it. It’s also one of orientation. Coastal China runs on global maritime trade, while the interior has far fewer commercial opportunities. Coastal China’s priority is reaching its customers, whereas the interior wants Beijing to throw it a bone by transferring wealth from the coast. Left to fester, this problem can result in internal conflict, with coastal interests frequently seeking intervention by their customers. (See: the British intervention in the mid-19th century.) Mao, like many before him, tried to solve the problem by closing China to trade (at least somewhat), demonizing and then crushing the coastal elite, and imposing a dictatorship.
The historical problem has not gone away. China is constantly searching for ways to balance relations between the coastal Han and the interior Han. With newfound wealth since Deng’s reforms has come newfound and staggering inequality, for example. The more that modern China trades with the world, the more potential there is for the coasts to resist attempts by Beijing to rebalance wealth and pursue strategic objectives that may jeopardize trade relationships.
Xi is dealing with this in any number of ways. In part, like many of his predecessors, he’s using sheer force to prevent coastal wealth from translating into political power and to prevent coastal elites from opposing his reform project. This was part of the motivation of his sweeping anti-corruption campaign, as well as his recent crackdowns on profligate private conglomerates (many of whose leaders are now in jail) and on capital outflows. His centralization of the party’s control over the financial system, meanwhile, is intended partly to keep the coasts reliant on the party. And one goal of Beijing’s massive infrastructure buildout is to better integrate coastal and interior markets, allowing manufacturers to better take advantage of regional income differentials and traditional exporters to fix their gaze increasingly on domestic markets.
At this point, it’s not immediately obvious that the trade war would turn the coasts against Beijing. Sure, disagreement over how exactly Beijing should handle it at home has already spilled out into the open. There will doubtless be resistance to Beijing’s efforts to transfer wealth to the interior, its restrictions on outbound capital flows, its willingness to give ailing firms a pass from the deleveraging campaign and any number of other points of contention whether real or conjured out of thin air to settle a political score. When money gets tight, knives tend to come out.
Still, there’s little evidence that exporters think the trade war could’ve been avoided altogether or that the coasts think Beijing is declining a deal that would serve their interests. The broad impression in China appears to be that Trump isn’t actually interested in a deal – certainly not one that China could accept – and that this is just the first major salvo in an emerging Cold War. And unlike many of his predecessors, Xi is not yet trying to close China off to trade altogether. China is certainly not in a position to go cold turkey. Instead, Xi has been busy portraying China as a champion of free trade and globalization, however disingenuously, while using the tools of the state to pry open new opportunities for Chinese firms abroad, foster economic dependencies and cultivate political support with dozens of countries.
But, of course, the U.S. is in some ways trying to make this decision for Beijing. Some recent Mao-esque rhetoric from Xi is notable in this regard. According to the Chinese president: “Internationally, it’s becoming more and more difficult for China to obtain advanced technologies and key know-how. Unilateralism and trade protectionism are rising, forcing us to adopt a self-reliant approach. This is not a bad thing.” These are words from a man with a historical memory long enough to know that nothing about China’s rise should be taken for granted.