The Fog of Trade War: Can China Outlast the US?

Both sides are digging in, but Washington can’t ignore the costs of tariffs forever.

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Last week, in response to mounting trade pressure from the U.S., Chinese President Xi Jinping called on the Chinese people to prepare for a “new Long March.” On Tuesday, Chinese state media cited the Korean War in touting China’s ability to dig in and grind down U.S. resolve. If it’s not clear, Beijing expects the trade war to devolve into a protracted, bloody slog.

Indeed, since the dramatic collapse of trade negotiations in early May, both sides have made moves of the sort you make only if it’s no longer necessary to prep the public for painful concessions, avoid collateral damage, and let the other side save enough face to ink a deal. China’s surge of nationalist rhetoric, for example, is a departure from previous efforts to tightly manage public anger, thus raising the political risks of backing down. On Tuesday, it announced the start of a process to ban exports of rare earth elements to the U.S. – a card it wouldn’t play if it didn’t think it had to, lest it risk diminishing its dominance over the sector by sparking a surge of investment in operations outside China. It announced plans to draft a list of “non-reliable” foreign firms and individuals, spooking investors already taking a long look at alternative low-cost manufacturing hubs and shaken by China’s retaliatory arrests of two Canadians.

The U.S., meanwhile, increased tariffs on $200 billion in Chinese goods and threatened to raise duties on another $300 billion in products, upending markets and provoking retaliatory tariffs, thus raising the impetus to exact greater Chinese concessions to justify the cost. The Trump administration also moved to slap tariffs on Mexico over non-trade issues, likely making it harder to persuade China to make painful concessions to get out from under U.S. tariffs (lest they just be reimposed over an unrelated issue six months from now). Most notable, three weeks ago, Washington launched the process of starving Chinese telecommunications giant Huawei of critical U.S.-made components.

In short, both sides are digging in. But we still believe conditions are ripening for a partial deal on trade that ends tariffs. If and when it comes, it will hinge foremost on two of the trickiest geopolitical elements to forecast – the exact timing of the next U.S. recession and the mood of U.S. voters ahead of the next election.

Going Big on the Tech War

In our 2019 forecast, we said Washington would settle for a trade deal with China that would do little to address core U.S. concerns or ease bilateral tension. The underlying logic was fairly simple: Caving to core U.S. demands would be more painful for Beijing than unilateral U.S. tariffs, limiting Chinese concessions largely to things it needs from the U.S., or reforms it wants to push forward anyway. It would quickly become clear what tariffs could achieve in the short window before the 2020 campaign season kicks into high gear. And the economic and political costs of the duties would compel Washington to accept a lesser deal and shift focus to a more targeted, defensive strategy – one wielded with non-tariff measures – to blunt Chinese technological threats.

The U.S. is indeed going big – very big – against Chinese tech with non-tariff measures, and there’s little incentive for it to back down anytime soon. Unlike its effort to curb Chinese trade practices, the U.S. doesn’t need Chinese concessions on the tech front. In fact, there’s not a lot that China could do to ease U.S. concerns. The U.S. can’t, for example, trust Chinese pledges that it won’t use Chinese telecommunications infrastructure to spy on foreign governments or threaten U.S. military logistics networks. Nor can it trust Chinese pledges to refrain from channeling state support to its tech firms. (China won’t concede this, anyway.) There’s just not much to negotiate, meaning the U.S. doesn’t need to seek leverage through measures like tariffs that harm the U.S. economy as well.

Rather, the U.S. can lean on unilateral moves to protect its own networks and blunt the creeping dominance of Chinese firms like Huawei. The U.S. doesn’t have to ask for permission to ban Chinese tech from U.S. networks or to impose more stringent reviews of Chinese investment, the hiring of Chinese scientists, and China-backed research undertaken at U.S. universities. And since Huawei is fully dependent on certain U.S.-made chip designs, semiconductors and software, U.S. export controls may cripple the firm for good.

To fully address its tech concerns, the U.S. likely will still need to persuade allied countries to ice out Chinese telecommunications firms, which is proving to be a tough ask, since doing so would hinder their own telecommunications development and risk Chinese retaliation. And unilateral U.S. measures will still carry costs and risks. Loss of access to the Chinese market, for example, will certainly sting for U.S. tech firms, even if the Chinese firms buying U.S. tech are emerging as long-term competitors. Loss of collaboration between Chinese and U.S. firms will hinder the development of new technologies and drag on global growth. And Chinese retaliation by, say, banning rare earth exports will be highly disruptive, at minimum. Moreover, if the effort to deprive Huawei of critical chip technologies leads to the development of homegrown Chinese alternatives, then the U.S. could inadvertently accelerate China’s rise to telecom dominance. Nonetheless, there’s broad, bipartisan recognition in Washington and some allied capitals that Chinese tech poses enough of a threat to make the potential costs worth bearing.

Rising Costs of the Trade War

The picture is quite a bit different in the U.S. offensive against abusive Chinese trade practices. This is why, despite the events of the past month, there’s still hope for our forecast that a deal removing tariffs gets done.

Most likely, the White House will blink first, given the economic and political toll the tariffs will take on the United States. The U.S. tariffs alone won’t tip the economy into recession. If the current 25 percent duties on $250 billion in Chinese goods remain in place, most estimates expect an annual 0.3 percent-0.5 percent hit to gross domestic product and the loss of up to a million jobs. In a vacuum – in a $20 trillion economy humming along at the peak of the business cycle and boasting historic lows in unemployment – this would be manageable.

But the U.S. has been overdue for a downturn, anyway, and the tariffs are certainly capable of accelerating its arrival. Before the announcement of the Mexico tariffs and the threat to tax another $300 billion in Chinese goods, the Fed said it was expecting growth to slow to 2.1 percent this year, down from 2.9 percent last year. The yield curve is showing signs of inverting, and private sector hiring plummeted in May. If the White House follows through with its threat to more than double the value of Chinese goods getting taxed – and stays the course on monthly tariff increases on Mexico – the slowdown will be all the more pronounced. The trade war will inevitably hit the U.S. economy in other ways as well, including by saddling U.S. firms that have manufacturing operations in China with added costs, by closing opportunities for U.S. exporters to the world’s second-largest consumer market, by raising the cost of consumer goods in the U.S., and by pinching off Chinese investment that has created millions of jobs in the U.S.

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Indeed, a slew of recent studies, including one by the International Monetary Fund, have made the case that the bulk of the U.S. tariffs thus far have been passed on to U.S. firms and consumers. The Fed, meanwhile, found that the 2018 tariffs imposed an annual cost of $419 for the typical household. It expects the jump in May from 10 percent to 25 percent tariffs on $200 billion in Chinese goods to raise this figure to $831 per household. And there’s growing evidence that a healthy majority of the U.S. public doesn’t believe President Donald Trump’s claims that, actually, it’s China that is eating the full cost of the taxes on its imports.

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In general, polling on trade has been pretty volatile, but the White House’s trade policies have typically fared poorly. It’s not unreasonable to assume public attitudes will sour further as costs mount. If Trump slaps tariffs on yet another $300 billion in Chinese goods, it’ll target consumer goods that have thus far largely been spared. The sticker shock of the trade war will be impossible to hide. And in the American system, where aggrieved interest groups like farmers, automakers and retailers can dominate media attention and wield outsize power in the legislature, the impact of tariffs is likely to be magnified further.

Diminishing Returns

None of this would matter if the tariffs were bearing fruit in the Trump administration’s two main goals: extracting major concessions from China and bringing jobs back to the U.S. But these don’t appear to be the case. Rather, while the costs of U.S. tariffs are increasing, the returns may be diminishing. Beijing, as a result, appears to believe that it can instead hold the line until the U.S. reaches the conclusion that the political and economic costs of tariffs have outpaced their utility.

The tariffs have succeeded in sharply reducing exports from China, but according to the IMF, third countries have been the biggest winners. Of the estimated $850 million in Chinese exports lost between August and November compared to a year earlier, less than $100 million were offset by U.S. producers in targeted industries. And as noted, China itself is paying only a fraction of the tariffs on its exports that are still flowing to the U.S., with little evidence that Chinese firms have had to lower prices to account for the tariffs. Meanwhile, the depreciation of the Chinese currency caused by the trade war has further mitigated the impact on Chinese competitiveness. Beijing has also made good use of tools like tax cuts and subsidies for affected firms, stimulus, and transshipments through third countries to circumvent tariffs. As a result, there’s been scant evidence that Beijing is willing, much less preparing, to back down on core U.S. demands for changes to the state’s role in the Chinese economy. If anything, it’s going the other direction, intervening more forcefully to manage the fallout of the tariffs. The political and economic risks of a rapid liberalization in line with U.S. demands are just too high.

This doesn’t necessarily mean Beijing has the upper hand. China’s ability to shrug off tariffs in the short term notwithstanding, its immense structural economic problems and rigid political system give it less room for maneuver over the long term. The effect on Chinese firms of the 15 percent increase in tariffs in May isn’t yet clear, and tariffs on another $300 billion in Chinese exports will certainly make Beijing nervous. But to push China to full capitulation, the U.S. would have to keep extremely high tariffs in place for an extremely long time. Moreover, if Beijing concludes it can’t stomach yet another U.S. escalation, we’d expect it to just agree to whatever makes the tariffs go away and then stall on implementation or renege later. The U.S. doesn’t have many good options for ensuring that Beijing follows through with its pledges.

If the overriding U.S. goal is to fundamentally blunt China’s rise and decouple the two economies, then it wouldn’t make sense for the U.S. to strike any deal that’s reasonably attainable in a short timeframe, costs be damned. All wars, whether fought with tanks or tariffs, have immense costs, and yet countries fight them anyway when they think they have to. At minimum, from a tactical perspective, the U.S. needs Beijing to believe in U.S. resolve to keep tariffs in place as long as it takes to force a capitulation. But the outlines of the draft deal that had emerged before talks collapsed suggested the U.S. was willing to settle for far less than full capitulation – reportedly dropping even core demands on state subsidies and cybersecurity – betraying an urgency to keep political complications from tying its hands.

Ultimately, what strikes a chord with U.S. voters ahead of 2020 is unpredictable. But if the downturn comes before then, it’s reasonable to assume that the Democrats will do everything possible to pin the blame on Trump’s tariffs for accelerating it – however valid this line of attack. Of course, Trump would also presumably get flack from some sectors for backing down. But trade policy is esoteric. It’s far easier to declare victory around a limited deal that removes tariffs and mutes criticism from affected industries than to defend a damaging fight that has yet to bring Beijing to heel or restore U.S. manufacturing’s lost glory. As it stands, there’s certainly enough Chinese concessions on the table to fill a stump speech. Besides, as noted, the tech war isn’t going away, nor are U.S.-China tensions over myriad other flashpoint issues. Trump will still have plenty to point to when claiming to have made good on his 2016 campaign pledge to get tough on China.

Of course, if the economy holds, tariffs could stay through the election, and the key variable in the trade war will once again become Beijing’s ability to hold out. But costs are constraints, and the U.S. won’t ignore them forever. Eventually, the U.S. will turn to a more targeted, defensive strategy for managing challenges posed by China’s rise.

Phillip Orchard
Phillip Orchard is an analyst at Geopolitical Futures. Prior to joining the company, Mr. Orchard spent nearly six years at Stratfor, working as an editor and writing about East Asian geopolitics. He’s spent more than six years abroad, primarily in Southeast Asia and Latin America, where he’s had formative, immersive experiences with the problems arising from mass political upheaval, civil conflict and human migration. Mr. Orchard holds a master’s degree in Security, Law and Diplomacy from the Lyndon B. Johnson School of Public Affairs, where he focused on energy and national security, Chinese foreign policy, intelligence analysis, and institutional pathologies. He also earned a bachelor’s degree in journalism from the University of Texas. He speaks Spanish and some Thai and Lao.