US-China Trade Conflict: The Fifth Thucydides Trap

As I write this, the US and Chinese markets have ticked up by 1 percent each reflecting the comments from US President Donald Trump, who claims to have had a “productive conversation” with his Chinese counterpart Xi Jinping ahead of the G20 summit later this month in Buenos Aires.

Yet, such comments are unlikely to dispel the scepter of the ‘Great Institutional Conflict’ that is likely to play out between the US and China in coming decades. As expected, both parties have agreed to keep talking without agreeing on much, something that will sound familiar to watchers of India-China trade talks as well.

Studying business in Shanghai at this point is quite an experience – perhaps in no other country does doing business involve cultivating such a deep understanding of the state and its broader policies given the state influence, if not outright control, over the business. Most importantly, being here, you get to understand local business executives’ and academics’ perspectives on global economic and policy issues, which are much more conciliatory and enlightened than the patriotism on display in the media.

This post, however, is not about policy making in China. I will focus on the current US-China trade conflict in a broader context, and how we can expect this to play out in the markets in the immediate and long term.

Firstly, I believe US-China trade talks will once again become the dominant narrative for the movement in global equity markets as the US Federal Reserve’s comments last week more or less left the markets unsurprised about the pace of rate hikes. The S&P 500 index has lost about 1.5 percent since the first announcement regarding trade tariffs on Chinese imports by the Trump administration in late February.

The bloodletting in the Chinese stock market, though, has been more dramatic with the Shanghai A-Shares index down more than 19 percent since the beginning of the US-China Trade War. The reluctance of the Chinese Government, at least in the early part of this year, to open the fiscal and monetary floodgates to stimulate the economy the way it had done in 2009 and in 2015, may also have had some role to play in the market’s underperformance.

Markets have calmed this week on hope there will be some meaningful resolution of trade disputes between China and the US as their leaders prepare for specific negotiations and conversations on the sidelines of the G20 meeting. In the absence of such results, the dominant narrative of a looming US-China trade war, with its accompanying uncertainties, is likely to continue weighing on the global equity market, especially as we move closer to the primaries of the US Presidential elections, which will begin in earnest next year.

That said, to consider the current US-China trade war in terms of a petty disagreement about the level of trade balance between the US and China is trivial. We must look at it in the context of a broader institutional conflict between the US and China over their worldviews on trade and corporate control.

In my view, the recent trade tariff measures by the US will do little to support the domestic industry. The nature of highly specialised, capital intensive global supply chains implies tariffs on Chinese goods are likely to be passed on to US consumers in terms of higher consumer prices. In a research report on the US Trade War, Goldman Sachs’ Jeff Currie and Hui Shan note President Trump’s tariff hikes will not produce the same effect on Chinese imports as in the 1930s, when similar measures were introduced to protect the US industry from European exports under the Smoot Hawley Act.

Since the 1930s, US production of metals and machinery has become highly capital intensive and dependent on intermediates from across the world (just 40 percent of product value is added inside the US).

Uncertainty in global demand and possible retaliation in trade measures by other countries where US supply chains are located are unlikely to encourage US firms in this sector to increase capex or production, ultimately passing on higher tariffs to consumers. Furthermore, given that some key American allies in Asia Pacific (South Korea, Taiwan, Thailand, Japan) are also vital contributors to China’s supply chain, imposing tariffs on imports where China itself adds relatively lesser value may end up collaterally damaging the economic interests of its allies.

On the other hand, China’s threat of reciprocal tariffs on US agricultural products, which are highly localised and where little value is added in a global supply chain (87 percent gross value add is within the US), could be more effective, sharply impacting exports from agricultural mid-western and prairie states, which had overwhelmingly voted for President Trump in the 2016 Presidential elections.

Loss in employment opportunities as a result of China’s actions could have adverse electoral impact on the Republican Party in the 2020 Presidential elections.

The current tariff measures by the US undermine the authority of the WTO as the Trump administration has failed to specify the reasons (hidden subsidies, deliberate dumping) for hikes on Chinese exports, or provided any evidence. “Cheating” by a vital founding member of the WTO creates incentives for other members to act on selfish national interests as well, unraveling the global trade order. That said, the US can still address its trade imbalance with China.

Firstly, President Trump should ask for a reduction in asymmetry in tariffs that China imposes on cars (22.5 percent higher than the US), heavy vehicles (20.2 percent higher) and grains (17.6 percent higher). The WTO provides mechanisms such as countervailing duties and safeguard action to address these issues, which should be the preferred course of action.

Reduction in tariffs by China for US exports, or even America’s promotion of the traditional manufacturing and commodity-based industry, is unlikely to resolve the problem of underemployment and the threat of job loss to outsourcing. Owing to the still-high labour costs and delays in adopting best manufacturing practices in the world, the US does not have the competitive advantage in manufacturing vis-à-vis the world.

And what is true of the US, is also true of other developing countries. Manufacturing is inherently less-skill intensive, requires scale advantages to produce higher operating margins and cannot disproportionately grow if one hires more creative people; all of these aspects remain stacked against developed countries.

As global supply chains become more advanced due to better shipping facilities, and markets become larger, manufacturing jobs are bound to shift away from the US, if not to China, then maybe to South Asia and Africa.

A big argument missing in the debate around the merits of globalisation is that it is lopsided globalisation that has created miserable conditions for the working class in developed countries. While we have seen a massive expansion in global supply chains for goods and outsourcing of manufacturing, which have advantaged developing countries, a similar easing of regulation has been missing in the services sector, where non-tariff barriers (freedom of movement of people, varying standards and licensing) have prevented developed countries and some developing country exceptions (India) to take full advantage of globalisation.

Ergo, while China sits in the globalisation game at an advantageous position, the US loses out because its strengths are not allowed to be introduced in the game.

Liu, Nath and Tochkov (2015) show that the US has a strong comparative advantage over China in education, healthcare, financial and business services - sectors which are strongly regulated or are de facto closed to foreign investment in China.

By proposing a comprehensive services trade agreement between China and the US (like the proposed Trade in Services Agreement between the US and EU), the US President can bind President Xi to his commitment towards opening China further to globalisation, and steer the US-China trade conflict dialogue towards constructive solutions. Opening up of services trade between the two countries will also help China in adopting best practices to move its economy away from manufacturing, as envisaged in its 13th Five Year Plan.

On the other hand, rather than embarking on a vitriolic propaganda about US and western interests being jealous of China’s rise, as their reflex response is, the government authorities in China must understand that disputes about trade talks are unlikely to be resolved simply by showing the US the folly of its own breaches against WTO. The broad support that the US President’s China policy has gained hints that there is much more than trade at stake in the current dispute – it has much to do with the model of State Capitalism that is China’s recipe for economic success, which is perceived as a fundamental threat by the US to its strategic interests.

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It is important to give some context about how the state links to the corporate in China. The State-owned Assets Supervision and Administration Council (SASAC) controls more than half of the Fortune 500 companies from China, including those in power, telecom and commodities sectors. It is the largest economic entity in the world, and while it does allow the controlled companies to make day-to-day business decisions independently, it is responsible for appointing top executives, approving sales and acquisitions of assets.

The last published data shows that over 60 percent of outbound foreign investments in China were made by SASAC-owned companies in 2016. The rest was made by non-SASAC-owned firms, which are still required to have a Communist Party cell within the firm.

Mind you, there is nothing malicious in this description. The way China organises its corporate system is evidenced on its economic success and that of a similar formula followed by countries like Singapore. The presence of the Party, in this context, should be understood of any political controlling mechanism in a Single Party state. The accusations of inefficiency or the predictions of doom that non-Chinese analysts make when they hear of Communism are at least far from the fruition, at least in China’s case. Be that as it may, this system is incompatible with the model of economy and business that emerged in the late 20th century as a result of the Washington Consensus – of a liberal free market economy.

Naturally, the indirect control the Chinese government retains through SASAC-ownership or Communist Party presence in Chinese firms doing business even in the US, raises the question of China’s interference in US national security matters.

Indeed, the way in which Russian hackers allegedly compromised the US Presidential elections – through social media networks like Facebook – has raised the public sensitivity towards FDI that could potentially be used to weaponise data or damage critical infrastructure.

There is a possibility that trade tariffs could merely be symbolic of an overall break in US-China trade relations, especially if President Trump carries out his threat of further tightening the rules on Chinese FDI in the US.

An amicable and generous solution by China should necessarily involve providing assurances of keeping an arm’s length relationship between the state and private firms operating in the US and obeying American data privacy laws. However, in my view, the government in China is unlikely to spend its political capital in resolving such deeper issues that underlie the US-China trade relations.

“Thucydides Trap” is a term coined by noted American Political Philosopher Prof Graham Allison at Harvard, who described it as a situation when a rising power causes fear in an established power, which quickly escalates into a war.

The term itself refers to the actions of Sparta in the mid-5th century BCE, after witnessing the rise of the Athenian democracy, which led to the Peloponnesian War. Since then, the world has witnessed at least four instances – The War of Spanish Succession, The Thirty Years War, the US Civil War and the First World War – where actions taken by a reigning global hegemon have escalated into long-drawn conflicts as the rising challenger confronts them with retaliatory actions.

As things stand now, given the military might of the US and the geographical impregnability of China, extrapolating the current US-China trade war to be a prelude to a military conflict would probably sound like a paranoid exaggeration. That said, the first phase of this long-term institutional conflict means that any cooperation between the two parties is likely to remain conditional, with rivalry and trade tensions being the norm.

In the next part of this article, I will try to evaluate where India could position itself between these two likely permanent rivals, both of which are vital to our national interest.

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