Why China ‘holds all the aces’ in a full-blown US-China trade war
On Friday the Trump administration announced it will impose a 25 percent tariff on up to $50 billion in Chinese goods in an effort to protect U.S. intellectual property and technology. The decision brought an immediate backlash from Beijing. China in retaliation said it will introduce taxation measures of the same scale and strength. As the world’s two superpowers inch closer to a trade war, market experts are asking: Is this a game the United States can win?
I suspect the real answer is twofold: In part, the president wants to be seen as reversing the loss of jobs and intellectual property to China between 2001 and, say, 2010. But since that horse has left the barn, he needs some other animals to round up.
His stated objective is to reduce the size of the U.S–China trade deficitfrom an estimated $370 billion to $200 billion by 2020.
There are two obvious ways to play this: (1) China could buy more U.S. goods and services, and/or (2) America could buy fewer Chinese goods and services. Both come with drawbacks for the U.S. economy and the American people. It is hard for U.S. companies to ramp up to export more to China when they are operating at full capacity and have close to no unemployment.
But before evaluating the policy prescriptions for this problem, we must first consider the starting point, which is flawed. The current $370 billion deficit estimate does not account for value-added. When looking at the value-added content of Chinese exports, the U.S. deficit with China is actually only half of what it seems. And if we then add back the U.S. surplus in “invisibles” and how much money the United States brings back from investments in China, the U.S.–China deficit shrinks from 2 percent of U.S. GDP to 0.8 percent, a report from Oxford Economics revealed.
In the case of the Apple iPhone, this means that China’s exports balance accounts for the full $500 iPhone value, when China adds only approximately $15 to $30 of the value to the phone. Most of the iPhone value accretes to Samsung in Korea ($150) and to Apple — the brand owner and engineer. This highlights how the normal accounting of trade flows is inherently distorted under the current trade-deficit estimates. So maybe the deck has only 25 not 52 cards.
The iPhone example also points to an area of weakness in the president’s policy prescription: If the United States introduces tariffs on China’s high-tech goods, U.S. companies and consumers could indirectly end up footing part of the bill. This is because the high-tech industries that Trump’s tariffs are focused on is where Chinese value-added has the lowest share. If Trump were really interested in impacting the true trade imbalance and not just the misleading headline estimate, he would introduce tariffs on those sectors where China’s value-added is highest. This would include sectors like textiles, where 75 percent of value-added is really “made in China.”
This brings us back to the president’s other objective, which is to gain political credit by addressing historical areas of imbalance in the U.S.–China trade relationship. A key area of focus here is China’s appropriation of the intellectual property (IP) of American businesses. This comes from three activities: corporate espionage, cybertheft and technology in exchange for market access.
The latter results from a longstanding Chinese policy that requires any foreign company wishing to do business in China to first form a joint venture with a Chinese firm. A common complaint about these joint ventures is that they open the door for Chinese companies potentially to steal trade secrets and then use that IP to build and grow Chinese industries in everything from cars and phones to medicine.
The U.S. government estimates that these alleged IP appropriations, along with direct corporate espionage, which go back as far as the 1990s, have cost the U.S. economy a lot, somewhere between $225 billion to $600 billion a year. China indeed appears to have been the better poker player.
While these are valid concerns that should be addressed, it’s too little too late. The truth is, China no longer needs these joint-venture rules in many industries, with several sectors and companies already competitive with their counterparts in the United States. In fact, in April 2018 China agreed to ease its rules on foreign auto companies operating in China, a clear signal that the quality of Chinese cars, including autonomous and electric vehicles, is rapidly increasing. It also just announced that foreigners would no longer need specific permissions to invest; they would just be prohibited from investing in a “negative list” of industries.
What is China trying to accomplish?
For China a trade war with the United States is likely to be more like the loss of a five-of-spades than the queen-of-hearts. China exports more than $2 trillion of goods a year, only about $400 to $500 billion of which goes to the United States. (On a value-added basis, only two-thirds of that is “made in China”.) While the United States is indeed China’s biggest trading partner, China has plenty of other markets to sell to, including the increasingly wealthy regions of Southeast Asia and India.
China also has made significant inroads into Latin America and Africa via its funding of major government-sponsored and private infrastructure projects, an investment that could pay significant dividends down the road, since these potential consumers would already be familiar with many Chinese brands.
President Xi Jinping has a longer-term vision for China 2025, which includes a blueprint for moving China up the value chain and increasing the domestic content of core materials in Chinese products. The goal is to lead the world in advanced technologies, like artificial intelligence, autonomous vehicles, electric cars, green technologies and biotechnology.
The early results show this plan is paying off and China is already emerging as a global leader in AI, renewable energy and electric vehicles, among other sectors. This technological advancement is tied to the recent trade talks in that China is increasingly incentivized to protect its own IP rather than trying to steal foreign IP. We are reaching the critical crossover point in China where the return on IP theft is falling toward zero and the return on IP protection may soon rise above zero.
The reality is that many of the Trump administration’s articulated demands are things that China is already doing, albeit at a somewhat slower pace. The United States wants China to buy more American goods and services — and so does China. Trump wants to impose stiff tariffs to prevent China from flooding the American market with increasingly less expensive technological products, like smartphones, computers and related accessories, which collectively comprise China’s biggest exports to the United States. And China agrees — they want to export higher value-added goods, especially those with a high innovation content. Interests are much more aligned than either country wants to admit.
The Chinese government believes the problem they are trying to solve is how to be a vibrant economy over the next 20-plus years and to be the global leader in dynamic industries with technology self-sufficiency.
On the other hand, the United States has not acted as if the problem they are trying to solve is how to create a dynamic economy based on innovation that keeps the United States vibrant over the next 20 or 30 years. It looks a bit more like the United States is trying to improve domestic polling numbers before the midterm elections in November 2018.
Above all else, the Trump–Xi trade shenanigans seem to underscore the different agendas at play here: one oriented toward political posturing and “winning” against a dubious scorecard, and the other focused on economic realities and a long-term development strategy. While the United States will undoubtedly declare victory, China seems to hold all the aces.