U.S.-China Trade Impasse: For Washington, Now is Not the Time to Blink

June 10, 2019

What a difference a few weeks makes. In late April, optimism about a looming U.S-China trade deal permeated the spring air. Stock markets were upbeat, and press reporting confident. Then, in early May, Chinese negotiators unexpectedly (or maybe expectedly) backtracked on previously settled commitments for structural reforms. Beijing is apparently no longer willing to change domestic laws covering intellectual property theft, forced technology transfer, currency manipulation, market access, financial services, and subsidies. It now argues that this is a matter of Chinese honor and principle. Per this thinking, America should trust China to make the changes it said it would make, even if that means changing regulations rather than changing laws. In other words, trust us to comply, there is no need to verify our compliance, and we’ll call it … insulting if you do.

Within days of Beijing’s ill-advised diplomatic cable riddled with reversals on core U.S. demands and stripping away the all-important binding language, U.S. President Donald Trump swiftly and forcefully responded to the backsliding. He increased tariffs on $200 billion in Chinese goods from 10 to 25 percent, and threatened to levy 25 percent tariffs on an additional $325 billion worth of goods if Beijing continues to negotiate in bad faith. Chinese President Xi Jinping modestly retaliated in kind a few days later with increased tariffs on $60 billion of U.S. goods and the threat to increase tariffs on the remaining $60 billion in U.S. exports to China.

So, what does all of this mean? Why did China precipitously scuttle the supposedly looming trade deal? What are Beijing’s options moving forward, and what are Washington’s? As the dispute protracts and both sides feel the increasing effects, who will blink first?

Chinese Brinkmanship — or Miscalculation?

The simple answer for why China suddenly backtracked on settled grounds may be that it got too greedy and wanted to renegotiate parts of the deal in the hopes of ending the trade impasse with the fewest concessions possible. This would be consistent with past Chinese negotiating practices of taking a deal entirely off the table at a critical juncture, as I discussed in War on the Rocks in January. It is a classic Chinese backslide intended to remind U.S. counterparts just how much they need the deal and can’t afford to come up empty-handed; give the Chinese negotiation team an opportunity to gauge the U.S. reaction to its latest maneuvers; and frustrate U.S. negotiators into a compromise offer that meets Beijing halfway. True to form, Beijing followed its eleventh-hour gambit with demands for a “fair and dignified” trade agreement — specifically, lifting all additional tariffs, establishing realistic procurement expectations, and ensuring that the text in any deal is balanced and acceptable to the Chinese people without undermining the sovereignty and dignity of China (a deliberately ambiguous and open-ended condition).

Xi may have miscalculated the nature and timing of the brinkmanship. As the trade talks wound down in late April and early May, he may have been unwisely swayed by a transitory and possibly illusory pickup in Chinese economic growth and a wishful forecast that the U.S. economy was about to enter a down cycle. Xi may have also misjudged Trump’s public criticism of the U.S. Federal Reserve and desire for lower interest rates as signs that his American counterpart was worried about the future trajectory of the U.S. economy and therefore perhaps more inclined to make a deal before the run-up to next year’s presidential election cycle. The Chinese leader may have thought he had a window of opportunity to push back against the growing domestic political backlash that he was perhaps conceding too much to Washington.

Beijing’s Options — and an Underlying Dilemma

A number of trade options may be under consideration in Beijing. However, due to the skewed U.S.-China trade balance ($525 billion Chinese imports versus $120 billion U.S. exports), shaky Chinese economic structures, slowing economic growth, and ongoing fiscal crises, these options could hurt China’s own economy more than America’s.

(1) Increase and broaden the tariffs to include U.S. imports that have not yet been penalized like semiconductors and Boeing aircraft.

(2) Put additional trade pressures on the U.S. constituents who supported Trump in the 2016 election, like farmers.

(3) Delay imports from the United States through additional regulatory actions. U.S. corporations in China are already experiencing slower customs clearances, more inspections, and delayed approvals for licenses.

(4) Raise the costs and risk of doing business in China for vulnerable U.S. corporations like Apple. China represents 19 percent of Apple’s worldwide sales, with the iPhone making up the bulk of that. Beijing could place constraints on and limit access to Apple’s retail stores, require Apple to use different or approved components such as domestic Chinese chips, and even more drastically, ban the sale of iPhones in China using the same “national security” justifications that the United States is using against Huawei.

(5) Conduct a tit-for-tat exchange. Beijing recently stated its intent to create a blacklist of foreign entities — composed of foreign companies, organizations, and individuals that harm Chinese businesses, in apparent retaliation for Washington’s blacklisting of Huawei.

(6) Link the outcome of the trade issue to other China-U.S. bilateral issues — North Korea, Taiwan, South China Sea, opioid epidemic, military engagements, and so forth.

(7) Encourage Chinese consumers to boycott American products and services, along the lines of last year’s boycott against South Korean products and services over the Terminal High Altitude Area Defense missile system deployment.

(8) Hinder the global supply chain by restricting Chinese parts and components to American manufacturers to include the export of rare-earth minerals and materials, as hinted by Xi’s timely visit to a Chinese rare-earth facility in late May.

(9) Devalue the renminbi, offsetting the cost of higher tariffs and making Chinese exports less expensive and more competitive in U.S. markets.

(10) Unload $1.1 trillion holdings in U.S. Treasury bonds to target the U.S. financial system, the backbone of the U.S. economy. China recently sold $20 billion in U.S. debt, stoking fears that Beijing may weaponize the U.S. Treasuries.

Beijing faces a policy quandary. These options share underlying risks and underwriting costs that favor America over China. Moreover, the latter five options are likely to have enduring and unintended political and economic consequences. First, linking the outcomes of the trade talks to other bilateral issues is a slippery slope for Beijing. Expansion complicates and lengthens negotiations and increases later risks and costs. If the outcomes are favorable, Beijing gains leverage on the other issues. If not, it will lose ground to Washington — a big gamble considering the Trump administration’s assertive approach to national security.

Second, boycotting U.S. products and services invites a big backlash from Washington that Beijing cannot afford or withstand for long considering the skewed U.S.-China trade balance. China needs access to U.S. markets and technologies much more now than the other way around. There is also a high risk that U.S. consumers may realize that they do not want or need Chinese products as much as they did in the past, particularly if cheaper alternatives (Vietnam, Indonesia, Malaysia, others) will fill the gap in the future.

Restricting the export of rare-earth minerals and materials to the United States may not be as effective as Beijing hopes or Washington fears. An embargo could accelerate existing global diversification measures; reinforce the narrative that China-based commodity supply chains are intrinsically unreliable; encourage U.S. corporations to reconsider China-based sourcing more broadly; and lead to harsher U.S. restrictions on the exports of semiconductors and other critical technology subcomponents that many Chinese firms need to operate. Ultimately, U.S. consumers of rare-earth minerals and materials can diversify their sources, adapt their production processes to use less, incorporate alternatives, and/or reprioritize key sectors — like defense — until alternative supplies become available.

Devaluing the renminbi to undermine existing U.S. tariffs and give Chinese factory owners an advantage when they sell their goods in the United States may seem attractive on paper, but as history shows, there is a long-term price to pay. In 2015, as the Chinese economy slowed, Beijing devalued the renminbi to stem the decline. Consequently, markets plunged, and as Chinese officials hurried to explain the move, people and corporations began to shift their money outside of China. Beijing was forced to expend more than $500 billion of its cash reserves to shore up the renminbi, curtail the capital flight to the United States, and keep the money that the Chinese economy desperately needed for sustainability.

 

 

Finally, weaponizing the positive-yielding U.S. Treasury bonds is the most dangerous and unlikely course of action that China could undertake, considering the main alternative Japanese and German bonds are negative-yielding. So, it makes little sense for Beijing to dump its U.S. holdings when the current outlook for the booming U.S. economy suggests the bond prices will increase over time. Hence, ditching debt would likely backfire on Beijing, and could wind up damaging China more than the United States at a time when Beijing already faces the challenge of rebalancing a slowing and highly indebted economy.

A Guide for Washington

When trade talks restart, Washington should consider the following 10 principles to bring about an enduring U.S.-China trade deal that will favorably redefine bilateral relations between the world’s two largest economies:

(1) Do not blink. Keep cool and do not let Chinese brinkmanship or public bravado detract from U.S. core interests — Chinese structural reforms with compliance measures, balanced U.S.-China trade, and an enduring and equitable bilateral relationship.

(2) Do not settle, do trust but verify, and do establish and institutionalize enforcement mechanisms when it comes to Chinese structural reforms.

(3) Demand transparency. Publish the complete trade agreement vice just the summary as Beijing has insisted in the past. Full public disclosure will discourage non-compliance.

(4) Be prepared to expand (that is, escalate) the trade dispute horizontally. Beijing fears multilateral cooperation and economic isolation (decoupling). If Xi continues to delay and prolong talks to test Trump’s resolve, encourage allies and partners to strengthen support for, or better yet, join in on the tariffs. Marshal a consensus of like-minded nations to persuade Beijing to make structural changes that contribute to the global economic order and dissuade China from trying to change the global status quo.

(5) Be prepared to expand and escalate vertically as well. If Xi continues to delay and prolong talks to test Trump’s determination, go forward with raising tariffs on the remaining $325 billion in Chinese imports. A full-blown trade dispute could cut China’s economic growth rate by 2 percent over the next 12 months. By contrast, if Beijing retaliates fully, a 25 percent tariff extended to all of China’s exports to America could deliver a 0.5 percent reduction to next year’s projected level of U.S. gross domestic product, currently annualized at 3.2 percent.

(6) Play both offense and defense. Continue pressuring other fronts to complicate Beijing’s strategic calculus like promoting ties with Taipei and supporting the 2020 Taiwanese presidential election, contesting the disputed South and East China Seas and Taiwan Strait, increasing pressures on North Korea, challenging the expansive Belt and Road Initiative, targeting Huawei and ZTE Corporations, countering United Front activities at home and abroad, and calling out Chinese human rights abuses. Continue buttressing targeted U.S. economic sectors like agriculture to offset China-related trade losses.

(7) Maintain the home-court advantage for future trade talks but pick a neutral signing location. The upcoming G20 Summit is a good opportunity to break the trade impasse in terms of time and space. June 28–29 is a viable target date for U.S. and Chinese negotiators to possibly restart and strike a trade deal before Trump and Xi meets again. The location in Japan gives Xi an opportunity to save face with the Chinese Communist Party’s (CCP) and the Chinese people.

(8) Prepare contingency plans in case Beijing attempts to further delay the trade talks until after the 2020 U.S. election in the hopes of a new and more pliant U.S. administration. Impose increasing costs on China and set the conditions to dominate the negotiations post-election when Beijing will be more eager to cut a trade deal. China can probably withstand one more year of a trade war, but certainly not four. Counter Beijing-sponsored United Front activities to influence U.S. popular perceptions and opinions, and further reduce China’s waning influence amongst political, corporate, and academic elites who themselves may be suffering now from “China’s promise fatigue.” U.S. Director of National Intelligence Dan Coats undertook a recent series of classified briefings to U.S. technology companies, venture capitalists, and educational institutions to highlight the risks of trade with China (focused on the threat of cyber-attacks and intellectual property thefts). This was another step in the right direction. Expect and mitigate Chinese “sharp power” efforts to infiltrate and undermine U.S. politics by misrepresenting or manipulating information to quell policy dissent and dialogue within Washington, particularly during the months leading up to the election.

(9) Take and hold the information high ground by dictating the strategic narratives. Respond strongly, unambiguously, and credibly to the intensified Chinese media campaign and information operations activities. Counter Beijing-directed anti-American themes pervasive across Chinese media and diplomatic channels — America is negotiating in bad faith and refusing to compromise, the trade deal is a matter of Chinese honor and principle, and another case of U.S. bullying and trying to contain China’s peaceful rise and prevent China from assuming its rightful place in the world. Challenge the just released Chinese white paper “China’s Positions on the China-United States Economic and Trade Consultations” and the talking points therein.

(10) Speak with a unified, bipartisan government voice. Senate Minority Leader Charles Schumer’s public support of Trump on this issue — “unfortunately, previous presidents, Democrat and Republican, just stood by as China did what it did to us…President Trump is exactly right” — is a step forward. Former Assistant Secretary of State Susan Thornton’s public statement in Shanghai — “China can weather the storm brought by the trade war with the United States but might have to keep steady, keep their heads down, and wait for change in the White House” — is a step backward.

All in all, U.S. negotiators should view the trade conflict in its wider geo-strategic context. The dispute is driven by five forces: the CCP’s foremost priority is the preservation of its political authority and legitimacy; the cultural and political imperative to save face for the CCP and as a nation; the notion of continuous negotiation; cultural respect for strength and resolve and conversely disrespect for weakness and vacillation; and the perception that Washington has a short attention span, lacks follow-through, and is inconsistent on policy matters. More broadly, the dispute represents a fundamental clash between two radically different economic and political models, and is part of a wider strategic competition for global pre-eminence.

In hindsight, letting China into the World Trade Organization back in 2001 did not work out as envisioned. China was supposed to further develop, follow the rules, become more democratic, and fully join the family of nations. Instead, Beijing feels disadvantaged by a biased, Western-dominated system of international organizations and rules established when it was weak and had little say in that system’s formulation. The new strategic message being peddled by Beijing downplays China’s benefits from the extant world order, and seizes on the nationalistic narrative that China’s rapid development is the “outcome of the Chinese people’s endeavors under the leadership of the CCP to promote reform and opening-up and build a modern, strong, and prosperous country.” Beijing views the U.S.-led world order as incompatible with its aspirations for global pre-eminence. Hence, it is trying to change the status quo from within these international institutions. 

Who Will Blink First?

A comparative analysis of both countries’ economies suggests China may blink first. A review of U.S. economic data shows a robust economy steaming ahead since the start of the trade dispute. The much-feared negative impact, if any, has not yet materialized. On the contrary, the unemployment rate of 3.6 percent is at the lowest level since 1969; wage growth of 3.6 percent is at a ten-year high; inflation remains at a low 2.0 percent; and current economic growth is entering its eleventh year.

On the other side, things are not as rosy if current reporting is accurate. The Chinese economy has significantly slowed down as evidenced by the falling currency, mounting unemployment, growing inflation, rising food prices, increasing capital flight, worsening banking and real estate crises, and swelling domestic and international debts. Following these declining trends, the more the dispute drags on, the more disadvantageous and tenuous China’s economic position may be, as evinced by a growing number of U.S. corporations leaving China; U.S. authorities cutting off more critical technologies to Chinese corporations; increasing advocacy to curb China’s access to Wall Street; global corporations reducing their dependence on Chinese factories to make the world’s goods; and a recent desperate attempt by Beijing to jawbone U.S. corporations from cooperating with the Trump’s administration ban on sales of key American technology to Chinese companies.

That being said, human nature and politics may dictate a different outcome. Beijing may have hardened its position, as demonstrated by Xi possibly preparing the populace for a protracted trade war or another “Long March.” Xi faces a difficult personal and political dilemma. He must choose either to protect his carefully cultivated aura of political invincibility and preserve national and personal pride or temporarily give up ground and avoid a punishing, protracted trade dispute. If he chooses the former, he will risk long-term economic fallout and put at risk the much-cherished “Chinese Dream” that he has embraced as his own. If he chooses the latter, he opens himself up to easy criticism by his political opponents for conceding too much to Washington. Either way, the stakes are high. China’s relationship with the United States is its most important, and if bilateral ties are mismanaged, it could damage China’s economy and undermine Xi’s political standing within the CCP as well as his political authority and legitimacy with the Chinese people. At risk is his mandate of heaven.

U.S. negotiators would be well-served to heed Chinese promises, both public and private, when the trade talks restart. More often than not, Beijing gives expedient guarantees during negotiations but rarely gives much that is substantive and enduring in the end. Instead, Chinese negotiators make grandiose gestures and empty promises to move negotiations along and buy time and space to set the conditions for realizing their long-term goals after the talks. For the Chinese, signing a contract is merely the start of the real negotiations.

At the end of the day, Xi will fail to keep his promises to Trump unless he is forcefully, consistently, and persistently encouraged or coerced to do so. Talk without the support of action means nothing and enforcement will be the key to any deal. U.S. negotiators should keep in mind that Beijing needs continued access to U.S. markets, technologies, and innovation to sustain its economy and facilitate its Chinese Dream of national rejuvenation. So, be calm and resolute and play the long game. It will be much more difficult to moderate bad Chinese behavior or seek additional structural changes once the trade deal is signed.

 

 

Tuan Pham is a seasoned China watcher with over two decades of professional experience in the Indo-Pacific and is widely published in international relations and national security affairs. The views expressed are his own.

Image: White House photo by Shealah Craighead