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The Yin and Yang of the US-China Relationship

Chimerica always seemed like an oversimplification of a complex and dialectic relationship between the US and China. However, it did express an underlying truth, that China’s rise over the last 40 years has been predicated on Deng Xiaoping’s political and economic reforms and, importantly, the world of free-trade (a reduction in tariff barriers to trade) promoted by the United States.

America seems to hold two seemingly contradictory views about China. Many economists and hedge funds have emphasized the heavy debt burden and excess capacity plaguing numerous industries. Kudlow, the top economic adviser of Trump’s, has scoffed at the Chinese economy, noting that it is weakening while the US is enjoying robust growth. Kudlow and others also point to 15.5%  slide in Chinese shares compared with a nearly 7% rise in the S&P 500 this year as more evidence of China’s underperformance.

The other camp makes it sound like China is about to eat America’s lunch. The yuan is being internationalized and will eclipse the dollar. China’s unfair trade practices have stolen well-paid American manufacturing jobs. It is stealing American technology. Its “Made in China 2025” is nothing short of trying to dethrone the US from the economic heights. It One Belt One Road Initiative seeks to create a Sino-centric world based on debt, trade and investment ties and wants to displace the US.

Some in this camp also emphasize other potential harm China can inflict in the US. There is seemingly ceaseless speculation that China would sell its Treasury holdings, which are over a trillion dollars. Others speculate that China will allow its currency to depreciate to offset the US tariffs.

Ironically both camps tend to support an aggressive confrontation of China. US and European policymakers and press complain that China violates global norms and rules. A recent article in Foreign Policy was explicit. “Many Americans agree that solving the distorted U.S.-China economic relationship is critical. But the answer isn’t to be found in trade alone. The root of this problem is not the deficit, but China’s deeply held belief that it is not beholden to the same rules as other nations.”

Few outside of China dispute these claims. The problem is to find a major country that doesn’t. Chinese policies, as Dani Rodrik, noted in a recent op-ed piece in the Financial Times, that “China’s policies are not so different from those they [US and Europe] embraced while catching up with technological leaders of the time.”

On another level, this tactic is misdirection. For the last 18 months or so, it is the US words and deeds are seen to be violating global norms and rules. From threatening to withdraw from NATO and casting dispersions on Article 5 that commits to a common defense and blocking the appointment of judges to the WTO adjudication panels to tariffs on aluminum and steel on national security grounds, the US has emerged as a powerful disruptive force.

Even in domestic affairs, including comments about the appropriateness of Fed policy and exchange rates, the US President is shown disregard for what has emerged as norms of behavior. To many, American exceptionalism has often meant that the US acted as if it was an exception to the general rules of engagement.

The biggest threat to the multilateral trading system right now is not China, which has never implemented the spirit or the letter of the WTO. It is the United States that seemingly no longer is a proponent of that post-WWII order that it was so instrumental in building.

Abigail Grace concludes her Foreign Policy essay with a spirited defense of that order: “For all its flaws, the post-World War II order has succeeded in making the world a more prosperous and secure place, nominally devoted to liberal democratic values and the inherent worth and autonomy of the individual.” But there is no room for China because its  “political priorities continue to stand in direct contrast to this concept of open governance.” Grace does not recognize that Trump Administration’s efforts to cast the US as a revisionist power has weakened that order by claiming it does not serve US interests.

What is also lost on many observers is that like football or basketball, the violation of the rules has been incorporated into the game itself. Sometimes is it perfectly rational and within the rules to violate them to prevent an opponent from getting an advantage such as a score. The importance of the rule-of-law is not that the law is not broken but that there is a conflict resolution process.

The US has lost many cases before the WTO that other countries have brought against its practices.  It typically wins cases that it brings against others. The US, no more than China, puts the WTO at risk from violating the rules and more than a basketball player fouling an opponent to prevent an easy score puts the game at risk. Instead, the more powerful threat to the WTO and the rules-based system is the US blocking appointments to the conflict resolution mechanism.

Some observers who might otherwise be defenders of free-trade are frustrated by the fact that China is not evolving into more like the US. They say that since everything else has been tried, the new tariffs are the only way forward. We doubt the premise (everything else has been tried, and there has been no progress) and the conclusion (that tariffs will work). Few observers integrate into their analysis that fact that more than half of China’s exports to the US come from factories that are at least partly owned by non-Chinese companies. These are inputs for American manufacturers (e.g., LED devices). Hence Trump’s tariffs on China will hit US and European companies and boost prices for goods impacted, likely washing machines.

The US is attacking the international supply chains, and Trump insists that companies build locally to serve the domestic market. China is defending the international supply chains. Unlike the US, it is trying to minimize the disruption of imports that are input into its domestic and foreign-owned factories. Almost two months ago, China reduced barriers for foreign investors to enter banking, agriculture, automotive, and heavy industry. It reduced some tariffs on countries in Asia that have entered into trade agreements with it. China recently allowed Tesla to be the first foreign automaker to operate without a local partner.

Both those that see China as being strong and bent on global domination and those that argue China is weak and headed for a dramatic debt crisis provide fodder for the war camp. China is dangerous and is a threat to our way of life. They provide a narrative for what the noted foreign policy expert and former presidential adviser Graham Allison called the “Thucydides Trap.” This is when a rising power causes fear in an established power, which escalates toward war.

There is no doubt that many of China’s practices and policies are not fair and do cause harm to other countries, like subsidizing heavy industry and excess capacity from which it exports deflation. It shows little respect for the individual and liberty (property rights). The US economic model is superior and has turned back other state-capitalist and authoritarian challenges. What worked on Japan is unlikely to be effective on China. The leverage is different, and China is more resolute.  Investors should be prepared for a protracted period of confrontation between the US and China.

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Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.
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