What Are We Getting Wrong about the Trade War?

As the trade conflict between the U.S. and China heats up, observers in and out of China have speculated on two potential “nuclear options” that China may deploy: substantial devaluation of the yuan, and the dumping of China’s roughly U.S.$1 trillion in U.S. treasuries. Yet these options are not credible, because they conflict with other important policy objectives of China’s. Also, they would likely cause more financial harm to China than to the United States. Although Western policymakers generally underestimate the pain that authoritarian leaders can impose on their citizens with hardly any political repercussions, substantially slower growth would undermine Xi’s own ambition for China to be a great power.

Yuan devaluation would severely jeopardize the relative stability in the foreign exchange market that Chinese regulators have tried hard to restore after 2015’s near crisis. Given that an exchange rate above 7 yuan to the dollar has not occurred at the end of a trading session for over a decade, devaluating the yuan past that point would be considered a “black swan” event by most of the trading algorithms, throwing the entire emerging market into turmoil. Devaluation to 25 percent would bring about even more dire consequences. For the past several years, Chinese banks and firms have borrowed close to two trillion dollars from offshore counterparts. Since much of this borrowing is in currencies linked to the dollar, a 25 percent devaluation would mean that Chinese debtors would need to pay 25 percent more in yuan to service their debt. Given the high domestic debt burden of the Chinese corporate sector, such a sudden increase in debt servicing would likely trigger a sizable wave of defaults by Chinese firms and even some financial institutions. Without a truly massive government bailout, which would deplete China’s foreign exchange reserve, many Chinese companies would be shut out of the global credit market for years—contravening Xi’s dictate to “hold the bottom line of financial stability.”

Unwinding China’s roughly U.S.$1 trillion holding in U.S. treasuries would cause temporary turmoil in the treasury market and a temporary decline in the price of treasuries. However, as the lone determined seller, China would likely bear the brunt of the losses. If China decided to upset the treasury market, it would have to keep selling—even as treasury prices begin to decline. Thus, sellers in this initial period would bear the bulk of losses. Once market participants determined that China was selling for political reasons, they would begin to buy in earnest, taking advantage of the unusually high treasury yields. The Federal Reserve would then likely step in to buy, extinguishing any panic. China would bear the brunt of the losses in the initial period, and besides making headlines for a few days would gain nothing of consequence while losing billions. And what would China do with all the cash? If it invested the money in a dollar money market, U.S. banks would borrow the cheap money to buy up treasuries, which would also extinguish the panic.

This trade war is not about trade. Rather, it is about the global dominance of technology, as evidenced by the Trump administration’s blacklisting of Huawei. There is no point discussing who will win the trade war. The only question is whether both sides—and the many entangled third parties—can survive the damage from the destruction of a global technological ecosystem 20 years in the making.

The global technological industry is a dynamic ecosystem in which interdependent companies work with one another through mind-bogglingly complicated divisions of labor. American companies such as Intel, Microsoft, Qualcomm, and Google mostly provide the central infrastructure on which European and East Asian players build their technological systems. Chinese firms are often the closest to the consumer market through end-product applications and manufacturing. Over the past decade, companies like Huawei have been climbing the technological chain, primarily to gain greater control of the production system. Proximity to the largest technological market, China’s comprehensive hardware supply chain, and the growing globalized talent pool have aided this effort. Like other hardware firms, Huawei had previously no reason to deviate from the global platform which strengthened its ability to work with the best the world can offer. The ecosystem also helped American companies focus on core competencies without worrying about providing end-solutions for the diverse global consumers in the developing world. As long as downstream vendors were locked into American suppliers, growth could be assured.

Now, the Trump administration wants to weaponize the system’s interdependence. It seems that all Chinese technological companies may become targets, regardless of whether they acted illegally. To be fair, the American government is not alone in weaponizing trade; China has done this for smaller trading partners. But even China has been cautious not to disrupt the global technological supply chain, as it is impossible to contain the damage that would hurt China as well.

If, as it is determined to do, the Trump administration cuts off Chinese companies from the technological supply chain, the hurt to China—as well as others on the supply chain including, American firms—will be profound. The worst case scenario would be the derailing of China’s technological trajectory: The progress toward 5G would be slowed; Huawei may or may not survive. Yet, such damage would not destroy China’s capacity. China’s massive talent pool, decades of experiences in innovation, and the world’s largest technological market would allow companies to regroup by developing alternatives away from American-dominated infrastructure.

There is no victor in this battle. Chinese companies will lose access to the global technological frontier and be forced to reinvent the wheel. America will lose the strategic control over China’s technological trajectory and access to the world’s largest and most dynamic technological market. Everyone else will be thrust into chaos and uncertainty. When an ecosystem is destroyed, no one wins.

Factors that have been mostly overlooked will determine the economic winners and losers of this trade war. The United States is better positioned to absorb the economic shock coming from reduced imports, higher prices, and major shifts of supply chains. With a U.S.$20.5 trillion economy compared to the $13.6 trillion nominal economy in China, the United States has significantly higher per capita GDP and a lower dependency on trade. Exports to China are less than 0.8 percent of U.S. GDP (according to the Wind Financial Terminal), while Chinese exports to the United States are more than four times higher.

The longer-term question, which will play the biggest role in determining how the world changes—assuming there is no near-term settlement—is how fast businesses and consumers can adjust to this new landscape. Put in economist speak, what are the elasticities facing business and consumers?

China seems to be facing much less elastic product movement. Huawei, for example, will find it very difficult to replace key U.S. inputs such as chips, which form the backbone of their products. Conversely, the United States has a much wider range of choices for low- and medium-skilled manufacturing throughout the world to replace China. While the U.S. shift away from Chinese manufacturing and trade will not be costless, American buyers have a much wider range of options to meet their manufacturing needs than China has to buy products like semiconductor intellectual property. This dynamic will be key to determining the costs and the speed of the economic transition.

There is one other factor that is widely overlooked: currency dynamics. The United States, with its freely traded international currency, does not need to worry about balance of payments and trade surpluses. But China, with its strict capital controls and heavily managed currency, depends significantly on the U.S. trade surplus to fund everything from Belt and Road investments to dollar debt repayment. With $1.2 trillion in U.S. dollar denominated debt coming due in 2019, a fall in the U.S. trade surplus will significantly hurt China’s financial position. In 2018, China ran a $323 billion goods trade surplus with the United States and $351 billion with the rest of the world. Any drop in the Chinese trade surplus would significantly hamper China’s ability to invest abroad and repay debt. If China cannot secure the U.S. dollars from the surplus it has trading with the United States, it cannot repay its U.S.$1.3 trillion coming due this year or continue its much publicized Belt and Road Initiative.

And while both sides face potential economic weakness, underneath the massaged headline data the Chinese economy is likely significantly weaker in this period of financial stress than the U.S. economy. This will push Beijing to take steps to ensure that growth holds up, lest the Chinese Communist Party lose its economic management luster.

Regardless, it is not going to be the easiest time for government, business, or consumers in either country.