Image: iStock
Image: iStock

The disputes between the US and China have been going on for a while. Why is this war happening, and what is the likely outcome for the two superpowers?

Why is the US pressing China on trade?

According to Robert Gilpin, author of The Theory of Hegemonic War, conflict is inevitable between the current hegemonic state and the rising state. The essential idea is that the power of states grows disproportionately. As the bipolarization occurs, the international system becomes increasingly unstable, and a hegemonic war inevitably follows. China and the US already have areas in which they conflict, such as territorial disputes, human rights and trade, and these conflicts have been intensified by China’s fast economic growth and military spending.

Furthermore, the US is the biggest importer of Chinese goods, and in fact, its trade deficit with China has been increasing since Beijing joined the WTO in 2001. Under the slogan of fair trade and leveling the field, the US is intent on putting constraints on the most rapidly rising power in the 21st century in Asia.

Historical lesson of the Plaza Accord

The Plaza Accord was an agreement among the governments of France, West Germany, Japan, the United States, and the United Kingdom to depreciate the US dollar in relation to the Japanese yen and German Deutsche mark by intervening in currency markets. The five governments signed the accord on September 22, 1985, at the Plaza Hotel in New York City.

The United States was running a huge trade deficit against Japan at the time, and Japan was expected to overtake the US in terms of GDP. In order to solve this chronic trade deficit problem, the US pressed Japan to intervene in the exchange market and let the yen appreciate against the US dollar.

Consequently, the resulting appreciation of the yen greatly undermined the competitiveness of the Japanese exporting companies. In response, the Japanese central bank lowered its interest rate to help out those companies, which led Japanese investors to look for higher returns in risky assets. High liquidity led to an explosive growth and appreciation of real estate and stocks in Japan, but unfortunately, the bubble eventually burst in the 1990s. The subsequent prolonged economic recession engulfed Japan for more than 20 years.

This is a simplified story of a series of complex macroeconomic and political events that led to the bubble bursting and an ensuing recession in Japan, but the core argument remains that the US effectively employed trade war tactics as a means to prevent Japan from threatening the US and maintain its hegemonic status in the world.

Why can’t China step back?

In part, China learned from the Plaza Accord and therefore is not ready to make the concessions Japan did. Also, there is growing criticism in China of Xi Jingping’s mishandling of the problem, making it more difficult for China to make more significant concessions. Moreover, this trade war is about more than just about trade because it is partly aimed at core industries that China is trying to foster to compete with the US in the future.

Made in China 2025

The so-called Made in China 2025 Plan was set forth during the 2015 National People’s Congress and aims to foster 10 core industries, such as IT, robotics, aerospace, future automobiles and biotech, and aims to achieve the target of 70% supply of components domestically. It also features preferential policies and offers subsidies to future Chinese tech companies, and simultaneously requires multinational corporations operating in China to transfer technology.

Washington’s demands include ending subsidies and technology transfer requirements, and enforcing strict protection of intellectual property, which could be seen as a critical threat to the survival of the future Chinese economy, and to some extent, the Communist Party of China.

Potential responses from China:

1. Using North Korea as a bargaining chip
The breakthrough on the Korean Peninsula is an important diplomatic achievement for Trump as the Republicans face the midterm elections this month and he heads into re-election in 2020. China could help North Korea economically by giving it access to oil and the opportunity to circumvent the sanctions, thus de-incentivizing North Korea to comply with the US on denuclearization and disarmament. China is likely to package trade and North Korea issues together to give the US the impression that China would cooperate on the Korean Peninsula only when the US stops retaliating on trade.

2. Shorting US Treasury
China has acquired a massive amount of US Treasury with dollars they earned from their export surplus in the past. However, the amount of Chinese-held US Treasury has been gradually declining, and now stands at about $13 billion. Some expect that China could deal a critical blow to the US finance market by shorting US Treasury, and thereby increasing the yield and driving down the price. But shorting a massive amount of US Treasury in a short period of time could backfire and create financial instability, and China would be in a difficult situation if it had to engage in a finance war with the US. Also, the value of the Chinese foreign reserve would decrease as a result of selling the US Treasury. China is not in a strong position to find alternative investment opportunities for investing their foreign reserve other than US Treasury.

3. Intervening foreign exchange market
The recent sharp depreciation of the yuan has shown that China is very vulnerable to the imposition of tariffs and is on the losing side of the game. Ironically, depreciation lowers the price of export goods, thereby offsetting the increase in the price of the export goods with tariffs. Further depreciation of the yuan is certainly possible, but at a great cost for the Chinese.

The devaluation of the yuan would cause foreign investors to withdraw their money from the Chinese financial market, which has already been dealt a critical blow with the trade war. Also, devaluing the yuan would decrease the purchasing power of the Chinese people when buying foreign goods, and thus would be not a politically popular choice. On the other hand, the appreciation of the yuan leads to more US imports and less Chinese exports to the US, and thus could potentially reduce the staggering trade surplus with the US. It is more likely that China would agree to let the yuan appreciate against the dollar in order to appease the US in the end.

Potential outcome of trade war:

China seems to be on the losing side of the game because China’s dependence on trade (exports constitute about 25% of the Chinese GDP) is much heavier than the US (exports constitute about 8% of the US GDP). However, it cannot keep making concessions as the trade war is targeted at some of the core industries that China is trying to foster.

Therefore, the most likely outcome is that China will employ all of the above methods – bargaining with North Korea and shorting US Treasury – but not to the extent that their actions would trigger a full-blown trade or finance war with the US. If the trade war can be resolved with a minimum amount of tariffs imposed by the US, China is likely to make some concessions – though not all – to the US demands, one of which could be the forced appreciation of the yuan.

Appreciation of the yuan would lead to increased purchasing power for the Chinese people, and Chinese consumer goods and industry could potentially benefit from it. On the other hand, it would lead to a decrease in the competitiveness of the Chinese exports industry, such as steel and electronics.

If the trade war rages on with the two sides unable to find the middle ground, then the Chinese economy would be dealt a critical blow while US consumers would face increased imported goods prices and US exports would face higher tariffs from China. The world as a whole would also suffer from the disruption to international trade supply chains and the rise of protectionism, which inevitably reduces welfare gains associated with trade. How the trade war can be resolved is a big question for the future of the world economy at this moment.

This article is originally from Joon’s Blog

Joon Young Kwon

Joon Young Kwon holds a master's degree in international economics and finance from Johns Hopkins University School of Advanced International Studies (SAIS), and currently works as an economics and finance consultant in Singapore. He runs his own blog and language-learning YouTube channel.