Are we at the start of a US-China cold war?

By Zac Tate, Economic Strategist, Hottinger Investment Management

In 431 BC, Athenian historian Thucydides wrote in his History of the Peloponnesian War that: “It was the rise of Athens and the fear that this instilled in Sparta that made war inevitable.” Modern history too is replete with examples of a rising world power challenging a ruling power in a way that forces the two powers into war.

In 1519, the election of King Charles of Spain as Holy Roman Emperor pushed the then preeminent France into 40 years of conflict in the Habsburg-Valois Wars. In the 17th century, the rise of England as a global naval power with a foothold in North America set off twenty years of Anglo-Dutch wars. The wars of the 20th century were at their heart about land, naval and ideological supremacy as Germany and Japan challenged the existing order. Yet war is not inevitable, as the decades-long stand-off between the US and the Soviet Union eventually proved.  

With the rise of China to global superpower status, the United States must contend with Thucydides’s trap and it is hard not to see the events of last week in this context.

Last week, the US government announced that the tariff rate on roughly $200bn of Chinese imports will rise from 10% to 25%. The Trump administration will also begin preparing for 25% tariffs on a further $325bn of imports that – together with the $200bn – make up almost all exports that China sends to the United States. Although China responded yesterday with tariffs of its own, it is still possible that the two sides could agree a trade deal that unwinds these measures.

However, it is clear that the Chinese side has significantly underestimated the force of conviction in the United States for measures of some sort to curb China’s ascendancy as an economic superpower. Support for being tough on China is cross-party. Senior US Democratic Senator Chuck Schumer took to Twitter to encourage the President to “hang tough… and don’t back down” during the negotiations.

Over the last 18 months, the American state has come to a realisation that the terms on which China joined the World Trade Organisation in 2001 are unfair; they have permitted China to provide huge state subsidies to its own firms and to discriminate against foreign firms operating in its territory. The naïve hope in the early 2000s was that China, by joining the global trading system, would become a liberal democracy yet remain subordinate to the United States. That hasn’t happened.

Instead, what has happened is that China has grown to become the world’s largest economy measured by purchasing parity, harbouring grand ambitions – through its Made in China 2025 strategy and its Belt and Road Inititaive – to dominate the Eurasian continent. The current standoff between the US and Iran over its nuclear policies has a Chinese element too, with investment in Iran planned as China’s land bridge between Europe and Asia.

The original impetus for the stand-off, however, was domestic in origin and about the US trade deficit with China.  A trade deficit is not necessarily bad for a country; it is often the flip-side of net flows of foreign investment, a vote of confidence in the strength of that country’s economy. For a country like the United States, which issues the world’s dominant reserve currency and offers the world’s safest asset, US Treasuries, there are structural reasons for its persistent trade (or current account) deficits.

Since global capital markets became liberalised after the breakdown of the Bretton Woods system of fixed exchange rates and capital controls in 1973, the US has broadly always run a current account deficit of around 1-4% of GDP (see Figure 1). With international business dominated by dollars and global investors attracted to dynamic US markets, the country enjoys what economists call an ‘exorbitant privilege’, where US borrowers and consumers can access capital on cheaper terms and US households can buy more than they make in a more sustainable manner than other countries.

Figure 1 shows that the period of free-capital flows that followed the end of the Bretton-Woods system of fixed exchange rates and capital controls has coincided with persistent US current account deficits.

One could claim that the trade deficit does not matter because it simply represents an excess of national consumption over national production; no one loses out if Americans buy more stuff from China using funds borrowed from China (see Figure 2). In fact, the argument goes, US consumers benefit from cheaper household goods, computers and smartphones.  This line of thought, however, is misleading because it ignores the distributional impact. The growth of Chinese imports of some items, while small in the context of total imports volumes from China, has harmed US producers of the same goods.

According to the US Census Bureau, imports of iron and steel products have doubled from $1.1bn in 2009 to $2.2bn in 2018. Imports of engine parts, such as carburettors, pistons and valves, have more than trebled to $2bn in 2018. Imports of parts for aircraft and trains have increased by a factor of 2-3.  Imports of trucks have grown by a factor of 8 and passenger cars by a factor of 20 (from $66m in 2009 to $1.4bn in 2018).

Figure 2 shows that China has indeed grown its exports to the US significantly since the early 2000s, with the disruption from the financial crisis being only brief.

While these items do not make up a significant portion of total Chinese exports to the US, they matter for US producers who must compete with them. The US manufacturing Rust Belt built its wealth through making things like steel, machine parts and engines. It reflects areas that swung behind Donald Trump in the 2016 presidential election. An influential study by Autor et al in 2017 concludes that the states of Michigan, Wisconsin, and Pennsylvania would have voted Democrat rather than Republican in that election if the growth of Chinese import penetration in their region had been 50 percent lower than what it actually was. This would have resulted in a victory for Clinton over Trump.

While industrial towns and cities are today part of Trumpland, they are working-class and have traditionally been Democratic fiefdoms, many of which chose Barack Obama in 2008 and 2012. The Democratic Party knows that its route back to the White House runs through these places, which is why there is cross-party support on pushing back on America’s growing trade deficit with China.

Higher tariffs will be disruptive to both US and Chinese equity markets. While many multi-national US firms have been rerouting their supply chains away from China in recent years, due more to rising labour costs than the threat of tariffs, the process is far from complete – and may never be. Companies such as Apple Inc. have built their entire business model around China. US consumers will likely treat higher tariffs as a tax if companies pass them on, which could raise inflation and reduce spending at a time when consumer activity already looks to be softening. In an environment where US earnings already look to be weakening, rising import costs coupled with falling demand could add to the squeeze and could signal the end to the equity market rally in 2019.

However, with equity markets near all-time highs, it will still require a big fallout from these new tariffs to spur the Federal Reserve into action. Earlier this month, with markets widely predicting rate cuts over the next 18 months, Fed Chair Jay Powell has tried to row back from his dovish tone earlier in the year. With core US inflation low and falling, any positive inflationary effect of tariffs could – counter-intuitively – make rate cuts less likely.

Meanwhile, the tariffs could do more damage to China. According to the World Bank, exports accounted for just under 20% of China’s GDP in 2017. The US is also China’s largest trading partner, buying 20% of its exports. If US consumers significantly reduce their purchases of Chinese exports, there would be a material impact on the economy. China has only recently managed to staunch the slowdown of the last six months through tax cuts and monetary stimulus and turn around last year’s poor performance in its stock markets. And as we have mentioned before, what is bad for China is now often bad for Europe.

The US-China trade stand-off is not just about the US Rust Belt; it is also about technology and intellectual property. The US administration is aware that it is engaged in a technological arms race with China that is not just about trade, jobs and GDP but also about the projection of global power, defence and security.  The ongoing dispute involving Huawei and their worldwide 5G footprint could be just the start of a US-China cold war centered on technology and global reach.

Conflict is not inevitable. The Treaty of Tordesillas, brokered by Pope Alexander VI, prevented war between Spain and Portugal over the Americas in the 15th century. The US surpassed the UK as a world power in the 20th century yet the two remained allies throughout. And war between the US and the Soviet Union in the late 20th century never materialised. In all three of these cases, both sides calculated that the costs of conflict were too high.

We should have hope that China and the US are so interdependent that more troubling forms of conflict never come to pass. There is still a good chance that the two sides will agree a trade deal. Nevertheless, for now relations between the two superpowers will remain fraught, which will bear on the outlook for risk assets.

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