The Chinese Communist Party loves its anniversaries—including the seventieth anniversary of the founding of the People’s Republic of China this year, and on the horizon, in 2021, the party’s own centenary. In celebrating these events, the party seeks to remind Chinese citizens and the world of its indispensable role in China’s past and future economic and political development. Yet, as the 2020s approach, China is being buffeted more and more, including by events outside the country, which are threatening the party’s intense desire for control and stability as well as its capacity to successfully address a confluence of economic pressures building at home. 

While China is no longer an export-led economy, as it was in the 2000s, there is little question that its economy and supply chains remain reliant on U.S. demand and technology, direct investment from foreign companies, stable and open conditions for global trade, and more recently, access to U.S. dollar financing. In normal times, these factors capture China’s interest in reaching some modus vivendi with the United States so that Beijing might address domestic economic problems more effectively, but political volatility and unpredictability render this judgment unsafe.

The Chinese government’s most pressing priority is the need to pacify the protest movement in Hong Kong that started in early June 2019. The outcome promises to be a lose-lose proposition for China however it is resolved. Further afield, growing pushback against China’s governance and financing habits among many countries partnering on the infrastructure investment of the Belt and Road Initiative testifies to the limits of China’s capacity to implement its signature foreign policy enterprise. Yet foremost among the events imposing themselves on Chinese leaders is the so-called trade war, which is in fact a commercial conflict with much broader, more ubiquitous consequences.

The Early Stirrings of a Trade War

The U.S. political thinker Edward Luttwak, while reflecting on what the United States saw as the trade threat emanating more than forty years ago from Western Europe and Japan, referred to the “logic of conflict” in the “grammar of commerce.” These U.S. differences with Europe and Japan, though, were a much more benign clash of interests than the current state of U.S.-China relations, for which this expression seems especially poignant.

George Magnus
George Magnus is the author of Red Flags: Why Xi’s China Is in Jeopardy (Yale University Press, 2018) and a research associate at Oxford University’s China Center and at SOAS University of London.

U.S. President Donald Trump and his advisers made no secret of their intentions with respect to trade with China during the 2016 election campaign. After a bit of shadow-boxing in 2017—when Chinese President Xi Jinping and President Trump exchanged visits to Mar-a-Lago and Beijing—the trade war erupted in earnest in 2018. Notwithstanding a four-month hiatus for talks following the G20 meeting in Buenos Aires late that year, the war kicked off again in May 2019. As of now, virtually all of U.S.-China bilateral trade is subject to punitive tariffs, some of which are as high as 25 percent.

Self-evidently, the trade war is about fundamental disagreements with respect to trade policies, market access, and public procurement. Yet, at its heart, this conflict is also about China’s technology and industrial policies, nontariff barriers to trade and other economic constraints, and, ultimately, a struggle for technological dominance in broad commercial and military spheres that goes beyond trade to include scrutiny and approvals of foreign direct investment deals as well as the targeting of one another’s companies on so-called entity lists. Both the United States and China have announced the preparation of these lists, which are intended to ban or restrict foreign companies from purchasing goods or services if they are deemed to threaten national security interests.

From the outset, Zhongnanhai, the headquarters of the Chinese Communist Party and the State Council in Beijing, seemed strangely unprepared for the persistence with which Trump has prosecuted this trade war. The politics of the conflict are clear now, as it has escalated into an existential struggle and talk of the virtues of containment, decoupling, and self-reliance.

The Fallout of the Trade War

The economics of trade conflict though are much more complex and costly, and little attention is being paid to whether these political goals are in any way attainable or what the implications might be. The costs of the trade war are starting to be counted, and while both sides will unquestionably pay a significant price, the costs to China seem more significant. Perhaps this should come as no surprise. According to U.S. Department of Commerce data, Chinese exports to the United States account for 4 percent of gross domestic product (GDP) and roughly one-fifth of total exports; for U.S. exports to China, the corresponding figures are 1 percent and 8 percent, respectively. China is the one running a big trade surplus, and Beijing remains highly dependent on both U.S. aggregate demand for its exports—for which there is no substitute—and sophisticated U.S. technology, especially high-end microchips.

None of China’s other trading partners are sizable enough to fill the gap, according to trade data from the Organization for Economic Cooperation and Development. Beijing’s next closest trading partner in terms of size is Hong Kong, which accounts for 12 percent of China’s exports; though it is, in fact, part of China, Hong Kong is still treated as a special administrative region and maintains its own economic accounts. After that, next comes Japan at 6 percent followed by South Korea and Vietnam at 4.5 percent and 3.5 percent, respectively. In terms of technology, it is clear that both sides would lose out if decoupling disrupts supply chains, international scientific collaboration, visa allocations, educational exchanges, and so on. Yet it seems as though China’s risk of loss is greater because of the stronger role that trade plays in its economy. Moreover, China is still highly dependent on chip foundries from the United States and other countries, a technological staple that the country has been trying to replicate for almost thirty years with only limited success.

In broad macroeconomic terms, the impact of the trade war on China’s economy at first was not significant—at least until the White House’s latest round of tariffs came into effect in September 2019. Yet with nearly all trade now subject to punitive duties, the cumulative impact should increasingly show up in forthcoming economic reports, as indicated by the weak export orders data now common in monthly business surveys through September. According to the National Bureau of Statistics, industrial output was growing at the slowest pace in more than a decade even before the latest punitive tariffs came into effect. 

Large banks in China have published surveys highlighting the negative consequences of the trade conflict for exporters and industrial firms, employment in the industrial sector, business investment, and private sector firms. The impact on private Chinese and foreign firms operating in China, which account for the overwhelming majority of Chinese exports according to the National Bureau of Statistics, is especially unfortunate when considering that it is state firms that are in the crosshairs of U.S. trade politics. There is, in any event, a feisty debate going on in China about how the Chinese Communist Party has come to discriminate against private firms and in favor of state enterprises in matters involving taxes, subsidies, credit, and regulation. The trade war has accentuated the plight of private companies in China—an irony in view of the rhetoric from the White House, rhetoric that weighs heavily in favor of private rather than state enterprises.

The cumulative impact of punitive U.S. tariffs on the broader economy is, therefore, likely to become more evident. In the last twelve months, for example, the drag on the economy may have been little more than an estimated 0.25–0.35 percent of GDP, an effect more than compensated for by some easing in tax and infrastructure spending and borrowing policies. Yet, looking ahead to the next twelve months, the tariffs may lower economic growth by between 0.75–1.25 percent.

The Monetary Impact of the Trade War

There will also be secondary effects on the value of the renminbi, and also on global and Chinese firms as they rethink their China-centric supply chains and look elsewhere for political and policy certainty as well as the ability to compete effectively. The value of the renminbi has already slipped back to levels not seen for over a decade, and China will have to pay close attention to its currency for fear that untoward weakness or policy miscalculations could trigger additional weakness and the risk of higher capital outflows. Surveys published in 2019 by the U.S. and EU Chambers of Commerce in China reported that between one-fifth and one-third of their member companies in China had already moved some supply chain operations to other nations, with comparable proportions indicating that they planned to do so in the future.

There doesn’t appear to be a great risk in the near future that, as many fear, the Chinese government will weaponize the renminbi in the trade war through deliberate devaluation. Doing so would almost certainly harm China’s financial system and relationships with Asia more than it would affect the United States. That said, the currency’s value is worth watching. Though China manages its own currency against a basket of currencies, the U.S. dollar is by far the biggest and most important component. It is also the key currency pair in Chinese economic and financial affairs. A semi-pegged exchange rate to the U.S. dollar may be unsustainable in view of China’s financial policies, the country’s weakening balance of payments position and persistent capital outflows, and the evolving trade war—phenomena that have remained in evidence since the country’s 2015–2016 financial troubles. If the link between the renminbi and the U.S. dollar snaps in the next few years, the past experience of other currency pegs around the world, recorded in data sets from the International Monetary Fund, suggests that a decline of between 25 and 35 percent is quite likely. A snap could happen because the expansion of credit and financial assets in China is running too far ahead of the roughly stable level of currency reserves—a relationship that successful peggers keep in check. A fall of this magnitude, whether soon or in the next two to three years would mean that China’s GDP in terms of U.S. dollars relative to the U.S. economy might be little different from what it is today. This would fly in the face of conventional thinking that China’s economy will overtake the United States within the next ten years.

A Bad Time for a Trade Conflict

These effects will be playing out in the Chinese economy at an unpropitious time. Economic growth came out of a sharp downturn late in 2018 and early 2019 to stabilize as new stimulus measures took effect. The economy remains volatile, however, and almost certainly on a slower trajectory than the government is estimating. For now, Beijing’s leaders are very mindful of risks of financial instability, underscored by the failure of three minor banks this year, but for reasons that have given them cause to worry about contagion. Every major policy meeting since the start of 2018 has been dominated by an emphasis on sustaining or boosting employment. At a State Council meeting chaired by Premier Li Keqiang, it was made clear that additional credit creation and fiscal stimulus would have to be employed if the economy, under pressure from the trade war and other domestic factors, lost more traction.

Yet, over the next few years, China’s economic prospects are more clouded, as the country will have to address a confluence of factors that will weigh on growth and on policymakers. These include the economy’s more limited capacity to carry and service high levels of debt, a rapidly aging population, and strategies to avoid falling into the looming middle income trap. The last thing China needs is the complicating aggravation of commercial conflict encompassing trade, cross-border investment, and disruptions to supply chains and interrupted access to markets and technologies. Self-reliance may make for a good Chinese political slogan, but in reality China’s relations with the United States and the rest of the outside world are still characterized by dependence and interdependence.

Small wonder that China and the United States are again engaging in talks that may yet end with a limited trade agreement in October. It would suit the political and economic agendas of both Xi and Trump as far as 2020 is concerned. Yet an agreement of significance is neither a foregone conclusion nor would it be of any consequence for the fundamentals of the conflict, which will keep the two protagonists engaged for years to come. This is after all a conflict that transcends trade specifically to encompass the struggle for industry and technology dominance as well as the assertion of standards and values.

The Uncertain Days Ahead

For China, the 2020s will most likely be defined economically by how it manages to deal with the largely domestic-driven slowdown in growth along with potential sources of financial instability. Yet external events, notably the trade war, also present sources of both economic aggravation and considerable political risk, not all of which will be easy to control or predict.

The U.S.-China relationship, Beijing’s most important external relationship by far, has already become more fractious than at any time since the reign of chairman Mao Zedong. It is by no means certain how the opinions of Chinese elites are divided between those who champion Xi’s assertiveness and call for self-reliance, and those for whom losing the U.S. relationship completely may prove to be a bridge too far. Many in the second group and their family members may have already been imprisoned or lost sizable assets because of Xi’s anti-corruption campaign.

How the party manages its relationship with the United States will be a test of both China’s economic resilience, and the party’s own political brittleness. The perception of China’s relative position and prospects in the world might evolve quite differently from what now passes as accepted narrative. Governments, corporate strategists, and international relations analysts alike will need to keep an eagle eye on the assumptions governing and the implications underlying their own narratives about China.

George Magnus is the author of Red Flags: Why Xi’s China Is in Jeopardy (Yale University Press, 2018) and a research associate at Oxford University’s China Center and at SOAS University of London.