When Presidents Donald Trump and Xi Jinping meet at the G-20 summit in June 2019, there are hopes that they will come to some agreement to end the trade war between China and the United States. But such hopes have already been raised and dashed several times since the trade war began in 2018. Yet observers still question how long the war could last. The economies of the two countries are closely intertwined, so much so that historian Niall Ferguson coined the term “Chimerica” to describe them. A long trade war would, no doubt, be costly for both. That should have been enough of an incentive for the two sides to settle their differences before the conflict intensifies further.
So far that has not happened. After an initial round of tariffs and retaliatory tariffs on $50 billion of goods on each side, the United States imposed a 10 percent tariff on a list of Chinese imports worth another $200 billion in September 2018. In response, China levied duties of between 5 and 10 percent on a list of American imports worth $60 billion. Then, after China backed away from pledges it had made during trade negotiations, the United States boosted the tariff rate on its $200-billion list of Chinese goods to 25 percent in May 2019. China followed suit, raising the tariff rates on its $60-billion list of American goods to as high as 25 percent. Not to be outdone, Trump ordered his administration to ready new tariffs on the remaining $300 billion of goods the United States imports from China. If those U.S. tariffs are implemented, China can be expected to slap tariffs on the remaining $20 billion or so of goods that it imports from the United States.
Much like actual wars, trade wars can take on a life of their own. At some point, careful calculations of costs and benefits begin to matter less than they did at the outset. A trade war can easily escalate to become an economic drag on both combatants. For the moment, neither China nor the United States seems overly concerned about that. To understand why, we should consider their respective perceptions of the trade war.
The Chinese Perspective
For China, the trade war with the United States did not come at the best time. Against a backdrop of global economic softness, Beijing is managing the transformation of its economy from one based on massive investment and export-led manufacturing to one where domestic consumption plays a larger role. No doubt the trade war has complicated matters. Even so, Chinese leaders have reasons to believe they are likely to prevail in a trade fight against the United States. One former Chinese vice-minister even publicly boasted about them.
Access to financial resources is among the greatest assets in Beijing’s trade-war arsenal, enabling it to cushion the impact of the conflict on its economy. As Chinese commentators often cite, China’s central bank, the People’s Bank of China (PBOC), holds about $3 trillion in foreign exchange reserves. Perhaps even more important is that China’s national government debt currently stands at only 50 percent of GDP (compare that to America’s, which tops 100 percent, and Japan’s, which is near 240 percent). That means that Beijing feels it has room to borrow. And borrow it has. Shelving efforts to rein in the debts of China’s local governments for the time being, Beijing is expected to allow them to issue new debt worth over $300 billion in 2019, a sum 13 percent higher than the year before.
The Chinese government can also direct the PBOC, as it has in the past, to boost financial liquidity. The PBOC can do so either directly with cash injections or indirectly by lowering China’s bank reserve requirements (the amount of money that Chinese banks must keep on deposit at the PBOC). In fact, the direct approach was needed in May 2019. After the government took over Baoshang Bank, a troubled Chinese lender, the PBOC injected $62 billion into China’s financial markets and another $72 billion two weeks later to calm them. Over the prior year, the PBOC has also used the indirect method—five times—to spur lending and economic growth. And, should that not yield the desired results, China has been known to set loan quotas to compel its banks to lend.
Furthermore, Beijing has shown its willingness to intervene in markets in even more direct ways. After China’s stock market plunged in 2015, the government stepped in to prop up share prices. It instructed the PBOC to make cash available to government-backed funds. It then ordered those funds, and even some brokerage firms, to buy shares. By early 2016, Beijing went so far as to suppress trading in futures and derivatives by conducting “what many fund managers complained were campaigns of intimidation against traders, both foreign and domestic.” In several cases, the Chinese government launched criminal investigations into managers who sold shares short.
There is, however, one lever that Beijing possesses, but has been hesitant to use: the devaluation of its currency, the renminbi. While doing so would give China’s economy an immediate boost, it would also ease the inflationary pressure that Chinese tariffs have put on the U.S. economy. Worse still, it would break China’s informal currency peg to the U.S. dollar, which has not traded above 7 yuan to the dollar for over a decade. While there is nothing inherently special about that level, breaking it would suggest that the economic conditions in China had worsened to a point where Beijing could no longer defend the peg. History offers a guide as to what could happen next. Within one month after China depreciated its currency by 2 percent in 2015, the PBOC’s foreign exchange reserves fell by nearly $94 billion. By the end of that year, over $320 billion was drained from its reserves, hastened by concurrent expectations of a stronger U.S. economy.
That being said, Beijing could seek to impose higher economic costs on the United States. To that end, further increases in tariffs on American goods have limited utility. That is because the value of China’s imports from the United States is only one-quarter of the value of China’s exports to the U.S. (Indeed, that is the crux of the trade war.) Still, Beijing could make trouble for American companies by slowing down their customs clearances and permit approvals. It could even prohibit them from operating in China altogether. But Beijing’s first step would likely be to restrict Chinese tourism to the United States, which totals over $30 billion annually. That was how China punished South Korea after it failed to heed Chinese objections to the deployment of the U.S. Terminal High Altitude Area Defense anti-missile system on its soil in 2017.
Some have argued that the PBOC could sell its $1.2 trillion of U.S. Treasury securities, which form a large part of its foreign exchange reserves. That would depress the prices of those securities and push up their yields. The resultant higher U.S. interest rates would hurt the American economy. While such a strategy was a very real option a decade ago when capital readily flowed into China, it is less realistic now. In 2019, China is on track to run a current account deficit. In other words, capital is flowing out of China. While one can debate whether China’s current account deficit is structural or temporary, the fact that it exists at all suggests that a sudden sale of U.S. Treasury securities would be risky. It could trigger a flight of capital from China, as the difference in yields between Chinese and U.S. government debt narrows. Meanwhile, given near-zero or negative interest rates in most major developed countries, global appetite for yield may absorb even a massive sale of U.S. Treasury securities without much difficulty, blunting the most harmful effects of China’s action.
Others have raised the possibility that Beijing could restrict the export of rare earth metals to the United States, since China controls roughly 90 percent of the world’s current production. Those metals are vital for many modern electronics, from smartphones to guided-missile systems. Certainly if Beijing did so, it would not be the first time. In 2010, China introduced a quota system that cut its exports of rare earth metals by 40 percent. That sent prices for the metals soaring for two years and prompted the United States to file a protest with the World Trade Organization (WTO). In the meantime, global supply and demand adjusted. Miners outside of China produced more rare earth metals and electronics manufacturers began using alternate metals. By the time the WTO ruled in favor of the United States and China lifted its export quota in 2014, the prices of most rare earth metals had already declined to just above their pre-quota levels. While some American companies were definitely hurt, no catastrophe befell the vast majority of them.
Finally, Chinese leaders might simply believe that they can outlast the United States. Only days after Trump announced his latest round of tariffs on China, he delayed imposing a portion of the tariffs related to auto parts after a U.S. Department of Commerce report revealed that the U.S. auto industry would need more time to adjust to the new tariffs. That may suggest to China that more economic pressure on the United States could cause Trump to blink. But even if he does not, Trump’s current term as president will end in early 2021. Should he fail to be reelected, Xi could bargain with a new American president, one who might be willing to strike a deal that is more favorable to China.
The American Perspective
For better or worse, Trump has not behaved like most American politicians. He has shown that he is willing to sacrifice short-term political capital, if not U.S. corporate profits, for longer-term American economic competitiveness. It also appears that he primed the U.S. economy for a trade fight. During his first year as president, he cut taxes, supercharging a U.S. economy that had largely recovered from the 2008 financial crisis. That has helped to produce record low unemployment and give the U.S. economy more room to absorb negative shocks.
Although Washington sometimes feels it has fewer economic levers than Beijing, as Trump has expressed in his tweets, the United States does have some natural assets in a trade war against China. Foremost among them is that China’s economy is more reliant on the United States than the other way around. American exports to China account for only 0.7 percent of U.S. GDP, whereas Chinese exports to the United States account for 4.5 percent of China’s GDP. While the long-term economic costs of a trade war may be more evenly distributed, the International Monetary Fund recently estimated that in the short-term the trade war will trim a modest 0.3 to 0.6 percent from U.S. GDP growth but slice a heftier 0.5 to 1.5 percent from China’s GDP growth.
The U.S. Federal Reserve, America’s central bank, is another valuable asset in the trade war. While American political leaders cannot directly steer its policy, it is reasonably responsive to shifts in the trajectory of the U.S. economy. Should the Federal Reserve detect that the trade war is beginning to take a real economic toll, it would likely lower short-term U.S. interest rates to boost economic activity. During the 2008 financial crisis, the Federal Reserve also proved itself willing to take extreme monetary measures, including a vast expansion of its balance sheet, to help the U.S. economy if needed. With such power, the Federal Reserve could be a very potent instrument in the trade war. But so far it has refused to play such a direct role.
Yet unlike Beijing, Washington has little reason to believe that it can outlast China’s current regime, especially after Xi enshrined his political philosophy into the Chinese Communist Party’s constitution in 2017. Washington could, however, hope to outlast China’s economic runway. It is no secret that the Chinese economy is cooling and that the enormous debts carried by China’s local governments, state-owned enterprises, and, increasingly, banks, could rapidly chill it further. For the moment, confidence in China’s $3 trillion in foreign exchange reserves to act as a backstop has helped to forestall a financial crunch. But with enough pressure on the Chinese economy and fuel for the U.S. economy, Washington could undermine those reserves and expose China to what could be a chain reaction of economic calamities.
Which Perspective Is (More) Right?
With so many intertwined trade war-fighting strategies, it is difficult to discern which perspective has the edge. A simple scoreboard evaluating each strategy in isolation would not capture how they all interact together. Instead, tracking markets, which are good at synthesizing huge amounts of information, may be the best way to tell which perspective is currently on top. Since China’s equity market is still relatively shallow, the best market to track may be the currency market, particularly the trading in the yuan/dollar currency pair. Even though China restricts trading of the pair to a predefined range, China’s currency can float within that range. And how it floats can be telling.
If China’s economic growth continues to decline relative to America’s, the yuan will naturally weaken against the dollar. Eventually, it will breach the 7-yuan-to-the-dollar level, regardless of what China might do to prevent it. But more important is how the yuan depreciates. Will it devalue in an orderly or disorderly fashion? A rapid plunge would suggest a loss of confidence in China’s ability to keep its economy chugging along. That could presage bigger problems for China, including perhaps a debt crisis or a massive capital outflow. After all, a devaluating currency does not attract capital. In May, when trade tensions between China and the United States flared, the yuan lost over 2.5 percent of its value against the dollar in just over a week.
The Long March
With each side reasonably comfortable that it can outlast its opponent in the trade war, neither has much motivation to give in at the moment. Hence, it came as little surprise that China backtracked on the commitments it had made in earlier trade negotiations. Meanwhile, the Trump administration probably felt little pressure to rush into a deal, especially if the deal fell far short of the administration’s goal.
In contrast, what has been surprising is how little criticism Trump has received over the trade war from his seemingly implacable political opponents in the Democratic Party. So far, they have criticized only his tactics, but not the war itself. One of the Democratic Party’s most senior politicians, Senator Chuck Schumer, even voiced his encouragement for Trump’s action. While that may seem remarkable, one must remember that it has been the Democratic Party which has traditionally supported more protectionist policies. Indeed, Trump has had more trouble with members of his own Republican Party, who have been long-time free trade advocates. So, even if Beijing finds itself dealing with a new American president after the next U.S. national election, it may not find an entirely new approach, especially if the Trump administration’s tariffs have made headway.
Far from concluding, the trade war between China and the United States might have only seen the end of its beginning. In May, Xi told China that it was on a “new Long March,” referring to the famous four-thousand-mile journey Chinese communists made to escape their enemies in the 1930s. Xi may have been signaling to audiences at home and abroad that the trade war could last a long time. If true, the United States would be wise to prepare for tariffs and economic disruptions to last a long time too. All the same, Xi should make sure the “new long march” on which he has taken China does not turn out to be off a short pier.
 Grace Zhu, “China’s Forex Reserves Resume Their Fall,” Wall Street Journal, Dec. 8, 2015, p. C3
 International Monetary Fund, World Economic Outlook, April 2019 (International Monetary Fund: Washington, 2019), pp. 124-125.