I’ve been hearing a lot of chirping around these parts about a trade war with China.
Talking heads across the political and economic sphere have voiced grave concerns about the Trump administration’s foray into hardline trade negotiations with China. Conventional wisdom is that China has entrenched its neo-mercantilist economic model so deeply into the globalized economy that any challenge to their long-standing goal of economic supremacy will prove to be damaging and, possibly fatal. With that, to the detractors I say, “Take a long walk off a short pier.”
Now, before I explain why that’s not the case, I have to point out how terribly embarrassing it is to have so-called experts espousing such a fatalistic view toward America’s economic future and our ability to determine it ourselves.
“Welp, there’s nothing we can do to stop them so we may as well play nice and hope for the best.”
Anyway – In order to understand why a trade confrontation with China is long overdue, it’s important to have at least a high level understanding of how American companies have to operate within Chinese borders. It’s no secret that the Chinese market, through its expanding middle class, is a key growth engine for American companies. That said, operating and/or selling in China often comes with high entry fees such as handing over trade secrets and intellectual property to the government, forcing American companies into JVs with other state-owned enterprises and already high tariffs. As the communist government has tight controls over the mainland economy, the trade secrets and IP are almost always handed over to local Chinese companies in order to leverage their depressingly low labor costs to replicate (steal) American products and compete with American firms in the global market. In other words, American companies are collecting large upfront payments via initial sales, but giving away future profit and market share to their Chinese competitors (and government).
So, what is America to do here? Furthermore, how is China supposed to respond? Most importantly, who comes out on top? Well, let’s take a look at the tools each side has at their disposal in an increasingly ugly trade spat and see why America will inevitably come out on top.
Tariffs v1: The Trump administration campaigned on imposing tariffs on Chinese-made goods and they sure did deliver. As word spread Trump was serious about the taxes, the Chinese government compiled a list of their own which was released almost immediately after Trump’s were announced. It appears as if that round was a wash, but in reality we can chalk this up as a victory for America. While past administrations have spoken about getting tougher on China, rarely has anything ever been done on this scale. This shot across the bow brought China to the negotiating table and, while the first round of talks fell apart, the U.S. got what it wanted in opening up a dialogue regarding the restructuring of U.S. – China trade relations.
Tariffs v2: The original tariffs that Trump imposed largely targeted raw materials, which China then mirrored in its response. This was an attempt to protect consumers from the direct impact of tariffs and lay the burden on companies. While there would obviously be marginally higher prices for consumers in order to compensate for higher production costs, they likely wouldn’t move the needle enough to have a material impact on wallets. Round two of tariffs have moved from raw materials to finished goods: a battle China can’t win and doesn’t want to fight. This means that the U.S. consumer has finally been dragged into this kerfuffle and will now be paying noticeably more for many finished goods imported from China. The problem for China is they need us to import more than we need them to export. I mentioned in the second paragraph that China is practicing neo-mercantilism. They’ve built their entire economic model off utilizing tight capital and currency controls, low labor costs and raw materials to encourage exports and discourage imports, with the hope of becoming the world’s indispensible manufacturing hub. We’ve always been China’s best customer in this model (we still are and likely will be going forward). We don’t have to be, though. Labor conditions in the U.S. have never been tighter and the Trump administration has been looking for ways to rebuild our manufacturing base while providing high-paying jobs. If the severity of tariffs or length of time in force were to increase, it’s likely that companies manufacturing abroad and importing to America would slowly begin to onshore production here. Not only would that avoid tariffs, but it would likely improve supply chain economics by consolidating operations locally and reducing transportation costs in a post-globalization world (which is where we seem to be headed). In fact, you’ve already seen this with Foxconn’s $10B capital investment in Wisconsin to build a LCD screen manufacturing plant. My point here is we aren’t really as reliant on China for manufacturing purposes as people think, and as the tariffs will be targeted on specific goods and not broadly implemented, I’m confident America has the work force, technology and guts to onshore any lost Chinese capacity and produce those specific goods here.
Currency Controls: A key component of any mercantilist economy is the aggregation of foreign currency reserves in order to help the local government more tightly control the value of its own currency. The idea is that U.S. dollars flow into China in exchange for goods and those foreign reserves are then actively bought and sold by China in order to keep its currency at a value it believes is optimal for driving exports. There has been chatter that instead of retaliating to Trump’s second round of tariffs with tariffs of their own, China may simply begin selling RMB and buying USD in order to make it cheaper for Americans to import Chinese-made goods, thus circumventing the impact of Trump’s tariffs and keeping trade humming along. This is actually a relatively effective strategy for China both from an economic and geopolitical standpoint. Economically it suffers very little and geopolitically China comes out looking like the adult in the room by not escalating the tariff fiasco, even though they’re doing it stealthily. The problem is that this mechanism’s effectiveness is likely capped as China is a member of the WTO. The Trump administration, since day one, has railed against China, calling them a “currency manipulator” and accusing the government of keeping the RMB artificially low in order to drive exports to America – even though at the time of Trump’s inauguration the RMB was relatively strong historically speaking. It didn’t make sense at the time, but one has to wonder if they were setting the stage for a trade war they knew they’d eventually launch and were using bluster to pre-emptively target and draw attention to one of China’s most effective weapons. Any prolonged, material weakness in the RMB through government intervention would likely result in cases brought in front of the WTO, which the U.S. has quite the track record of winning.
Raw Materials: This is an area where China has our number as it stands now. Chinese companies have, quite presciently, amassed large positions in raw materials all around the globe – especially in the rare earths space, which is absolutely critical to technology production. If push came to shove, China could inflict quite a bit of damage on the U.S. by restricting or outright banning the sale of some raw materials into the U.S. or to U.S. companies. Again, we don’t have to be so reliant on China for supply of raw materials. According to the USGS, the U.S. alone boasts a $6.2T supply of minerals and rare earths – so our problem is largely self-inflicted: regulatory burden. The permitting process to excavate a new mine in the U.S. is a grueling, years-long undertaking that many mining firms aren’t willing to endure (with good reason – if there isn’t a need to mine and pollute our ecosystem we should refrain from doing it). Things are changing, however, as Trump signed an executive order last December to increase critical minerals production domestically in order to end America’s “vulnerability” to China. Despite this, I will give this round to China as they would be able to turn off the spigot relatively quickly, leaving the U.S. scrambling to source enough materials to meet production needs. In the long run, though, America has the flexibility domestically and relationships abroad to diversify our mineral supply chain – and we should.
Capitalism / Open Economy: This one isn’t even close. Despite China’s ascendance on the global stage, the U.S. has built the deepest, most dynamic economy the world has ever known. The ability for individuals to raise capital, innovate and cash out has given the U.S. one major, distinct advantage over China: human capital. People flock to America to learn at our universities, work for our companies, invest and, frankly, to have a better life. The same can’t be said for mainland China, or many other places in the world, either. This is our ace in the hole. This is what glues all of my other arguments together. The Chinese have built a powerful economy through brute force and coercion, not opportunity and profit. Were a trade war to actually break out in a prolonged fashion, the U.S. economy would handily outlast the Chinese as our system would likely adapt to new opportunities, whereas the Chinese government would need to devise and implement a new strategy through bureaucracy and decree. Toss this one to the U.S.
That’s that. The United States has been far too complacent for far too long when it comes to trade. We’ve always been proponents of free trade and open markets and we always will be – but we can no longer turn a blind eye to the hollowing out of our finances by third parties at the expense of our citizens. This isn’t about reckless nationalism. It’s not about blowing up the global economy. It’s about math – that’s all.