Why China Needs To Temporarily Accept Tariffs

by: The Global Portfolio

In 2017, $376 billion of the United States' $796 billion trade deficit was attributed to China.

With respect to game theory, it might be beneficial for China to play the chicken temporarily.

Because of its centralized economy, restricted central bank, and major position in the U.S. Treasury, China has a lot at stake if it continues to retaliate.

Editor's note: Seeking Alpha is proud to welcome The Global Portfolio as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to the SA PRO archive. Click here to find out more »

As a kid you might have played chicken against a friend on your bicycles, or maybe you've seen the movie "Footloose" where two characters play chicken with tractors. Believe it or not, the leaders of two of the world's most developed countries are going head to head in a game of chicken.

The Current U.S. Trade Situation With China

Starting earlier this year, the U.S. imposed tariffs on several countries that it does extensive trade with. Most notably are those assessed on China. As of July 6th, 2018, the U.S. and China have imposed a proportionate $37 billion of tariffs on each other, which started with the US and ended with subsequent retaliation from China. As of July 11th, the Whitehouse has announced an additional $200 billion. As far as threats go, Trump has talked about a grand total of $416 billion, which would pretty much be the entirety of imports from China.

In 2017 the U.S. ran a current account (exports minus imports) deficit of $796 billion with the world as a whole. A staggering $376 billion of that trade deficit is from its relationship with China. Let that sink in. But this isn't old news; the U.S. trading deficit with China has increased exponentially over the past few decades (figure 1).

Figure 1

Source: Created by author using data from census.gov.

Furthermore, the Chinese portion of the U.S.'s current account deficit with entire world has been trending up since the late 1980's (figure 2):

Figure 2

Source: Created by author using data from census.gov.

With these facts stated, it isn't surprising that the competitive Trump administration would want to impose at least some tariffs on China, although a lot of economists will argue that it is not necessarily a bad thing to run a trade deficit. In the same light, a majority of market pundits claim that trade wars always end in destruction with unintended consequences. But in defense of the tariffs, the imbalance of exports to imports is arguably extreme at this magnitude. Not to mention, for the past few years China has been the source of nearly 50% of the U.S. foreign trade deficit. In all, this type of relationship makes the two countries sensitive to each other's economic decisions, creating an overall mutual sense of reliance.

A Game of Chicken

A more common name for "chicken" in game theory is the "hawk-dove" game, where a competitor can either act aggressive like a hawk or timid like a dove. A lot of game theory revolves around this basic game and parallels can certainly be made to it in regards to the United States' current trade situation with China. The game results in four different outcomes that can be described numerically. A table representation of a "hawk-dove" game for the trade war is below:

Source: Created by author.

Here, there are only two situations where the outcomes for both sides are reciprocal. If both the U.S. and China act aggressively, the outcome is costly and destructive to both (0,0: you and your friend crash and wreck each other's bikes). On the other hand, if both act calm like a dove, each get a proportionate piece of the pie and carry on in harmony (2,2: you and your friend don't play at all). When one acts hawkish and the other dovish, the hawk takes advantage and "wins," but the dove still gets to keep something (3,1: your friend swerves away last minute and you get bragging rights).

In game theory, an instance of Nash Equilibrium, named after mathematician John Forbes Nash, is where each player's strategy is a best response, or highest available payoff, after taking into account the other player's strategy. Furthermore, there is no incentive for them to flip-flop. All in all, if faced with a hawk, it is in the best interest of both parties to turn dovish, as a hawk versus a hawk results in nothing for anyone.

With respect to the trade war, the U.S. started the conflict with acting hawkish and imposing tariffs after years of being in a deficit. While the trade war is still premature, China has retaliated with duplicate hawkishness. Based on the fact that we have been running such a massive trade deficit with China for so long and duplicate hawkishness leads to duplicate destruction, it is in the best interest of itself and the world for China to play the dove until the imbalance is relatively evened out. It is the pure-play Nash Equilibrium strategy.

But Why Should China Submit to a Loss?

The majority of the U.S.'s imports from China are from the practice of shipping raw materials and receiving them back in the form of final products. Sure, American businesses benefit from cheap labor and manufacturing in China, but American's can achieve this level of productivity domestically, but that's a separate discussion. As far as China itself is concerned, it is no doubt that they are skating on thin ice in regards to reliance on American trade. There are two main reasons why this is the case.

The first is that the communist Chinese government owns the largest companies that control their stock market indexes. This means that when their government and other closely involved countries governments make economic announcements, the value of these state-owned companies are affected, as well as the SSE Composite Index (China's version of the DJIA and S&P 500). Moreover, since the U.S.'s first tariffs were administered on Jan. 23rd, 2018, the SSE composite is down 22% as of July 11, 2018! This is compared to declines of 2% and 6% over the same period for the S&P 500 and DJIA, respectively. This shows how sensitive political matters are to markets in a centralized economy.

The second reason is that China's banks support roughly a third of China's economy, and a solid chunk of debt is above lending limits set by the Peoples Bank of China. This is due to a lot of Chinese businesses that operate off the books, unregulated, because they otherwise can't compete with the state-owned companies. With this being said, the Peoples Bank of China does not have a lot of wiggle room to influence its people with rates. Chinese citizens could not handle an increase in interest rates so they are stuck very low.

Knowing these instances, the rich and influential class of Chinese people invest their savings in the safest investment in the world: the U.S. Treasury. According to data directly from the U.S. Department of Treasury's website, China is the single country with the largest portion of US Treasury securities at 19%, or $1.2 trillion. Maintaining low volatility among these assets and the U.S. dollar (of which the Chinese own over $3 trillion in their foreign exchange reserves) is paramount to preserving the bourgeois' wealth.

In summary, the Chinese must proceed with caution with retaliatory tariffs. It's almost as if the Trump administration is trying to help the two countries become more self-reliant, which is worth a thought as the two parties involved have such different values. It is apparent that the Chinese have much more to lose in this trade war, which is why they must "chicken out" for the time being or face the potential of self-destructive consequences.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.