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The Trade War Is Not Over; China Loses

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by: Herve van Caloen
Summary

China is already paying a hefty price for delaying a trade agreement.

Foreign companies are leaving China.

A new binary world; one economic sphere based on the rule of law and another based on the rule of the Chinese Communist Party's whims.

In a recent article, The Trade War Is Over, We Won, I optimistically predicted that China would sign a trade deal because a trade war is not in China's best interests. As of this writing, no deal has been signed, and China is already paying the price. Yet, even at this late stage, I still expect Xi Jinping to come to the table. The alternative would be a "One Globe Two Systems" economy and China would end up spinning its wheels for a few decades. I believe he is too smart to want this.

Deng is dead. Long live Mao!

For two decades, the Chinese Communist Party has been guided by the late Deng Xiaoping's wise words: "Hide your strength and bide your time." Deng's successors remained faithful to his reforms. They implemented a restrained foreign policy while continuing partial economic liberalization. Both Jiang Zemin and Hu Jintao even agreed to step down after two terms in office.

All that changed with Xi Jinping. China's new strongman quickly abolished term limits. He once again prioritized state owned enterprises. Unlike his predecessors, Xi has not been shy about projecting China's strength in the region.

Even so, Xi is too smart to start a trade war with the US if he can avoid it. It is one thing to bully smaller regional countries. It is altogether another to challenge the world's strongest economy. At this juncture, an imperfect deal looks like a better long-term strategy because it buys precious time for China to catch up and close the technology gap with the West. Once a deal is signed, China can always drag its feet.

Despite the delay, the signing of some kind of deal is still my most likely scenario. I believe the two global powers are likely to iron out a mutually acceptable compromise in the coming months. Nevertheless, serious damage has been done to China. Intensified trade tension has caused foreign companies to rethink their commitment to the Chinese market. Many corporations are already diversifying production out of China. Others are growing leery of doing business in a country where the laws are applied selectively and arbitrarily. The just marked 30th anniversary of Tien An Men and demonstrations in Hong Kong may also be reminding people what country they are dealing with.

A New Binary World

In another recent article (Market Volatility And China's One-Way Road), I argued that we have moved away from globalization and toward a new binary order in which two separate economic spheres try to coexist. One sphere is based on the rule of law, but the other is based on the rule of the Communist Party in Beijing. Since I wrote that article, Nokia (NYSE:NOK) and Ericsson (NASDAQ:ERIC) have announced that they are making drastic changes to their corporate structures. Both Scandinavian tech companies are separating operations into Eastern and Western hemispheres to protect themselves against the escalating global trade war. They may be the first ones to do so, but they surely will not be the last.

As of now, it does not appear that China is in a position to isolate its economy from the West. If Xi Jinping truly believes otherwise, and he chooses not to compromise with Trump, a major slowdown in Chinese economic growth is likely, maybe even a Japanese style implosion followed by decades of stagnation. Xi's warning of a new Long March ahead may come true. Not that there is a need for the government to start a long march to the north to escape an invading power. All Xi meant by this metaphor is that in the event of a trade war real hardship would result.

The Risks of a No-Deal

An early deal could have been sold as a new era of cooperation between the two world powers, a win-win situation. Both countries could have given it a positive and credible spin. It would have lifted the whole world economy. Xi and Trump would have been unanimously praised for their vision.

This was not to be. Perhaps the US was asking for too much. Maybe China was not negotiating in good faith. Whatever the reasons, pretending that a trade deal is the result of constructive cooperation is more difficult now. China has painted itself into a corner. The risk of China losing face has increased considerably and this could lead to a historic mistake.

For the US, the stakes are very different. Forget the huge trade deficit. The real issue is stopping China from stealing our technology before it is too late. Keeping a laissez-faire stance in the face of a Chinese predatory economy is suicidal, plain and simple.

What Are the Options?

Xi does not want to become China's Nikita Khrushchev. A major confrontation with the US in the early 1960s brought down Stalin's successor. When Khrushchev blinked in the Cuban Missile Crisis, the Central Committee of the Communist Party of the Soviet Union could not forgive the humiliation. He ended up spending the rest of his life confined to a dacha near Moscow.

If Trump pushes too hard, Xi will thus have no choice but to walk away. Alas, the alternative to an increasingly difficult deal is probably worse for China because a trade war will exacerbate the structural problems inherent to the Chinese system. As The Economist put it: "China's state capitalism funnels cheap capital towards state firms, bullies private companies and breaches the rights of foreign ones".*

Xi's authoritarian policies have made things worse. Instead of continuing Deng's liberal policies, Xi Jinping has further tightened government's grip. State-owned companies' share of new loans has risen from 30% in 2013 to 70% today, for example. More ominously, firms must now establish communist cells which have a say over hiring and investment decisions!

There are precedents in history for such an economic model. Mussolini and Italy's Labour Charter of 1927 come to mind. It confirmed the importance of private initiative in organizing the economy while still reserving the right for state intervention, most notably in the supposedly complete fascist control of worker hiring.** That model is not the best history has to offer.

The irony, as Liu He, Xi's top trade negotiator, seems to believe, is that the changes Trump is trying to impose on China would save it from gradually becoming an even more fascist economy: "China will further speed up reform and opening up, especially on market access, fair competition and protection of property, especially intellectual property," Liu said recently.*** There is hope.

* "Can Pandas Fly?" The Economist of Feb 23, 2019

** Wikipedia

*** Bloomberg June 12, 2019 "External Pressure Can Accelerate China's Opening Up, Liu He Says"

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.