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The China-US Trade "War": Questioning Economic Predictions - Part 1

BLOG - 27 November 2019

From 2018 to mid-2019, the consensus among economists on the consequences of the US-China trade conflict was deafening. One economic think-tank after another issued papers and/or op-eds explaining that the Trump administration’s tariff increases was akin to dropping a stone on one’s own foot. In a second volley, it was often said that "decoupling" technologies and their financing would hurt America’s high tech sector and its international partners as much as China, which would also be encouraged in its push for self-reliance. Assessments from Chinese sources, and especially the PRC’s controlled media1, have hovered between ambitious claims and more cautious perspectives. One of these affirmed that China would prevail "in the long term", thanks to the resilience of the Chinese economy and/or political system, with even a chance for China to develop self-reliant technologies. The less optimistic perspectives, according to another viewpoint, mentions "the extreme case, where the United States imposes tariffs on all imports good from China, and China on all imports from the US, China will suffer more than the US. Therefore, China should not be driven by the US and flight in the field that is disadvantageous to itself".2 Others have stuck to a middle course, emphasizing the lose-lose nature of a full-blown trade conflict.3 There have also been variations in time. Firstly with optimism, until the resumption of Trump’s trade offensive in the spring of 2018. Then succeeded by a more hesitant mood. A return to stridency in August 2019 when there was a new phase of tit for tat tariffs announcements. Several statements since that date have been ambivalent, legitimizing both "principles" and "flexibility/compromise" on the Chinese side. Clearly, Chinese analysts are having a hard time predicting the behavior of their own side in the conflict.

The school of self-castigation

Some Western think tank interpretations or predictions went further, without fearing a degree of inner contradiction: the global economic slow-down in 2019 is often attributed to lower growth in China, with lower external demand and less financing going abroad. Thus the trade conflict would have no significant impact on China, yet enough impact at the same time to slow down global growth...
 
Decoupling itself has become a topic of discussion. Even if this is not something the Trump administration recognizes as its strategy, the fact that Steve Bannon is pushing it, and its frequent mention by Chinese sources even as the "strategic goal" of the Trump administration as opposed to its "trade goal"4 have given real saliency to the issue. The IMF has opportunely published a paper based on a two-country modeling of changes in value chains, deducing that value chains are mostly inflexible. The conclusion, left implicit, is that "decoupling" simply cannot happen. In response to a Nomura Research Institute study that pointed out the trade diversion effects of the US-China trade conflict, IMF’s Christine Lagarde acknowledged it yet pointed out that the net impact on the overall US trade balance would not be felt and that these trade diversion benefits for other economies were only "a short term fix". Yet a shift of US imports to other providers, unless it results from bogus Chinese sales through these third countries, implies shifts in the value chain5, and would seem to contradict the IMF’s theoretical model. As we shall see, some value chains are indeed very hard to replace, and both parties in the trade conflict have chosen to spare these for the time being. But that does not apply, by any means, to the entire mutual integration of what was once called Chimerica.
 
Yet a third volley of papers has focused on the "uncertainty" brought by the trade and wider economic conflict. That is indeed an important political aspect of the situation, heightened by the peculiar circumstances of the Trump presidency, and we shall return to this third aspect.6

A dismal track record for economic science applied to China

Interpretations derived from the dismal science should be checked, especially when they intersect with political issues. So it is with the US-China trade conflict, with some pundits going as far as to predict a "catastrophic outcome" that would be "worse than world wars". On China – perhaps more so than on many other issues – economic consensus or quasi-consensus has been proven wrong on a number of occasions. A prime example is the contention that globalization, and its number one feature – direct investment in China making it "the global factory", had NOT resulted in an overall job loss in older industrialized economies. Less than three years ago, Peter Navarro, author of the best-selling Death by China, who claims that job losses for the United States have been very large, was appointed to Donald Trump’s White House. This was met with a barrage of scorn from economists and many others. Yet, by 2016, a pioneering study had begun disputing the thesis that globalization and the increasing trade deficit had a net positive impact on employment in America. A similar forecast has been published by the European Commission on the potential impact of market economy status in sectors where Chinese production is sold at dumping prices.

About the US-China trade conflict, some pundits going as far as to predict a "catastrophic outcome" that would be "worse than world wars".

And what to make of Paul Krugman’s recent and courageous apology for his role in what he now calls "the 1990s consensus"? Krugman now writes that the surge in the American trade deficit "explains more than half of the roughly 20% decline in manufacturing employment between 1997 and 2005". He does qualify his reversal, saying that the "China shock" coincided with a wave of "hyperglobalization" that has now ended. In his view, reverting now to protectionism would "create a new set of winners and losers". Certainly. Meanwhile, for decades, critics of both hyperglobalization and of imbalances with China have been treated at best as mavericks, at worst as crackpots.

Neither is this the only issue on which revisiting the past leads to changed conclusions. The whole of China’s 2001 admission to WTO is now seen in a new light. The dominant view at the time was that China was going to take a turn towards marketization, motivated by the benefits of integration in the global trading system. Nevertheless,  the concessions made by China at the time of signing the WTO accession protocol were often vague: the 15 articles, re-read, are almost all abstract and open-ended commitments. In reality, WTO accession has turned out to be at best the ceiling of future liberalization, not the floor. The adjustments that have been made since then are mostly the result of transactional concessions in response to repeated pressure, or the beginning of a structural change with lower growth, that rebalances China’s path towards the domestic economy: slowly, the share of consumption and of the service sector are growing inside China’s GDP.

China’s current account surprise in 2019

Another occasion when economic analysis has been caught on the wrong foot is very recent: at the end of 2018 and the beginning of 2019, the reduced trend for Chinese exports led to economic predictions that China’s current account balance would turn to a structural deficit. How deep a deficit was still an open question, but the direction was assumed. It is interesting to note that the prediction rested largely on the new realization that US tariffs were indeed having a strong impact on these exports. Such a conclusion was in fact warranted by the most recent figures in early 2019 but ran counter to most predictions made six months to a year before. Very few economists have gone against the idea that China’s current account was shifting to a structural deficit. And yet, China’s current account has swung back to what will likely be a 200 billion USD surplus in 2019. Those who had predicted a structural deficit missed some key points: a sharp curtailing of government-induced stimulus in the domestic economy, reduced stockpiling of items now placed under embargo by the US, and the negative sentiment of consumers and private investors alike, have all pushed imports further down than exports. In 2018, price increases for commodity and energy import prices had also brought down surpluses.

The government took measures to reduce outward capital flows – stopping the reduction of its foreign currency reserves as well: China’s foreign currency, after reaching a peak of around 4 trillion USD in 2014, were drawn down until early 2018, but  now hover above 3 trillions. In sum, those who predicted that the current account would go lastingly in the red missed the impact of government intervention on capital flows, and the pessimism of Chinese actors, which is also likely to be at the root of a deep cut in imports.

The answer to the question of who "wins" and who "loses" is likely to be relative, not absolute.

Finally, let’s admit that nobody is perfect – the reasoning above still leaves China with an extraordinary 1 trillion USD global trade surplus in manufactured goods (as opposed to the balance on intermediary goods and components that is lower). Some export trade diversion also helped Chinese exporters, compensating reduced sales to the US. That could be a source of vulnerability over trade conflicts with the United States and other trade partners, but it is also a sign of economic strength.

In that sense, and in that sense alone, the tariffs have not made a dent in China’s mercantilist economy. In fact, if household savings remain at a high level while investment slows down, which is the case, and if the debt pyramid does not collapse (the state is increasingly cautious as we shall see about new credit to the economy), excess savings are likely to produce an even larger external account surplus.

The answer to the question of who "wins" and who "loses" is likely to be relative, not absolute. As we shall see, decoupling – or the denial of critical technologies, whether these are embedded in software, components, or intangibles such as advanced education and research  – is likely to be a question with more absolute answers in a longer term perspective. For the time being, it is important to dissect who won and who lost in what will soon be a three-year span of trade conflict, rather than a "war".

 

1To be developed in part 2 of this blog series
2Lan Yisheng, “Responding to the Trade War, China has Favorable Geographical Condition and Popular Support 应对贸易战,中国占据地利与人和”, April  08, 2019, available at http://www.cssn.cn/hqxx/201804/t20180408_3899484_1.shtml

3"How to Respond to this Unavoidable Trade War - Interview  with Yu Yongding  at the Chinese Academy of Social Sciences 如何应对这场不可避免的贸易战? ——专访中国社会科学院学部委员余永定", June 7, 2018, available at http://www.cssn.cn/jjx/jjx_gd/201807/t20180706_4498089_2.shtml
4Yao Zhizhong,  “Recognition What the Victors are in the Trade War 打赢贸易战的标志”, July 11, 2018, available at http://www.cssn.cn/gj/gj_hqxx/gj_tt/201807/t20180711_4501126.shtml
5See coming part 4 of this blog series.
6See coming part 3 of this blog series.

 

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