The U.S.-China Trade Dispute

Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Linda True.

And I’m Paul Tierno. We’re analysts in the Country Analysis Unit, and our job is to monitor financial and economic developments in Asia. Today, we continue our series, Rethinking Asia, as we consider noteworthy and unusual trends in Asia in finance and economics. Today we sat down with Louis Kuijs, the head of Asia Economics at Oxford Economics.

We spoke with Louis about the current status of U.S. and China trade talks, and the role that ongoing trade negotiations have played on their broader economic relationship. They have exposed some deep seated beliefs on U.S. and China competition that will be here for some time to come.

It was also interesting to hear Louis talk about how China’s evolution from being a major re-exporter to a huge final consumer has major implications for the global economy. There’s that old saying “when the U.S. sneezes, the world gets a cold.” Well, according to Louis, that logic applies to China for more and more countries these days.

Great. Well let’s get to our conversation with Louis.

Thank you for being with us today.

Pleasure.

So Louis, to get started and for the benefit of the audience, can you provide an overview of where we are now in trade talks? And how likely is an all-out trade war?

I think there are two points to make. One, with regard to the trade war in the narrow sense – I think the situation, the mood has improved quite a bit. The U.S. and China are now talking. They’re negotiating and that is much better than what was the case for most of last year, when there were no meaningful discussions. It looks like the U.S. side is a bit more interested now in actually coming towards a deal. I still would not assume the U.S. will completely remove the specter, the threat of tariff hikes anytime soon, but I do think it’s quite likely now that some deal emerges eventually, whereby these tariff hikes will be off the radar screen for a while. Not indefinitely, but at least for a while. That would be a reflection of quite positive vibes around that discussion between these two sides.

But I also want to add that if you look a little more broadly, I would say the relationship is obviously deteriorating. We’ve seen quite a shift, I would say, in the U.S., in terms of how do we look at China. A few years ago, I think … most people in Washington, D.C. at least, were talking about potential cooperation, things like that. Now the talk is much more about rivalry, and rivalry in many dimensions.

There is, of course, always that issue in the background that issue that China has a very different political and economic system, and I think that the recognition in the U.S. that that system is not going to converge to a U.S. or a Western system, was a little late. But when it took hold, it started to shift opinions in Washington, D.C., it looks like.

We’re not talking much more about national security, rivalry, and even … I think, some people would plainly admit it the need to contain China, at least technologically. So a very different background, and of course, that whole technological discussion and the measures that the U.S. is taking against that background, I think that will affect relationships going forward, and that will also show up in the economics, in the economic statistics. It will affect productivity growth, it will affect the room for things like economies of scale, and for fruitful movement of technology, and of learning; these kind of things. I would say, more broadly, that the situation looks a little less rosy than if you just look at that tariff issue.

You talk a little about the endgame for the U.S., in terms of the perspective shifting to one less of cooperation perhaps, and one now more of rivalry. Can you talk about what the endgame is for China, and what they hope to see out of the negotiations?

I think that when Xi Jinping announced to the world — of course to China but also to the world — China’s really big picture objectives in October 2017. He talked about China in the coming three, four decades, really big picture vision and strategy. He said two things, and I think that he was genuine in declaring China’s objectives.

On the one hand, he wanted China to open up more to the global economy. He wanted to see China integrate further in the world economy and the world financial system. And I personally still think that is a genuine desire among China’s leaders.

At the same time, he hammered on the fact that they are not envisaging caving in or toning down on that issue of, ‘We want to continue with strengthening our existing system, which is socialism with Chinese characteristics.’

If you wonder what that means, it means a particular model. Of course there is the political side of things, but even in terms of economic policy, there are quite some differences, you know, if you compare it with the U.S. It means a strong role for state-owned enterprises, a strong role for the government in leading, basically, many processes in the economy, and of course that important role for the Party- the Party being at the heart, also, in terms of economic decisions and things like that.

So those two objectives together involve a little bit of tension. There is a degree of incompatibility, I would say, between those two objectives, because the U.S. is not the only country that has issues with China’s economic model, and we see some of those complaints and tensions also coming out in other international discussions.

But if you ask China’s leader, “What is your endgame?” I would say, “We’re going to try it anyway. We are going to try for us to reform and open up more, but on our terms. We are definitely interested in working more with the global community and integrating further, but it will be on our terms, with our model.” And I would say that is the endgame for China.

Economists have many different estimates on the potential impact to global GDP. Based upon these estimates, it looks like the impact will be sizeable but not catastrophic. How should these estimates be interpreted? Are there factors that are not being considered, that could affect market participants?

We’ve seen a lot of work being done by many very sensible economists and institutions. And of course, most of that work has focused on the impact of the trade tariffs on the economy, especially via weaker exports and also via higher prices. I think broadly the results of that work have converged a bit. It’s pretty sensible, it’s pretty thorough, and I think there is a reasonable degree of similarity in results across different studies.

But there’s one issue; the wild card really here is confidence effect. And if you look at various studies, including our own, we all agree that the impact of those confidence effects is really quite sizeable compared to the direct impact. If you just look at the direct impact on trade, that is not going to really move the dial in a significant way, but everybody has those confidence effects, and what they do to economic activity via financial markets.

At the same time, we all know it’s really hard to quantify, to put an exact number on those confidence effects, and if you look at the IMF study, it’s also quite interesting. The IMF has a very broad range of the size of those confidence effects, and you know, that really underlines how difficult that is. I think that also, we at Oxford Economics actually last year at some point, reduced our estimate of the impact of the trade tariffs, simply because we noticed that those confidence effects were not as large as we had initially embedded. So I think that’s an important point to make.

But then on the other hand, of course, there are two additional uncertainties or issues that are not necessarily picked up very well by all those studies. One of course is that medium term impact of the trade war, and the more broader technological strategy that the U.S. is carrying out with regard to China, and what that will mean in terms of corporates relocating manufacturing production.

Of course, some in the Trump administration hope that we will see more relocation of parts of supply chains to the U.S. I think it remains to be seen really how much we can expect on that front, but it is quite likely that if those tariffs are really very sizeable, that we will see some movement to other countries in Asia. Everybody is aware of the issue; there has not really yet been an awful lot of such relocation, because nobody knows exactly how high these tariffs are going to be and how long they will be in place. But such relocation is quite likely to happen and to add to the more direct impact of the tariffs, in terms of what they do to exports in the short-term.

I think a second point that we kind of already touched on, is that medium to longer term impact of that underlying tension between the U.S. and China, that increase in underlying tension. And you know, some people use the word Technological Cold War; it sounds like a big word, but I think there is something to be said for it.

One major consequence that we noticed after the ZTE case last year – this is the case of the Chinese telecom producer that was sanctioned quite harshly, initially, by the Commerce Department, for having violated the terms of an agreement on the violation of sanctions – and at some point it looked like that company may well go under if nothing happened. In the end, President Trump intervened. ZTE is still operating, but that case led to a galvanization of minds in Beijing that ‘we have to double down on our objective to become technologically more independent of the U.S.’ And so, in that sense, a little bit of an ironic impact, but this is also very much an impact of that broader tension between the U.S. and China, that it leads to a stronger desire by China to become technologically independent.

Louis, I wanted to pick up on something that you said, specifically that if tariffs start to bite really hard, we might see relocation of manufacturing away from China. Some people use the term Factory Asia to discuss how Asian economies and supply chains are sort of intertwined. Thinking about the supply chain, but also export production, import consumption, kind of the various linkages, could you give a broad picture of the trade flows between the U.S., China, and the rest of Asia, as well as trade positions, and just maybe drill down a bit little deeper?

This is a great question, because it is so fascinating, and it changes so steadily. If you look at the trade links within Asia, especially if you look at where do the products end up eventually, then I would say a few points to make are that we’ve seen a spectacular increase in the role of China as a as a destination for imports from all kinds of Asian countries, whether you are Japan or whether you are Indonesia, or whether you are Australia. Massive increases of China, in terms of the importance as an export destination.

Now it’s quite interesting, because we have on the one hand, of course, there is that traditional channel, these global supply chains where components are being put together and are eventually assembled in China, and then the products tend to go to the U.S. or Europe. So in that sense, they are being re-exported out of China. That is one channel.

The other channel, one that has risen quite significantly in terms of the numbers, is really just going to final demand in China. We did some work last year showing that actually that second channel has risen much faster than the first one, and has become the larger one for most Asian countries.

So I would say, if you want to understand what is going to be the impact on the rest of Asia of the trade war between the U.S. and China, you have to very closely look at what’s happening to China’s economy, because the majority of that impact will be via what is happening to growth in China, China’s domestic growth, and its demand.

You just painted a picture of a very integrated supply chain, and a world that is increasingly interconnected and dependent on trade. With that in mind, what does the potential fallout of U.S. China trade tensions mean for global growth?

Even without the trade war, we at Oxford Economics we already expect the U.S. economic growth to cool and also in China. So have those two largest economies in the world slowing down, and that, of course, means that global demand is under pressure, that we have less import demand globally for the rest of the world. And that, you know, has put downward pressure on international trade, on commodity markets, and thereby also of course on the financial markets.

For me, as I mentioned, looking at what is going to be the impact on the rest of Asia, it’s become really important to look at what’s happening to China’s economy itself. Now we definitely have China slowing in 2019 in our forecast, but we still think that China is quite well-placed to at least dampen the impact of the trade war and also dampen a bit more generally the slow down. So we have China slowing from 6.6% last year to 6.1% this year. That’s definitely a step down in growth, but it should not be completely the end of the world.

So we think, actually, that the sell-off that had taken place in financial markets, especially in December, was a bit overdone and of course, probably what happened more recently was perhaps a realization of that. I think that yes, the global economy is going to slow down in 2019 compared to what it did in 2018, but at least in our reading, it will continue to see quite decent growth, because the probability of a recession in the U.S. remains quite modest, in our view. Also, China’s government, in our view, will be able to contain the impact of the slowdown and will contain the degree of that slowdown. So we are not that negative on growth in 2019. It’s not going to be as good as last year, but that’s not the end of the world.

I’m wondering if there any silver linings. I mean the talks have been pretty negative so far, but I’m wondering if there are any silver linings, in terms of rearrangement of supply chain, and whether some Asian economies could actually benefit from less trade between the U.S. and China? If so, who would stand to benefit the most, and why?

This is something that people in Asia are discussing a lot and looking at. There is definitely some scope for more production moving to other countries. And of course, this is not something new, right? We already saw significant amounts of manufacturing production moving out of China. That was not just done by multinationals, it was also sometimes done by Chinese companies, who have looked at Vietnam, Cambodia, even also Malaysia and Thailand; especially in Vietnam and Cambodia, where labor costs are much lower.

That process of rationalization and optimization in terms of these supply chains may, in a way, be amplified by tariffs on Chinese goods. I am a little concerned though, that this could be a partial gain, and that if you look at the broader picture, it’s hard to see the positive. I think it’s quite interesting. I think Vietnam’s prime minister a few days ago said, “Look, we may well benefit from an additional factory here and there, but overall, this trade tension is bad news for us, because it weakens growth in China, it weakens trade more generally and that is not good for us.”

So I’m a little skeptical, personally, as to whether there will be countries for which the overall result is a net positive. But, you know, that doesn’t take away the fact that yes, if you are a country where there is already a quite established manufacturing capacity to produce certain parts of the chain, in electronics or, for instance, in automotive parts, then you may well see some additional manufacturing capacity moving your way. So certain sectors may benefit, and it’s not impossible that a country like Vietnam could eventually be a net gainer. I would just caution that I think for the bulk of Asian countries, this trade tension is a net negative.

I have two questions on two different multilateral free trade agreements. One is on the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, or CPTPP; the other is on the Regional Comprehensive Economic Partnership, or RCEP. For the CPTPP, which came into effect on January 1st for eight economies, will we see an increase in intra-regional trade? How would the RCEP be utilized in comparison to the CPTPP, given the context of the trade war?

Even though the U.S. withdrew from the TPP, the other countries involved in the TPP basically proceeded, and the CPTPP came into effect on January 1. You know, I think the empirical evidence on trade liberalization is pretty convincing, pretty overwhelming, so I think that by itself, a further agreement to lower barriers to trade is going to boost trade between those eight economies.

We’ve seen quite an interesting process in Asia over the last five, six years or so. There has been attempts, for instance, within ASEAN (Association of South East Asian Nations), there has been attempts to lower trade barriers between those countries and to see more intra-regional trade. If you look, say, 10, 15 years ago, it was quite striking to see that many Asian countries exported a lot, but often the trade between them was really very low. That is changing. There are efforts, and I think these initiatives may further stimulate more intra-regional trade, which makes a lot of sense.

If you look at Europe, intra-European trade is dominant. It’s very, very sizeable and it tends to be good for productivity increases and for division of labor. So the desire that we still see, at least in Asia, for trade liberalization, I’m quite hopeful that will yield results and that it will lead to more trade between those countries.

Now, of course, it is true that without the U.S., clearly that Trans-Pacific Partnership is not the same as it was originally intended. If the largest market is not there, then clearly it’s in a different ballgame, but nevertheless, I think by itself the CPTPP is a positive.

Then thinking about the RCEP, some people would put it that the RCEP is less ambitious than the CPTPP – sorry for the many abbreviations—so the RCEP is more straightforward trade liberalization agreement and doesn’t have all these clauses and conditions on things like labor conditions and other social considerations. It’s a little more straightforward on trade. Of course, it is driven by China, so it has a much larger market that it can promise, and therefore, that also means that many countries in Asia are actually quite interested in pursuing it. It’s definitely less advanced; the negotiations have been taking place for a much smaller time period than in the case of the Trans-Pacific Partnership. Some people view it as a competing arrangement but I think it would also be possible, in principle, to see it as an additional layer or an extension.

I think it would pay for the U.S. to wonder if it really wants to stay on the sideline as such a lot of trade liberalization continues to be pursued in Asia. Because I think there’s one interesting observation to make about globalization and trade liberalization. I would say in much of the West, globalization has gotten a bad name and we’ve seen a backlash. I would say in Asia, for a whole set of very complex reasons, there has not been as much of a backlash, and I think the appetite, especially among governments itself, for further trade organization is pretty strong, and that ranges all the way from Japan and Australia on the one hand, via China, to countries like Cambodia and other ASEAN countries. I would say I think that Asia is pretty likely to continue to see further trade liberalization.

The tables have turned a bit, in terms of how the different countries, and the different regions look at it. I wanted to ask you: You said the U.S. is sitting on the sideline. I know that prior to the U.S. pulling out of TPP, some people had talked about how it was meant to be a competition for China, but now with the U.S. out of the picture, is there any sense that China would actually join the CPTPP?

I think we cannot rule it out. There recently was a senior policy maker, a senior politician, a Chinese one … He may even have been Minister of Commerce, don’t quote me on that … so I think there have been some signals from the Chinese side that “this is something that we may want to explore,” because I think from China’s perspective it may make sense, and then probably also with the U.S. not being there the other countries might hammer a little less on some of these conditions and considerations other than pure trade liberalization. Yeah, I guess China has put a lot of capital in its own scheme, its own project, that RCEP, but I wouldn’t rule it out that there will eventually be some kind of convergence or some way in which the CPTPP will embrace China.

Louis, I just wanted to look at the future a little and maybe ask you to put your forecasting hat on. Where do you see things standing in, say, two years? Or maybe given how quickly and how drastically things change, perhaps even one year? Assuming there’s going to be prolonged trade tensions, for lack of a better term, will China respond by enacting more stimulus and put structural reforms on hold? Are there any silver linings for the Chinese economy, perhaps because now they feel emboldened to do more on the structural side?

I think that just looking at what policy makers in China are telling us and what they are striving to do, it’s obvious that they have already eased their macroeconomic policy plans, and they are now providing more stimulus than they had envisaged a year ago. So yes, we see efforts to make domestic demand robust and to make a domestic economy less vulnerable to declines in exports, things like that. So really there is an effort to have solid growth of domestic demand in China, and that means more stimulus. Also, as I mentioned before, quite interestingly, an effort by China’s government to continue to be seen as being a responsible stakeholder in the international system and opening up its reform. You know, like in the words of trade economists, to do ‘unilateral opening up.’

I think some of what China is trying to do is to say, “Look, we have huge issues with the U.S. but we are still interested in opening up our economy, and we will also continue to reform.” Now, of course, I think there is a degree of skepticism around internationally. That skepticism and criticism about China’s economic model is not just confined to the U.S., but is actually quite broadly spread, definitely in Europe.

It remains to be seen how that evolves but I’m quite sure that China will continue to present its strategy as one of opening up and reform, very consistent with its own long term plans, like its five year plans and its even longer term plan. So I think that they will continue to reform.

There’s a lot of discussion, has China backtracked on reform? I think there are huge issues in terms of the politics and in terms of suppression and censorship, all these things. But I would argue that in the very technical dimension of economic reform, I don’t think that we have seen really a regression or a backsliding. And I would expect that to continue; so continue with reform, but very much of course on China’s own terms, and likely to see market-oriented reform in specific sectors without moving to a full-blown U.S. type capitalist economy, in the sense that they still will be very keen to have SOEs (state-owned enterprises) play a large role. They want the government to play a large role, and so it is very much reform with Chinese characteristics.

I have a tangential question, which moves back to your very first response and also requires a very long forecasting hat. You had mentioned the Technological Cold War. I sort of remember about nearly 10 years ago, China had its policy for indigenous innovation. Back then I saw it apply more to different automotive vehicles and design. Now you have China successfully growing the first plant on the moon … although I believe it died. Do you see China winning the Technological Cold War?

I guess it depends a lot how you define a win.

I think the U.S. is still obviously so much stronger than China, technologically. There’s absolutely no doubt about it, and again, the ZTE case showed that. If President Trump had not intervened, then probably ZTE — ZTE is that Chinese telecom producer, which as some of its peers has made remarkable progress in terms of moving up the value chain and becoming a big player globally. But at the end of the day, it is still reliant on high-end U.S. chips and some other really high-end U.S. material, including also of course the Google Android system. So at the end of the day, the U.S. is still miles ahead of China technologically, but I think we should really not be so surprised about it.

I guess what is intimidating many people in the U.S. and in the West is the vast progress that China is making. The fact that you have a country with a GDP per capita of only like $8,000 or $9,000 – that it’s amazing that we are even talking about China as a technological threat to the U.S. and to the West. So I think it is the steady progress, and the likelihood that many of us see that this will continue that some would define as a win, that China will continue to get closer to the frontier.

Louis I just wanted to go back to one of your first responses, when you said that things have started to look a little rosier now that there have been discussions. Assuming that things have gotten a little rosier, can you also say, however, that a lot of the damage has already been done in terms of confidence first, if you look at some hawks in Washington, perhaps being a bit more emboldened to stick with their positions, but also in terms of attitudes by multinationals across Asia, realizing that it doesn’t pay to put all of their eggs in one basket perhaps, when it comes to China?

Yeah, for sure. I mean, this is something that once you start with process, it’s difficult to close the lid again on that box. So, yes, of course, the changed attitude by the U.S. government, and as you mentioned, it’s not just the government but I think more generally also the business sector. That changed attitude and the trade tension that has been a result of that has created uncertainty, it has created the threat of tariff imposition, and the imposition of other measures. That uncertainty will not go away so soon, and I guess some people in Washington, D.C. actually explicitly don’t want to see that uncertainty go away, because they want multinationals to continue to hesitate before they make further investments in China. So I think that yes, in some ways, damage has been done, and that damage will not go away so soon.

There’s one theme if you talk to business people in Asia; some people call it ‘wait and see.’ It’s really a postponement of decisions in the midst of that uncertainty, and I think also that more general rivalry that is in the background of all this will not help in this particular sense. Clearly trade relations, and plans for globalization, and for strengthening of ties on these dimensions we clearly have seen things moving the wrong way, in such a way that it’s really hard to imagine for that to go back to zero, in terms of the damage being undone. Yeah, I agree with that.

Well this has been great, Louis. We really appreciate you taking the time to speak with us today.

Very much a pleasure.

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