Background of the China-US trade war and how it will hopefully end

1.     The current trade war

The world’s biggest economies have been engaged in an escalating trade war that is starting to have a greater impact on financial markets and global growth. What was seen in the beginning as a general policy aimed at all of the trade partners of the US, including friendly ones like the EU and countries bordering with the US and having trade agreements (Canada and Mexico), has turned into a trade war with China, the second largest business partner of the US (Europe is actually the biggest). Trump has decided to end the big trade deficit with China (close to 350 billion dollars) and has enacted trade tariffs on Chinese goods to prove how serious he is on this matter. The Chinese in turn, put similar trade tariffs on almost all imports from the US. And this is just the beginning. Trump is threatening to tax all Chinese imports if his demands are not met. A full out trade war seems to be inevitable at this point.

2.     The dangers of a trade war

Although it is not logical to expect the US to accept enormous trade deficits for long, a trade war will almost certainly lead to lower economic growth in the US as well as in China. The best historical example is the period after the start of the great depression (1929). The US government tried to strengthen its economy with the 1930 Smoot-Hawley Tariff. It increased 900 import tariffs by an average of 40 to 48 percent. Its purpose was to support U.S. farmers who had been ravaged by the Dust Bowl. But it also raised food prices for Americans who were already suffering from the Great Depression. Other countries retaliated with their own tariffs. It forced global trade down by 65 percent, worsened the depression, and contributed to the start of World War II. The current trade war has the potential to cause even more damage since the world is more interconnected and interdependent then in the 1930s. Any economic conflict has serious consequences for all sides.

3.     China’s historical reference: the opium wars

The current conflict between China and the US is not without historical precedent. The opium wars of the mid 19th century were also in essence trade wars. Commerce between China and the western world (Europe and the US) revolved around Chinese tea (which had high demand mostly in the British empire) which was exchanged for silver. China had a high demand for silver due to its shift from paper money to coins in the early period of the Ming Dynasty. The Ming dynasty experiment with paper currency eventually failed due to self-imposed inflation along with an inability to stop the production of counterfeit bills. The Ming attempted to produce copper coins as a new form of currency, but production was inconsistent. Hence silver became of high value because it was a valid currency that could be processed abroad.

This Silver-Tea trade created chronic deficits for European governments, which were forced to risk silver deficits to supply merchants in Asia. As supplies of silver decreased in Europe, Europeans had less ability to purchase highly coveted Chinese goods. Merchants were no longer able to sustain the China trade through profits made by selling Chinese goods in the West and were forced to take silver bullion out of circulation in Europe to buy goods in China (thus creating deflation in Europe). In the 19th century, American merchants began to introduce opium to Chinese markets. The demand for opium rose rapidly and was so profitable that Chinese opium dealers began to seek out more suppliers of the drug, thus inaugurating the opium trade; one merchant declared that Opium "is like gold. It can sell any time." From 1804 to 1820, a period when the Qing Dynasty needed to finance the suppression of the White Lotus Rebellion, Chinese merchants were soon exporting silver to pay for opium rather than Europeans paying for Chinese goods with the precious metal (thus reversing the silver flow).

In 1810, the Daoguang Emperor issued an edict concerning the matter, declaring, "Opium is a harm. Opium is a poison, undermining our good customs and morality. Its use is prohibited by law." Following a debate at court in 1836 on whether to legalize the drug or crack down on its use, the emperor decided on the latter. An upright official, Commissioner Lin Zexu led the campaign against opium as a kind of "drug czar." The British, offended by the seizure of their property in opium, sent a large naval expedition to China to end the restrictive conditions under which they had long traded with that country. Thus began the first Opium War, in which Britain's industrialized military might was proven in China's rout. In 1842, the Qing dynasty was forced to sign the Treaty of Nanking—the first of what the Chinese later called the unequal treaties—which granted an indemnity and extraterritoriality to Britain, opened five treaty ports to foreign merchants, and ceded Hong Kong Island to the British Empire. The failure of the treaty to satisfy British goals of improved trade and diplomatic relations led to the Second Opium War (1856–60), and the perceived weakness of the Qing dynasty resulted in social unrest within China, namely the Taiping Rebellion.

Unequal treaty is the name given by the Chinese to a series of treaties signed with Western powers during the 19th and early 20th centuries by Qing dynasty China after military attacks or military threats by foreign powers. Historian Immanuel Hsu explained that the Chinese viewed the treaties they signed with Western powers as unequal "because they were not negotiated by nations treating each other as equals but were imposed on China after a war, and because they encroached upon China's sovereign rights ... which reduced her to semi-colonial status". Starting with the rise of Chinese nationalism and anti-imperialism in the 1920s, the Kuomintang and Communist Party used these concepts to characterize the Chinese experience in losses of sovereignty between roughly 1839 to 1949. The term "unequal treaty" became associated with the concept of China's "century of humiliation”.

These historical events, which are not known to most people in the west, are extremely important in understanding China’s response to the current trade war. It would not be an exaggeration to say that the Chinese president, Xi Jinping, will do everything in his power to prevent any treaty that is perceived as unequal or humiliating to China.

Saying that, it is important to mention that in history it is very easy to confuse Cause and Effect. While most Chinese perceive the opium war as the cause of the unequal treaties and century of humiliation, most modern historians regard the calamities in China in the 19th century as a general sign of the decline of the Qing dynasty, that started with the “White Lotus Rebellion” in the end of the 18th century (1796), well before the opium wars. 

4.     The plaza accords

A more recent example for a trade related conflict is the Plaza accord of 1985. In the 1980s, during the Reagan administration, trade friction between the United States and Japan extended to every possible area: electronics, automobiles, machine tools, precision machinery, construction equipment, semiconductors, communication equipment, supercomputers, tobacco and rice. In the U.S., this led to a rising flood of calls for regulations on Japanese imports. Left unaddressed, the trade imbalance would have prompted a greater eruption of protectionist appeals in the U.S., threatening the system of free trade. U.S. Treasury Secretary James Baker possessed both the historical perspective to recognize that “the isolationism and protectionism of that era [during the aftermath of World War I] in part helped caused the Great Depression” and a determination to avoid repeating that folly. The result of Baker’s initiative was the 1985 Plaza Accord between the U.S., Japan, (West) Germany, England and France, which cantered on adjustments to the currency exchange rates. As far as currency manipulation goes, the Plaza Accord worked. Between 1985 and 1988, the yen appreciated 88% against the U.S. dollar, according to data from the U.S. Federal Reserve. However, America’s trade deficit with Japan did not go away.

All of this has led China to suspect that the Trump administration will soon press for some kind of currency adjustment akin to the 1980s Plaza Accord — Plaza Accord II, if you will. The plaza accords led the Japanese government to flood the market with cheap money that led to a real-estate bubble that collapsed in 1989 (Japanese assets lost about 87% of their value in this crash). This has led to a long stagnation of the Japanese economy (of almost 3 decades) due to what Richard C. Koo calls “Balance Sheet Recession”: Basically, Japanese companies stopped investing in the economy in order to fix their balance sheets that is probably full with a lot of real-estate assets that lost most of their value in the crash of 1989.

However, this is probably not the way the plaza accord is seen in China. Most likely, China sees the Plaza accord as one global power (the US) trying to stop the accent of a rival global power (Japan). The only weakness of such an argument is the fact that Germany also had a stronger currency after the Plaza accords, but did not descend into the same recession as Japan.

5.     What do the Chinese want? (in one word = Stability)

China’s export machine is not an end in itself – it is a means to an end. The real aim of Chinese policy is one familiar to politicians everywhere – jobs. In the 1990s China finally broke the “Iron Rice Ball”: the welfare policy that had previously guaranteed the Chinese people food and some social services at the cost of slow growth and inefficiency. Something resembling a market economy began to appear, which meant that Chinese workers had an opportunity to do better for themselves but had no guarantied support if they failed. The key to this social contract was the steady creation of millions of jobs for the new job seekers.

No one knows better than the Chinese communist party leadership what would happen if those jobs where not available. The study of Chinese history is the study of periodic collapse. In particular, the 140 year period from 1839 to 1979 was one of almost constant turmoil. It began with the opium wars (1839-1860) and continued through the Taiping rebellion (1850-1864), the Boxer rebellion (1899-1901), the fall of the Qin dynasty in 1912, the warlord and gangster period of the 1920s, civil war between nationalists and communists in early 1930s, Japanese invasion and world war II (1931-1945), the communist takeover (1949), the great leap forward (1958-1961), the cultural revolution (1966-1976) and finally the death of Mao and the downfall of the Gang of four in 1976. These events were not just noteworthy points in a chronological history but involved continuing episodes of external war, civil war, widespread famine, mass rape and murder, terror, mass refugee migration, corruption, assassination, political execution and the absence of any effective political centre or rule of law. By the late 1970s, the China politically, morally and physically exhausted and the people, along with the communist party, wanted nothing more than stability the economic growth. Source: Currency Wars by James Rickards. 

6.     The creation of the trade imbalance and turning the Renminbi into a reserve currency

The surest way to create jobs was to turn China into an export machine and indeed in the past 20 years China has become the factory of the world. The trade surplus with the US alone is about 375 billion dollars. In these years China has amassed foreign currency reserves (mostly in dollars) of close to 3 trillion dollars. This mountain of foreign money is considered to be a strategic asset in China, a sort of cushion to soften the blow of any future crises. For instance: since the government owns nearly all the banks, the Chinese government is essentially on the hook for the debts of the entire banking system. As a result, China's official reserves are a hedge not only for country's currency, but for its entire financial system. But there is a big problem with the foreign reserves of China: most of them are in dollars, due to the large trade surpluses with the US. Unfortunately, since the 2008 crisis the dollar has been decreasing in value due to the massive monitory expansion of the American federal reserve bank.

It probably drives some people in China crazy: their economy is the second largest in the world, maybe even first according to some estimates (a position it last held in the beginning of the 19th century), but the Chinese currency is still not considered to be a foreign reserve currency.

The definition of a Reserve currency: “A reserve currency (or anchor currency) is a currency that is held in significant quantities by governments and institutions as part of their foreign exchange reserves. The reserve currency is commonly used in international transactions, international investments and all aspects of the global economy.”

If you look at historical examples, the currency of the nation that has the largest trade, is usually used as a reserve (or hard) currency. This has been true for the pound sterling in the height of the British Empire, the Dutch guilder when “The Netherlands” was the biggest trade nation in the world etc…

The previous global currency (before the dollar) was the British pound. Although the US surpassed Britain in population in 1860 and in GDP in 1890, it took many years before the dollar overtook the pound sterling as the dominant global reserve currency. Although a rapid global switch to the USD was widely predicted after 1945, the end of sterling's reserve role was prolonged until the late 1970s by the structure of the international monetary system and collective global interest in its continuation so. At the end of the Second World War, it was clear that the US dollar would be the dominant international currency in any global economic reconfiguration, and this became the core of the Bretton Woods system. Most of the richer countries pegged their currencies to the USD, while the USD alone valued its currency directly in gold. In the 1950s the sterling area (35 countries and colonies pegged to sterling and holding primarily sterling reserves) accounted for half of world trade and sterling accounted for over half of world foreign exchange reserves. In the early post-war years, this share was even higher – the IMF estimated that official sterling reserves, excluding those held by colonies, were four times the value of official USD reserves and that by 1947 sterling accounted for about 87% of global foreign exchange reserves. It took ten years after the end of the war (and a 30% devaluation of the pound) before the share of USD reserves exceeded that of sterling.

There are several Advantages for a country to have it’s currency as a reserve currency:

• First and foremost – Stability.
• People who live in a country that issues a reserve currency can purchase imports and borrow across borders more cheaply than people in other nations because they do not need to exchange their currency to do so.
• Lower interest rates: the US government as well as Americans citizens borrow at lower costs, granting them an advantage in excess of $100 billion per year. If you count to the year that the US dollar became the world’s currency (1944 in the Breton Woods convention, although the pound remained the major world currency for another 3 decades) and assume the same borrowing rate over the years, the US has gained as much as 7.4 trillion dollars due to the dominance of its currency alone.
• Making it somewhat easier for a country (like the US) to run higher trade deficits with greatly postponed economic impact or even postponing a currency crisis.
• The dollar's role as the undisputed reserve currency of the world allows the United States to impose unilateral sanctions against actions performed between other countries, for example the American fine against BNP Paribas for violations of U.S. sanctions that were not laws of France or the other countries involved in the transactions. In 2014 Beijing and Moscow signed a 150 billion yuan central bank liquidity swap line agreement to get around American sanctions on their behaviours. 

There is also one big disadvantage fo a reserve currency which is summed up by the The triffin dillema: The Triffin Dilemma represents the biggest drawback of having any national currency as the world’s reserve currency: The accumulation of international reserves required persistent deficits to be run by issuing countries that ultimately undermined confidence in the value of those reserves. In other words: countries that want to build a big amount of the world’s reserve currency (for their own stability) need to run trade surplus with the United States (the issuer of the Dollar which is the world’s reserve currency).

A super-national reserve currency

In the Breton Woods conference in 1944, which marks the beginning of the use of the dollar as the world’s reserve currency, the famous British economist John Maynard Keynes realized the problems of having the dollar as the world’s currency and tried to push an idea for an super-national currency (BANCOR) to be issued by the worlds bank or the IMF. The idea was rejected by the American representative of the Breton Woods conference (Harry Dexter White) who insisted of making the dollar into the worlds currency and backing it up by gold (the US was back then the world’s biggest holder of gold). The idea did not die completely and the IMF does issue a note called the SDR (Special Drawing Rights) and its value is based on a basket of key international currencies which are reviewed by the IMF every 5 years. Since the outbreak of the financial crisis in 2008 Keynes's proposal has been revived: In a speech delivered in March 2009 entitled Reform the International Monetary System, Zhou Xiaochuan, the governor of the People's Bank of China called Keynes's bancor approach "farsighted" and proposed the adoption of International Monetary Fund (IMF) special drawing rights (SDRs) as a global reserve currency as a response to the financial crisis of 2007–2010. It is always amazing to see how most Chinese leaders, who grew up in a communist country, understand the basic principles of the world’s economy better the biggest capitalists.

However, it is a difficult process to change the worlds reserve currency (as the transition between British pound to the dollar has showed). It is also unlikely that the US will give up its privileges as holder of the world’s global reserve (the attitude of the US is summed up by Nixon’s treasury secretary John Connally: “The dollar is our currency, but it’s your problem”).

This has lead China to take some steps to turn its own currency into a global currency:

• Purchasing gold
• Adding the Chinese Yuan to one of the currencies that the SDR is based on
• Starting to trade in oil nominated in Yuan (thus gaining similar advantages to the Petro-Dollar system)

The aim is not to replace the dollar as the world’s reserve (doing so will put the mountain of foreign currency held by China to waist and put it in the same Triffin Dilemma as the US), but rather to create a different monitory system which is more global instead of local and national.

7.     Chinas new growth strategy

The growth of the Chinese economy in the past 20 years was heavily based on exports and loans (Chinas loans are estimated to be 2-3 times it’s GDP). China’s government probably realized that the steam behind these two growth engines has run out and other methods are needed to insure growth, jobs and stability in the coming years. Furthermore, the big trade surpluse with the US has become a liability since it allows a foreign country and its leader (Trump) to have too much power over China’s policies and economy. The Chinese leadership (again, with an unbelievable grasp of economics) has decided to take a different road to growth and prosperity:

• Expand trade and create markets via the Belt and Road initiative.
• Transfer the economy from cheap manufacturing into high level technology, quality over quantity and innovation via the China 2025 initiative.

8.     Chinas belt and road initiative

Beijing’s multibillion dollar Belt and Road Initiative (BRI) has been called a Chinese Marshall Plan, a state-backed campaign for global dominance, a stimulus package for a slowing economy, and a massive marketing campaign for something that was already happening – Chinese investment around the world. Over the five years since President Xi Jinping announced his grand plan to connect Asia, Africa and Europe, the initiative has morphed into a broad catchphrase to describe almost all aspects of Chinese engagement abroad. Belt and Road, or yi dai yi lu, is a “21st century silk road,” confusingly made up of a “belt” of overland corridors and a maritime “road” of shipping lanes. From South-east Asia to Eastern Europe and Africa, Belt and Road includes 71 countries that account for half the world’s population and a quarter of global GDP.

There is a lot of controversy in the rest of the world about the BRI (Belt and Road Initiative), but this program is aimed first and foremost in increasing trade and economic activity and thus creating growth in both China and the countries involved.

9.     China 2025 initiative

The China 2025 is another economic initiative. Its guiding principles are to have manufacturing be innovation-driven, emphasize quality over quantity, achieve green development, optimize the structure of Chinese industry, and nurture human talent. The goal is to comprehensively upgrade Chinese industry, making it more efficient and integrated so that it can occupy the highest parts of global production chains. The plan identifies the goal of raising domestic content of core components and materials to 40% by 2020 and 70% by 2025. Although there is a significant role for the state in providing an overall framework, utilizing financial and fiscal tools, and supporting the creation of manufacturing innovation centres (15 by 2020 and 40 by 2025), the plan also calls for relying on market institutions, strengthening intellectual property rights protection for small and medium-sized enterprises (SMEs) and the more effective use of intellectual property (IP) in business strategy, and allowing firms to self-declare their own technology standards and help them better participate in international standards setting.

Although the goal is to upgrade industry writ large, the plan highlights 10 priority sectors: 1) New advanced information technology; 2) Automated machine tools & robotics; 3) Aerospace and aeronautical equipment; 4) Maritime equipment and high-tech shipping; 5) Modern rail transport equipment; 6) New-energy vehicles and equipment; 7) Power equipment; 8) Agricultural equipment; 9) New materials; and 10) Biopharma and advanced medical products.

This initiative follows the course set by Japan, Korea and Taiwan who also started as exporters of cheap products and have later moved to high level technology items. This is also the first sign of China’s moving towards better protection of Intellectual property rights. Japan, Korea and Taiwan were also major sources of copied goods until they accumulated enough IP and patents of their own to make it worth their while to invest in IP protection.

A small historical anecdote: after the American independence, when the US was just a small struggling country and Britain a big empire, Americans were considered to be the biggest thieves of patents and technology from the United Kingdom. Especially remembered is Samuel Slater who brought the technology for the textile industry to the US and most likely started the American industrial revolution (it seems a bit strange today, but back then textile was the most sold commodity).

10.     So what does Trump want from China?

Trump has a long list of demands from China:

• Cut its trade surplus by $100 billion in the 12 months starting in June, and by another $100 billion in the following 12 months.
• Halt all subsidies to advanced manufacturing industries in its so-called Made In China 2025 program. The program covers 10 sectors, including aircraft manufacturing, electric cars, robotics, computer microchips and artificial intelligence.
• Accept that the United States may restrict imports from the industries under Made in China 2025.
• Take “immediate, verifiable steps” to halt cyberespionage into commercial networks in the United States.
• Strengthen intellectual property protections.
• Accept United States restrictions on Chinese investments in sensitive technologies without retaliating.
• Cut its tariffs, which currently average 10 percent, to the same level as in the United States, where they average 3.5 percent for all “noncritical sectors.”
• Open up its services and agricultural sectors to full American competition.
• The United States also stipulated that the two sides should meet every quarter to review progress.

11.     How will the trade war end?

It was mentioned earlier in this article that China wants stability more than anything else. A recession caused by the trade war will lead to less jobs and possibly civil unrest. More than that, what China fears most is losing face: fear of being seen as giving up to a Western bully (Trump). This fear is rooted in the series of “unequal treaties” and the ”century of humiliation”.

Trump’s greatest fear is facing the American voter. He already lost the congress to the Democrats and his “shot from the heap” politics is causing him to lose support in his own Republican party. He has based his reputation as the man who can get the US a good deal. He now has to deliver on his promises. If he does not reach a deal with China, then the trade war will probably lead to slower growth of the US economy (as well as the world’s economy). Furthermore, the growth of the US economy has been fuelled since the last recession by cheap money (due to extremely low interest rates). This has led to an overheated economy (with very high share prices in the stock market). The Federal Reserve bank is now trying to cool down the economy by higher interest rates which can lead to an end to the current business cycle. Unlike the subprime mortgage crash of 2008 or the dot-com crash of 2000, there is no apparent bubble in the market (the Bitcoin and other crypto-currencies had the potential to become the next bubble, but luckily most governments around the world are making efforts to stop this danger). Therefore, it is most likely that the market will go into a series of corrections. This is preferable to a full crash, which is exactly what the Federal Reserve bank is trying to prevent. In any case, the first to be blamed will be the politician in charge :Trump.

China has some advantages in this trade war: It can wait for two years until the next US presidential elections and in the meanwhile point its actions to those who are important for trump (farmers in rural US and large Republican donors). Trump probably has a bigger advantage: he has less to lose from this trade war since his country is the one in deficit with China and has more Intellectual Property to protect.

There is no way that China is going to stop its “Belt and Road” initiative or the “China 2025” initiative, but it is in China’s own interest to reduce the trade imbalance and to give more protection to intellectual property rights. If only Trump could find a way to let president Xi Jinping save face and present a deal with America as in the best interest of China (and not just giving up to Trump’s demands)?

If only president Xi Jinping will deliver to Trump a trade deal that he can sell the American voters as a good deal (reduction of trade imbalance over the next few years and more protection of IP should be sufficient and will be a monumental achievement which no president before succeeded in attaining)?

And what happens if there is no deal? Then the rivals of both China and the US will seat on the side and see these two empires spend the next few years wasting time, energy and money in a conflict which does not benefit either of them and might even lead to another global recession.

Disclaimer: The author of the post is expressing his own opinion. The views in the post are the sole responsibility of the author and do not reflect the views of any past or current employer (or their parent company or affiliates). All external sources used for this article are referenced. All external data used in the article is derived from public sources and does not violate Copyright law. Any comments on this post are the sole responsibility of their writers and they will take full responsibility and liability .

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