How to avert a trade war with China

Employees work at a production line inside a factory of Saic GM Wuling, in Liuzhou, Guangxi Zhuang Autonomous Region, China, June 19, 2016. REUTERS/Norihiko Shirouzu - S1AETQJGBJAA

Chinese President Xi Jinping has dispatched his top economic adviser to Washington this week to manage down risk of a U.S.-China trade war. The visit comes as news is rippling out about a revision to China’s constitution, which will permit Xi to maintain his grip on power into the indefinite future. The synchronous events are a reminder that Xi plays hard on issues that matter to him. Xi understands strength, leverage, and resolve. He appears to want to eliminate any doubt that he possesses these attributes and will use them in a trade war with Washington.

From Washington’s perspective, Beijing has been flagrantly pursuing unfair trade practices, including by compelling U.S. companies to transfer intellectual property to Chinese joint venture partners as a condition of entry into the Chinese market. President Trump built his political brand, in part, by pledging to confront China and secure a better deal for American workers. He promised more balanced trade with China, and he presented himself as a master negotiator. Meanwhile, the U.S. trade deficit with China has ballooned under Trump’s watch.

When Xi’s envoy arrives in Washington this week, Trump’s natural instinct will be to push to the edge of a trade war in hopes of compelling Beijing to blink (i.e., accede to demands for greater market access, better protections for intellectual property, and the dismantling of Xi’s signature industrial policies). An approach based on brinkmanship is unlikely to succeed, because it is built on a series of flawed assumptions:

1. Assumption: Xi has big domestic challenges and cannot afford a downturn in relations with the United States.

Reality: Xi gains politically in Beijing by standing firm against U.S. pressure and punching back against punitive measures. Historically, China has always retaliated proportionately to U.S. trade actions.

2. Assumption: China depends on its exports to the United States to sustain economic growth, and thus cannot afford trade disruptions with the United States.

Reality: In relative terms, the importance of the American market for China has declined, a trend that will continue as China’s economic growth model becomes less export-dependent and more consumption-based. For example, when measured by value added, Chinese exports to the United States account for only 3 percent of its GDP. Xi will prioritize domestic economic initiatives he believes are necessary to transition China’s economy, even if it comes at the expense of friction with Trump.

3. Assumption: Xi is the weaker player in this two-player test of wills and thus will buckle when under pressure.

Reality: Xi likely calculates that Trump needs Xi more (on North Korea) than vice versa. Beijing believes any trade war would hurt the U.S. economy, which would have a more immediate political effect in the United States than China. Xi will not face a referendum on his performance any time soon, whereas the United States has its midterm elections this November.

4. Assumption: Trade tensions will not spill over into other areas of the U.S.-China relationship, including North Korea.

Reality: If past is prologue, Beijing likely will use all of its available leverage, including on North Korea, to respond to U.S.-initiated trade actions.

At a more fundamental level, Beijing does not share the same diagnosis of the problem. From Beijing’s perspective, the U.S.-China trade imbalance is a result of many factors—automation, evolving global supply chains, increased competitiveness of Chinese firms, the Federal Reserve’s normalization of interest rates, and the Congress’s deficit-increasing tax cuts. Because the trade balance is the difference between savings and investment, Beijing also views U.S. fiscal and monetary decisions as contributing to America’s overall trade deficit—including with China.

Beijing also is determined to demonstrate that challenging China on trade issues yields more costs than benefits.  As a result, its response will be designed as much to deter other countries from following Washington’s lead as it will be to discourage the United States from taking additional unilateral trade actions against China.

So, where does this leave things?

While it may be too late to alter course, a wiser strategy than issuing unrealistic (and vague) demands privately and making loud threats publicly would be to concentrate on defining what specific steps Washington needs Beijing to take in order to have confidence that both sides are committed to solving underlying problems in the bilateral trade relationship.

The Trump administration could give Xi an opportunity to showcase his strength and boldness by introducing a series of specific requests that Xi conceivably could accept and that, if accepted, would avert a trade war. Such requests could include a significant opening of the Chinese market to U.S. agricultural exports; new Chinese commitments on enforcing intellectual property protections; a new, authoritative, and enforceable commitment that Beijing will prohibit demands for technology transfer as a condition of market entry; new and quantifiable pledges to cut excess capacity production, particularly in the steel and aluminum sectors; and a time-bound commitment for further market opening in key sectors such as financial services, health care, entertainment, and autos. This list is illustrative, not exhaustive.

The goal would be to use the threat of major punitive actions as leverage to force a time-restricted negotiation on new market access and fair trade commitments from Beijing. If such an approach succeeds, Trump could justifiably proclaim he had delivered important breakthroughs on trade with China that had eluded previous presidents. If not, Trump would be no worse off and could still take unilateral trade actions against China.

The alternative—brinkmanship leading to a trade war—will deliver concrete costs for uncertain benefits. Xi will not retreat and capitulate under pressure. Xi will punch back and, in so doing, he likely will target states and districts where Trump’s political base is concentrated.

The moment of maximum leverage for the United States is now, as is the moment for Xi to demonstrate statesmanship in defusing a looming crisis. Progress on trade would generate momentum in the bilateral relationship that could be applied to other challenges, including North Korea. Let’s hope leaders in both countries have the courage and vision to seize this opportunity.