The trade war – the Chinese response
Andrew Collier | Jun 07, 2019
Executive Summary
We analyze the response of China to the trade war in four buckets: politics, macro-economy, global supply
chains, and technology. Of the four, China’s technological development and global supply chains are likely to
suffer the most.
Xi’s political power is weakened
The political realm is the most interesting aspect of the impact of the trade war on China. Because Xi has
established his central role in the country’s leadership, he thus will take full responsibility for the success or
failure of the trade negotiations. His own policies have hindered his success.
Xi entered the trade negotiations with a weakened and more ineffectual bureaucracy due to the
centralization of his power. To increase his direct control of the government, Xi created 29 new Leading Small
Working Groups (LSG) on top of the existing 54. Xi personally controls at least a dozen. This has a) lessened
the input of bureaucratic experts; and b) reduced the effectiveness of policy implementation. Among the
casualties has been the trade war negotiations.
As a result, initial advice on the trade war came from just a few trusted advisors, who are far more powerful than the original top negotiator deputy, Commerce Minister Wang Shouwen. These include economics czar Liu He, briefly at Harvard, former PBOC head Zhou Xiaochuan. who studied at the University of California for two years, and CBIRC Chairman Guo Shuqing, who was at Oxford for a year. All three are part of what I call “globalists” who view the world in the rational terms of international trade. In turn, they reportedly relied on American advisors such as Hank Paulson and Henry Kissinger for advice on trade negotiations. The result was a disaster and a failure for Xi Jinping as neither the Chinese nor the American side had any insight into the Trump Administration.
Other foreign policy failures have further hurt Xi’s reputation. This includes the Belt and Road, which many
domestic institutions view as a waste of capital, and the diplomatic opposition from many Southeast Asian
nations to Xi’s clear attempt to broaden China’s economic and military reach. This has led to quiet grumbling
internally among the elite, both at academic institutions, and among the Snancial and business crowd. These
complaints include the following:
In October 2018, Peking University professor Zhang Weiying criticized the China Model for being both
bad policy and bad facts: “(The China model) will mislead us and destroy our progress. If we single-
mindedly emphasize the uniqueness of the China model, internally we will strengthen SOEs, enlarge the
authority of the government, and rely on industrial policies, which will lead to a retrogression of reform
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and a total waste of the great strides in reform. The economy will lapse into a quagmire.” He was echoing
other critics of Xi Jinping thought.
Xi’s assertive foreign policy is widely seen inside of China as a radical departure from Deng Xiaoping’s
policy of keeping a low profile. More recently, public pledges of support for Xi within the State Council
was viewed not as a sign of strength but of weakness – why ask for support if you are in a position of
strength?
Deng Pufang, the eldest son of Deng Xiaoping, at a national conference of disabled persons, criticized
the spirit of Xi’s policy and called for “seeking truth from facts … maintaining a clear head, knowing one’s
own strengths and weaknesses, and avoiding overestimating oneself and behaving recklessly.” The
speech was seen as an attack on Xi and quickly censored within China.
Long Yongtu, a former vice minister of commerce who negotiated China’s entry into the World Trade
Organization (WTO) in the late 1990s, publicly criticized Beijing’s handling of the trade dispute with
Washington.
What does this mean for the outcome of the talks? Short-term, not much. China’s closed media environment
will prevent these incidents from reaching ordinary people and eroding Xi’s national power. However, longer
term, Xi’s clear failure to manage the trade talks, along with his backSred attempts to create a more powerful
global China, have damaged his inTuence within the elite in ways that are likely to come back to haunt him.
On the economic front, trade is just one factor
China is no longer as dependent on trade as it once was. Chinese exports to the U.S. account for only 3.6% of
GDP, down from 7.3% of GDP in 2006. China has issued a rash of stimulus policies but it is not clear these are
directed at the trade war as much as the slowing economy in general.
Pushing the economy
China has three mechanisms for controlling the economy: credit policy, Sscal policy, and the exchange rate.
The state has focused its efforts on the Srst two by expanding credit and reducing taxes. There was a
substantial increase in Srst quarter 2019 total social Snancing, whose effects we witnessed during our
interviews in Fujian a week ago. Local investors said the property market said they had seen a sharp
turnaround in the property sector, up from a 30% price decline in 2018. Credit growth has moderated since
Q1 2019 but remains above GDP growth. On the Sscal front, the interest rate on corporate loans was cut
by 1%, and Beijing has continue to encourage the issuance of local government bonds and corporate bonds
for local government Snancing vehicles (LGFVs), as a way to put investment capital in the hands of local
governments.
There was one policy clearly directed at the US tariffs. The Ministry of Finance announced two rounds of VAT
rebates on a variety of products covering by the US$50 billion and $200 billion tariff lists. Along with other
measures, the head of the Ministry of Finance, Kun Liu, said the total deductions would add up to Rmb1.3
trillion.
Despite these measures, Beijing appears to be digging in the for the long haul on handling the economic
impact of the trade dispute on the domestic economy, and views it as part of a larger issue of keeping
economic growth on an even keel.
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Propping up the yuan “behind the scenes”
Countercyclical factor
The one area that has not been touched is the value of the currency. Beijing is unwilling to broach the 7.0
level for the yuan. There are signiScant tools the state uses to maintain the stability of the currency. China has
acknowledged this when in 2018 it introduced “counter-cyclical factor” to keep the yuan’s daily midpoint Sxed
to a relatively stable value.
The PBOC said it would institute this retroactively to May, 2017. The PBOC’s China Foreign Exchange System
(CFETS) requested banks to feature this factor in their daily Sxing to avoid “irrational Tuctuation” –- but not
reveal their methodology. A more upfront policy was apparent when, in March 2019, China sold US$20.5
billion in US treasuries, the highest level since October 2016.
State support for the yuan
Yuan trading is dominated by the large, state-owned banks; foreign banks have low market share. SigniScant
inTows have been managed by state entities to support the currency. According to SAFE, in 2018 the net
foreign capital inTow grew 9% YoY to US$483.8bn, among which net FDI in the stock market rose 29%
YoY. During the same period, the net purchase of domestic bonds by foreign institutions rose to US$96.6bn,
up 68% YoY. Also, the net purchase of domestic listed stocks grew by 85% YoY to US$42.5bn. The strong
momentum continued in 1Q19, with the net purchase of domestic bonds and stocks reaching US$9.5bn and
US$14.9bn, respectively.
But much of this was probably not foreign capital. We estimate that 80% of this so-called “foreign capital”
consists of domestic funds transferred to Hong Kong via back channels created by the Chinese government.
This inward capital controlled by Chinese institutions is then required to be reinvested in the domestic
markets under a new label: offshore capital.
These “back channel” routes for strengthening the currency support the dual role the state has played in
promoting an image of the free markets while quietly propping up the yuan. Bottom line, we expect continued
“hidden” support to keep the yuan above 7.0. “We have never taken any intentional measures that would
cause depreciation of the yuan to offset [the impact] of conTicts over trade,” CBIRC head Guo Shuqing told
state media in May.
Global supply chains are the wild card in the trade equation
The impact of the trade war on China’s integration in global markets is hard to predict at this stage given
the uncertainty about the outcome of the discussions. China has a dominant capacity in a number of sectors,
including telecommunications, which will be difScult for other countries to replicate in the short-term. Longer
term, the cost advantages in Southeast Asia and India in particular, in addition to their lower political
confrontation with the U.S., will make them attractive alternate sources of manufacturing capacity.
Already, there is signiScant movement of production to Southeast Asia. For the top two manufactured goods,
China has greater than 35% market share and more than 20% for the rest, which makes it difScult for other
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nations to challenge in the short run. ASEAN trails China except in electrical machinery. Vietnam’s economy
has been boosted by almost 8% due to a shift in production from China, resulting from the US-China trade
war. The majority of Vietnam’s gains came from additional imports of goods covered by US tariffs on China,
including electronic equipment for telephones, furniture, and automatic data process machines, because
multinationals were able to move production to Vietnamese factories.
China’s tariffs mainly target commodities (soybean and oil) and, to a lesser extent, high-tech products that
ASEAN economies hardly produce or for which they do not have any relative comparative advantage
The altered supply changes have been underway for some time, however. China’s inward FDI declined from
62% of total global FDI in 2006 to only 27% by 2017.
China’s hoped-for dominance in tech is at risk
Huawei is the bellwether for China’s foreign policy failures
It is in technology that China has mishandled the trade war particularly badly. President Xi Jinping’s
aggressive posture on creating global giants, has backSred, as the U.S. has had signiScant support from Europe
against China’s ambitions. This is not only a blow to China’s transition from low to high-value-added goods,
but to the country’s personal prestige as a force in global tech.
Huawei is the poster child of China’s problems in the tech sector.
China’s global market share exceeds 40% in the telecommunication sector as well as in ofSce machinery.
Ericsson and Nokia respectively hold 27% and 22% of the 2G/3G/4G gear market against 31% for Huawei.
According RWR Advisory Group, Chinese state-owned banks have lent Huawei and Huawei’s customers up
to £7.5 billion. More than 70% of Britain’s 4G infrastructure was built by Huawei.
Huawei, itself, has shot itself in the foot by misrepresenting its ownership. The company’s chairman claims
it is owned by employees. But in a careful note, legal scholar Donald Clarke of George Washington Law
School and economist Christopher Balding argue persuasively that the company is either privately held by
the chairman himself or by the state through proxies. If it is owned by a trade union, this is essentially state
ownership. However, the ownership structure remains opaque. “Regardless of who, in a practical sense, owns
and controls Huawei, it is clear that the employees do not.” If Huawei is a proxy for the state then its claims to
be operating without following national security goals are unlikely.
Global supply chain problems
Huawei is highly dependent on U.S. suppliers for semiconductors and software. Huawei reportedly stockpiled
a year’s worth of semiconductor inventory, but it can’t stockpile software updates, which would be the Srst
step in harming its operations. ZTE suffered a similar fate when the Commerce Department embargoed its
operations, as it could not upgrade the Oracle database in its mobile base stations.
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Huawei supplies carriers in more than one hundred countries around the world. It is also going to be the lead
in rolling out China’s 5G networks, which is poised to lead the world in new technology. The embargo could be
a catastrophe to China’s attempt to become a leader in 5G globally.
Huawei would also lose access to the key design chips produced by western Srms like Cadence, Synopsys and
Siemens’ Mentor Graphics. Reliance on US semiconductor Srms in future years will be questioned due to the
political nature of the attack on Huawei. In turn, however, the American embargo could backSre and harm the
U.S. semiconductor industry that supplies circuitry to Huawei.
Undermining Beijing’s ambitions: the Tsinghua example
Although Huawei says it is a private company, there is signiScant state support for the technology sector
in general in China. Among other Srms, Tsinghua Holdings, under the state-owned Tsinghua University, is a
signiScant Snancial backer for China’s tech sector. As China’s top university, Tsinghua University is far ahead
of its peers in terms of investments. Acting as the University’s investment platform, Tsinghua Holdings Co
Ltd (Tsinghua Holdings) mainly operates in Sve specialized areas: advanced technologies (integrated circuitry,
environmental protection and healthcare); innovation services; sci-tech Snance; creative and cultural
industries; and online education. These operations are carried out by three major afSliated comprehensive
groups such as Tongfang Co Ltd., Tsinghua Unigroup, and Tus Holdings Co Ltd.
After spending approximately US$5.19bn, Tsinghua Unigroup established its presence in the chip industry
and was able to convince the Chinese government to appoint it the lead backer for China’s Tedgling
semiconductor industry. Since then, the company has become the prime instrument for China’s strategic
development of the domestic semiconductor business and has received substantial support from policy banks
and the government’s VC funds. This state-supported model is under threat due both to the trade war and the
security concerns in other nations, particularly in Europe.
Conclusions: What are we likely to see out of the trade dispute?
1) Weak domestic opposition. The internal pressure on Xi Jinping due to his foreign policy failures is unlikely
to cause a dramatic change in the country’s leadership. The domestic media is heavily controlled, and the
dissent by inTuential academics and former leaders is not enough to alter domestic power relations. Xi’s
failures, however, are being noted domestically, which could accelerate his departure in the future.
2) No easy bargaining chips. The two main demands by the U.S., the end of state subsidies and new rules
governing IP protection, are either impossible or unlikely given domestic nationalism. China could offer a
“clawback” agreement, suggested earlier by the Trump Administration, whereby examples of stolen IP or
other transgressions would be met with a resumption of tariffs. This could be mediated by a third party – if the
White House would agree. This, although it would be met with resistance, would be achievable within China.
3) Focus on the economy. The trade war is only a smaller part of the larger problem Xi is facing of a weakening
economy and excess debt. Therefore, Beijing is unwilling to make signiScant concessions that a) would weaken
the perception of the leadership domestically; and b) fail to solve the larger problem of the economy.
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4) Quiet concessions. Despite the conTicting aims, Xi is likely to use Liu He and moderates such as Steve
Mnuchin as a “back-channel” to make concessions such as:
a. An increase in purchase of US goods.
b. An agreement to pay Snes if IP contracts are abridged.
c. Quiet curbs on companies such as Huawei.
d. Continue to offer opening to the domestic market, as Guo Shuqing offered in a speech in May.
All of these discussions would have to be deniable. The collapse of the talks recently followed an exchange of
documents – it is doubtful the Chinese backtracked from verbal commitments as the Trump Administration
has claimed. Instead, the agreement, once on paper, was less than the White House had wished for. The
Chinese do not traditionally lie in negotiations but prefer to issue vague statements to give them policy
freedom.
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chinese-response
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