In response to President Trump placing 10% tariffs on an additional $300 billion in Chinese exports beginning September 1st, China allowed its currency to depreciate below the important psychological CNY¥7/USD$1 level, which shook global equities markets. In quick succession, the U.S. slapped China with the “currency manipulator” label, China announced it would stop buying U.S. agricultural products, the U.S. government began enforcing its prohibition on purchases of Huawei equipment, and China’s Rare Earth Industry Association agreed to essentially weaponize their control of global rare-earth supply.

The speed and magnitude of recent escalations seem to reflect the lack of urgency either country feels to reach a resolution. With 5,000 years of history, China is a patient player focused on the long term. It views the current trade conflict as a minor inconvenience in its inevitable march to regain what it sees as its rightful position as the world’s most powerful country. President Xi ’s current term doesn’t end until 2023, and in 2018 he abolished presidential term limits, so he can afford to wait until after the U.S. elections.  President Trump will use the trade war as political currency and try to get a win in advance of the 2020 elections, so he too can wait.

Additional important economic and structural considerations:

  • Although the West still considers China the “factory of the World,” over the past decade China’s economy has turned its focus from manufacturing to domestic consumption and services. In 2018, China’s exports only contributed 19.5% to its GDP.[i] Domestic consumption will be responsible for more than 80% of China’s GDP growth in 2019.[ii]
  • China no longer emulates the West’s economic system and believes its own form of state-led “capitalism with Chinese characteristics” is superior.
  • China will not yield to any U.S. demands to change the fundamental structure of its economy. This is non-negotiable and is the primary reason for the negotiation breakdown in May.
  • The yuan has long been overvalued and China has been intervening to prop up its value since 2015. China can afford to let the yuan depreciate somewhat towards market equilibrium levels, but we don’t anticipate a dramatic devaluation. If the trade war turns into a currency war, things will get worse by an order of magnitude.

Some other important cultural and psychological considerations:

  • U.S. negotiators underestimate the cultural importance of China’s “Century of Humiliation” and its effect on China’s national psyche. Xi cannot lose face to the U.S. in any negotiations.
  • The Chinese people feel a lot of national anger at the U.S, driven by the perception that it is trying to repress China’s rise through unethical means and is using its might to exploit them. Chinese national pride also runs high right now, fueled in part by intense media censorship and propaganda around the upcoming 70th anniversary of the founding of the People’s Republic of China.
  • Being tough on China is one of the few political positions that receives bipartisan support in the U.S. Any weakness toward China would not be acceptable.

Our base case is a prolonged trade war with some possible minor concessions along the way, and an agreement that President Trump can tout as a win in advance of the 2020 presidential elections. Any agreement prior to mid-2020 would not have the desired effect on the November election.

[i] Source: The World Bank

[ii] Consumption Seen Accounting for 80% of Chinese GDP Growth in 2019. (Feb. 12, 2019). Retrieved from www.chinabankingnews.com.