Multi-Asset

The U.S.-China relationship in a changing global economy

An inevitable blame game between the U.S. and China has followed COVID-19, but the crisis has really just extended the “trust deficit” that has been steadily building between the two countries in recent years.
July 2020

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An inevitable blame game between the U.S. and China has followed COVID-19, but the crisis has really just extended the “trust deficit” that has been steadily building between the two countries in recent years. Though the “Phase One” agreement between the countries remains intact, it is very fragile and China is turning to a more domestic focus. The U.S.-China relationship, however, remains pivotal for the global economy, and in our mini-forum devoted to the topic, we began with a discussion of the relationship from China’s perspective.

The U.S. relationship from China’s perspective

The Chinese Communist Party (CCP) views the U.S. as pursuing a massive containment strategy on multiple fronts. While the U.S. has been willing to pursue this objective unilaterally under the Trump administration, the CCP remains fearful of a potential U.S.-led global alliance against China. In this regard, the upcoming U.S. election may bring tactical changes but is unlikely to change China’s expectations for further confrontation. President Trump is likely to continue pursuing a hard line with China unilaterally if necessary, while Joe Biden is more likely to pursue an international alliance to counter China. Either way, the Chinese expect further U.S.-led efforts to contain China’s influence technologically, economically and geopolitically. At present, China hopes to “buy time” and delay escalation while improving its own position.

Unsurprisingly, the trust deficit has widened further following COVID-19. In May, the U.S. Department of Commerce expanded its efforts on the technology front by further tightening export restrictions and adding more firms and universities to the “entity list” that U.S. companies are restricted from doing business with. An underappreciated outcome of these expanded restrictions is that MATLAB, a U.S.-based product that is the industry standard for presenting data in scientific journals, will no longer be supported at two of China’s leading research universities, thus hampering the ability of researchers there to publish work and obtain patents. The U.S. also tightened rules for Chinese students studying in science and engineering in the U.S., and wealthy Chinese families are becoming wary of sending their children to U.S. universities due to rising anti-China sentiment and hostility in the aftermath of the COVID-19 outbreak.

In recent years, China’s enforcement of intellectual property rights has actually improved quite a bit, albeit from a low starting point. Nonetheless, the substantial trust deficit between the U.S. and China leaves little room for negotiation. China is feeling the pressure of containment and focusing inward on a path to become more consumption-driven and technology self-sufficient. That path may ultimately be successful, but China still needs a healthy export sector.

Supply chains and China’s larger links to the global economy

Supply chains are usually spotlighted in any discussion of U.S.-China relations. COVID-19 has intensified the attention on this subject, but the situation had already begun to change even before the 2018-2019 trade war due to rising production costs in China. While Western countries and the U.S. tend to use words like privatization and “de-monopolization” when discussing state-owned enterprises in China, from China’s perspective other changes are more relevant. Changes in price controls affecting resources such as land, water and energy have already affected the production-cost equation in China. In addition, higher labor costs in China have led multinational to reassess their manufacturing supply chains.

State remains big in industry: SOE+state holding enterprises, % of industrial, January to November 2019

Chart showing State remains big in industry

Source: TS Lombard, CEIC.

China’s dominant role in global supply chains makes the trajectory of production costs there crucial to understanding inflation dynamics around the world over the last two decades. China’s over-investment in manufacturing infrastructure has driven the cost of some goods so low that it has even spurred demand in emerging economies. Diversifying supply chains out of China almost certainly means higher costs and probably higher inflation where the goods are ultimately consumed. COVID-19 has increased the urgency for multinationals to move from “just in time” inventory control to “just in case,” which will raise costs as well. At the same time, a global backlash against goods made in China could cause deflation within China as exports fall and its enormous production capacity overwhelms the domestic market. This scenario could lead to a debt crisis.

Changing attitudes around the world toward China and Chinese-made goods have led economists to ask whether China can become a more consumption-led economy like the U.S. At first glance, some Westerners may conclude that this transition is well underway, as many Chinese households already possess and regularly upgrade consumer items such as televisions, phones, cars, etc. However, while China has made enormous investments in industrial infrastructure, it has devoted less attention to urban infrastructure and services such as schools, transportation, sanitation, water, gas, etc. The latter type of infrastructure, combined with stable export demand, is typically the formula for consumption claiming a greater share of the economy.

Even with the desire to diversify supply chains following COVID-19, a large-scale exodus by multinationals from China is unlikely in the near- to medium-term for several reasons. Despite the cost increases resulting from the removal of some price controls, China still offers better infrastructure, more skilled labor and broader supply-chain capabilities than its neighboring countries. Moreover, multinationals seeking to sell into the Chinese market have a built-in advantage if the goods are made in China.

U.S. imports from China (millions)

Chart showing US imports from China in millions

Sources: U.S. Census Bureau, Bloomberg LP, BMO Global Asset Management.

Nonetheless, over the longer term, more new supply-chain investment outside of China is likely as a result of COVID-19 and increasing distrust by the U.S. and its allies. Taiwan, Vietnam and Mexico are often cited as potential beneficiaries of this change. Taiwan may have the advantage here due to its location, technology and supply of skilled labor. Vietnam may also benefit, but increasing costs are working against it: over the last 18 months, land prices in Vietnam have doubled and labor costs have increased notably as well. In the end, however, no single state can truly absorb large supply-chain losses from China — the scale and infrastructure are simply too massive, at least at this point in time.

A changing global order?

Over the longer term, China’s relationship with its neighbors will be an essential piece of the puzzle. While the geopolitics are certainly complex, in the future the multilateral WTO could be replaced by regional trading blocs composed of the Americas, Europe and Asia, with free trade within the blocs but tariffs imposed against the other regions. Any progress toward this scenario would force China to dial back its heretofore “muscular” approach toward its neighbors. Beijing seems aware of this, with President Xi Jinping now promoting a more economic approach including financial support and the opening of China’s vast markets. While U.S. politicians are increasingly skeptical of China’s motives, such statements likely illustrate a potential shift as China tries to find its place in a changing world.

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