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U.S. and China: Tale of the Tape

 

The Bottom Lines

 

  • U.S.-China trade policies need to be updated, and China is not in a strong position for trade negotiations.

  • The United States has the best risk adjusted prospects in the world today.

 

A Brief History

 

The first trade war involving both the U.S. and China occurred from 1840-1842 and triggered the first Opium War between Britain and China. On paper China looked big and strong, but the war was practically over before it began, and Britain was ceded the prize areas of Hong Kong and ports in Canton via the Nanjing Treaty. The U.S. gained trade advantages as well; however, the amount of trade remained low for over 100 years.

 

There was no trade between China and the U.S. from 1950 to 1970, as China backed North Korea and the U.S. backed South Korea. Things were not going well in China because it had a large population but little capital and few ideas. The U.S. had excess capital and many ideas but lacked a large enough population to capitalize. Sensing an opportunity, the U.S. gradually reestablished trade with China in the 1970’s. Deng Xiaoping became the paramount leader of China in 1978 and was a central force behind massive reform away from the communist economic ideologies into the early 1990s. From 1980 to 2004, trade grew exponentially from $5 billion to $231 billion1, and this was the key driver in lifting some 800 million people out of poverty in China as the poverty rate fell from 88% to 6.5%2. The exponential growth in trade has continued, and the estimated value of goods and services traded in 2017 was $710 billion3.

 

It should come as no surprise that during the unprecedented growth in trade, from $0 to $710 billion, trade arrangements needed to be updated periodically, and this caused trade tensions. The current trade tensions with China have been festering for many years. When China joined the World Trade Organization (WTO) in 2001, it was supposed to revise hundreds of laws, regulations, and other measures, all intended to facilitate a shift from state-led policies and practices to a market-oriented framework. The rules established were ineffective and China remains a state-led economy that undertakes market-distorting behavior4. For example, China’s top down overexpansion created significant overcapacity for refining, shipbuilding, aluminum, cement, and other basic industries. Further still, China’s unused steelmaking capacity exceeds the total steel capacity of the U.S., Japan, and Germany combined5. Now the country’s “Made in China 2025” plan is intended to broaden state subsidies to various high-tech industries which, if successful, will likely cause overcapacity globally and negatively impact many U.S. and European companies. 

 

High-level dialogues between the U.S. and China occurred in 2003, 2006, 2009 and 2017 to address lack of compliance with the WTO rules. Further, the U.S. secured broad commitments from China to improve adherence at meetings in 2010, 2012 (including the Obama-Xi summit meeting) and 2014. However, all these efforts have essentially failed. China has been willing to take modest steps to address isolated issues and sometimes make broader commitments when pressed, but it has not followed through on significant commitments4. Both the Obama and Trump administrations have estimated that Chinese theft of American intellectual property is several hundred billion dollar per year.

 

The U.S. is now taking a stronger stance and different tact, and we argue China is not in a strong position to negotiate. China is large, but very inefficient and its total debt is the largest ever recorded by a developing country. Its debt has also risen faster than any country, quadrupling between 2007 and 2017. A significant amount (perhaps nearly all) of the public sector investments in the past few years has been nonproductive, and China’s debt problems have emerged quickly and severely enough to prompt a growing number of analysts wondering if this may be the year that China’s economy breaks6. The title of a book by Carl E. Walter, first published in 2011, hits the nail on the head: Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise. And the stock markets support a skeptical view of finances in China as the Shanghai Composite Index is around the same levels as it was in December 2006, and only approximately 14% higher than the peak in 2001. U.S. stock market indexes such as the S&P 500 and Dow Jones Industrial Average were up approximately 75% or more from the peaks in 2000.   

 

Further evidence that China is not structured or governed for wealth creating growth can be seen in terms of GDP per capita. With $16,600/person, China ranks just below Iraq, while the U.S. registers $59,500/person. And remember that Hong Kong was leased to Britain for 99 years following the first Opium War. Well, Hong Kong’s GDP per capital is $61,000.

 

In Unrivaled: Why America Will Remain the World’s Sole Superpower, Michael Beckley argues that sustained economic growth depends on three broad factors: geography, institutions, and demographics. The U.S. is on rather solid footing while China has substantial challenges.

 

Geography

 

Energy Resources

 

The U.S. recently became the world’s largest oil and natural gas producer and is projected to be a net exporter of energy by 2030 or even as soon as 2022. Unique property rights enable private landowners to lease mineral rights to among 22,000 independent oil and gas companies, all competing vigorously to be the most efficient in extraction and transport.   

 

China is expected to be the world’s largest petroleum importer by 2035 and it may be forced to import up to 85% of its oil from the Middle East. China has vast reserves of oil and natural gas that will probably never be tapped because of challenging geology and lack of water required for fracking. 

 

Transport Infrastructure

 

America is fortunate to have cheap, natural internal transport. The continental U.S. has 14,650 miles of navigable rivers (can handle drafts of nine feet or more for at least nine months of the year), which is more than the rest of world combined. It also has more natural deep water port area than the rest of the world combined.  The ports on the west, east and Gulf coasts enable the U.S. to exploit its swing capacity, depending on whether Europe or Asia is in recession. In the post WWII era, no recession in Europe or Asia has caused a recession in the U.S., but every U.S. recession has triggered recessions in Europe or Asia.

 

China leads the world in infrastructure investment and is undergoing a massive upgrade of its transport infrastructure as the government determined future economic growth would require a more efficient system. Logistic costs account for 20% of a product’s price in China, compared to 10% in the U.S. China’s massive, top down approach to infrastructure spending has probably resulted in significant malinvestment and ensured high future maintenance costs.       

 

Buffers

 

The U.S. is bordered by allies and ocean, while China must secure its 14,000-mile land border from 15 different countries, spending hundreds of billions of dollars per year to secure its homeland.

Institutions

 

Capacity

 

A relatively weak U.S. state facilitates entrepreneurship and private investment, but also results in less services provided to its citizens. China, in contrast, has a centralized state and vast challenges in implementing reforms initiated in Beijing. Corruption is high. For example, local governments will seize land from peasants and transfer ownership to a shell company, which then uses the land as collateral for borrowed funds used for personal gain, patronage networks, or extravagant infrastructure projects. It is estimated that these bad loans total 40% of China’s GDP. If this estimate is even approximately accurate, China has little true financial capacity remaining and even a small economic recession could cause large financial fallout.  

 

Governance

 

China has been improving various governance indicators but remains far behind the rest of the world, and the U.S.

 

Source: World Bank 2019.

 

Demographics

 

The U.S. is the only major power with a working-age population that is projected to grow throughout the century. The U.S. is projected to add 40 million workers while China is projected to lose 470 million, half of its current workforce! 

 

The U.S. is projected to have the second youngest population amongst the great powers in 2040 and the median age will remain stable for the rest of the century. The median age is expected to rise in all other developed economies.

 

Due to the one child policy, China’s median age is expected to rise sharply from 35 to 50 between 2015 and 2050. The number of Chinese over 65 is expected to rise from 130 million to 410 million. China currently has 8 workers per retiree and by 2050 will have 2 workers per retiree. Even though the one child policy was relaxed in 2015, the demographic trend will not be reversed anytime soon, and many current Chinese families choose to have one child for financial reasons.  

 

In conclusion, the U.S. is decidedly in the stronger position when it comes to trade negotiations. A stronger stance and tougher tact are appropriate as both the Obama and Trump administrations have estimated that Chinese theft of American intellectual property is several hundred billion dollars per year.  We expect that relatively minor amounts of temporary economic turbulence will continue to occur as a result of trade negotiations. But just like the periods following the first Opium War and the Korean War, we expect favorable developments for the U.S. and U.S. companies are likely to follow.

 

1 https://www.cfr.org/timeline/us-relations-china

2 http://www.worldbank.org/en/country/china/overview#3

3 https://ustr.gov/countries-regions/china-mongolia-taiwan/peoples-republic-china

4 https://fas.org/sgp/crs/row/RL33534.pdf

5 Beckley, Michael (2018) Unrivaled: Why America Will Remain the World’s Sole Superpower

6 https://carnegieendowment.org/chinafinancialmarkets/77178

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