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Nov 14, 2018 | 22:50 GMT

9 mins read

How China Will Handle Its Trade War With the United States in 2019

An employee works in a textile factory in Xiayi county in Shangqiu in China's central Henan province.
(STR/AFP/Getty Images)
Highlights
  • Beijing will deepen its public sector reform by opening space for foreign capital in sectors such as financial, auto and energy and attempting to ease restrictions in sectors in line with its interests.
  • The threat of supply chain disruption from the U.S.-China trade war will increase Beijing's desire to support the development of its tech sector, limiting progress in trade talks and increasing the likelihood that disputes will continue into 2019.
  • Beijing will seek to diversify its export market while deepening trade and tech cooperation with major powers in order to prevent U.S. supply chain disruptions and collective international attempts to isolate China.

Editor's Note: This assessment is part of a series of analyses supporting Stratfor's upcoming 2019 Annual Forecast. These assessments are designed to provide more context and in-depth analysis on key developments in the coming year.

China and the United States are and will remain divided on crucial ideologies for decades to come, meaning their economic war and competition for tech dominance is set to last a very long time. China increasingly recognizes that economic attacks are only one component of the United States' long-term plan to contain Beijing's rise, while the Chinese government harbors no illusions that it can end the current trade war easily – or without major concessions that could outweigh the cost of the trade war. But between U.S. demands to widen market access and stagnating reforms at home, Beijing also has a long-term imperative to enhance its domestic competitiveness, further open its economy and present itself as a guarantor of free trade at a time of growing global unilateralism and protectionism.

Beyond this, in 2019, Beijing will seek to diversify its export market while advancing trade and tech cooperation with major powers in the hopes of preventing the United States from disrupting important supply chains and dissuading its allies from advancing trade agreements with China.

The Big Picture

Economic tensions between the United States and China have been growing throughout 2018. The White House is framing economic attacks and checks on China's technological development as part of a broader competition. Beijing and Washington have competing fundamental interests, so this economic fight is here to stay – and could even last years or decades.

What the U.S. Will Be Focusing On

Washington has just two rounds of tariff options left before it ends up taxing all imported Chinese goods. But even if a tariff battle truce is possible in the coming months, the United States will maintain its many efforts to combat China's rise, including actions to target industries associated with Made in China 2025; challenge Chinese trade practices, restrictive market access and intellectual property practices; and oppose industrial espionage by teaming up with allies. It will also seek to revamp international trade rules to better challenge, and to some extent, isolate China's non-market economic system, while working to dissuade China's prospective free trade partners, such as Japan and the European Union, from making deals. Even Washington's struggle between reforming and threatening to withdraw from the World Trade Organization is part of its search for better tools to challenge China.

China will thus be focusing on three main approaches in order to manage current and future U.S. challenges: prioritizing negotiation and dialogue with the United States, establishing the dual goal of liberalizing while also becoming more self-reliant, and seeking more markets abroad.

A map showing local debt in various Chinese regions.

Prioritizing Negotiation

Beijing has already matched U.S. tariffs with two rounds of its own retaliatory tariffs, and it initially signaled its intention to hold U.S. businesses operating in China hostage. But recently, the Chinese government has adopted a more prudent approach to the U.S.-China power competition, maintaining open dialogue and ensuring that its responses to various developments support its domestic economic interests and reform path.

Though it will keep an eye on its extended economic competition with the United States, China's short-term strategy will be to keep an open attitude toward negotiation and to maintain its relationships with U.S. business conduits. This is partly due to domestic economic challenges: The Chinese economy is already burdened by a mountain of debt and the strain from efforts to contain the highly speculative property market. External pressure from the United States has exacerbated these existing challenges and limited Beijing's policy options.

As part of reform efforts, Chinese authorities have revamped monetary and fiscal policies to stimulate investment spending – including on several large transport and rural infrastructural projects – and they have scaled back tough deleveraging initiatives that indiscriminately attacked the private sector and local governments instead of ineffective state-owned enterprises (SOE). In light of increasing manufacturing struggles, particularly in the export-oriented coastal regions at the frontier of the trade war, Beijing also increased export rebates on key electronic, semiconductor and machinery products. Since China's dependence on exports has fallen by nearly half since the 2008 financial crisis – at the same time as jobs in the growing services sector have replaced those in manufacturing – the Chinese economy cannot afford another massive stimulus and property boom, especially considering its high household and private-sector debt.

A chart showing the percentage of household debt in China.

Still, Beijing's short-term policy options will ultimately depend on the degree of tariffs and trade pressure that the United States implements – something that is contingent on negotiations between the two powers in the months ahead. If Washington chooses to fully implement tariffs, it could increase Chinese unemployment by 5.5 million people, reduce China's gross domestic product by roughly 1 percentage point and possibly cause China-based manufacturers to relocate. This scenario would put pressure on Beijing to both keep its economy afloat and refrain from credit floods to contain further debt risks. Policy constraints also mean authorities will have to turn to less desirable tools – such as widening its fiscal deficit – to mitigate declining consumption and stimulate the private sector.

A map showing the effect that tariffs will have on China's provinces.

In its dealings with the United States, Beijing has directly offered to increase purchases of U.S. products such as certain agricultural goods, coal, oil and natural gas; widen market access, including an April announcement to open financial and auto sectors; and improve intellectual property protection. Indirectly, China's leaders have been keen to show the world their commitment to opening the economy up by increasing imports, modernizing free trade zones in Shanghai and Hainan and further liberalizing health care and education. So far, however, these carefully crafted and phased measures have failed to convince Washington to ease off on tariffs. Still, rather than pressuring U.S. businesses as a punitive response to Washington's escalations, Beijing has remained committed to remaining open to foreign business and is working to ensure that the business community remains a conduit to the United States.

Building Two Fronts

The Chinese authorities' commitment to continued reform has as much to do with growing external pressure as it does with the domestic need to keep reforming the economy – particularly when it comes to its inefficient SOEs and certain sectors that require foreign cooperation. Beijing understands that its protectionist policies, in many ways, contrast with its objective to create a more competitive and value-added domestic industry. But its reforms will encounter vested bureaucratic interests and risk undermining domestic industries and employment. Amid elevated external pressure demanding that China reduce its protectionism, the race to strengthen its domestic industry and update its value chain makes further liberalization more certain. In this context, Beijing may find it convenient to create more access for foreign and private capital in selected industries, such as finance, high-tech, telecom and energy, and to widen SOE ownership to lessen the influence of state capital. But the combined trade war and an already-slowing economy will limit Beijing's pace, as it must hedge against threats to its domestic firms and employment.

While Beijing prioritizes negotiations with the United States and continued liberalization in some areas, it will prioritize self-reliance in other issues. Specifically, the Chinese government sees little point in meeting hard-line U.S. demands aimed at undercutting China's development, especially in the high-tech realm. Instead, the fear that the United States could disrupt its tech supply chains – as illustrated by the recent U.S. ban on semiconductor exports to ZTE – will only harden Beijing's resolve and encourage its efforts to become more self-sufficient in strategic technologies such as semiconductors, biotech, aviation and information technologies.

The United States' ultimate goal in economically pressuring Beijing – as with other adversaries like Russia – is to alter any Chinese behaviors that clash with the interests of Washington and its allies, particularly regarding advancements in technological development that are increasingly challenging U.S. supremacy. Beijing, meanwhile, will likely strengthen cooperation with other tech powers such as Japan, South Korea, Taiwan and Israel, and increase technological acquisition abroad, raising national security concerns in the developed world about Chinese investments in strategic sectors.

To insulate itself from long-term export disruptions and U.S. trade rules, Beijing will seek to diversify its export markets and break the siege of the United States, its allies and international trade organizations.

Seeking Markets Abroad

To insulate itself from long-term export disruptions and U.S. trade rules, Beijing will also seek to diversify its export markets and break the siege of the United States, its allies and international trade organizations. These combined objectives will drive China to further prioritize the relationships it is establishing with its massive Belt and Road Initiative. Belt and Road countries accounted for 27.3 percent of China's total foreign trade value in the first seven months of 2018, exceeding the country's trade with the United States. Of course, the markets of participating countries and others are a wholly insufficient substitute for the U.S. market. But to Beijing, the Belt and Road – and the overland and maritime access it has opened up – helps to answer any possible U.S. containment strategy along the eastern coast. Despite growing resistance and pushback from the developed world and some hosting countries, Beijing will deepen its Belt and Road push and integrate more countries into its framework.

China will also accelerate its push for regional free trade agreements, such as the Regional Comprehensive Economic Partnership (RCEP), as well as negotiations with key trading partners, particularly the trilateral trade negotiations with Japan and South Korea. And it will likely seek talks with other developed countries such as the United Kingdom, Canada or others. Because Washington intends to replicate the clause in the United States-Mexico-Canada Agreement in upcoming free trade agreements to dissuade trade partners from dealing with non-market economies such as China, Beijing and its trade partners will likely need to use sectoral agreements and other means of skirting the agreement. Right now, the prospective negotiation process between Beijing and Ottawa may offer a signpost for how that strategy evolves.

Even as regional states seek to advance RCEP negotiations to hedge against rising trade unilateralism, India remains a stumbling block. In the months ahead, how Beijing and New Delhi work to manage their competing tariff timeline and implementation will be a key issue in the fate of the trade agreement.

China is anticipating all the changes that will come with declining trade relations and a growing power competition with the United States. And in 2019, it will take a variety of steps to try to limit the negative impacts and keep its economy afloat.

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