Roubini: All out trade war inevitable

Via Nouriel Roubini:

The nascent Sino-American cold war is the key source of uncertainty in today’s global economy. How the conflict plays out will affect consumer and asset markets of all kinds, as well as the trajectory of inflation, monetary policy, and fiscal conditions around the world. Escalation of the tensions between the world’s two largest economies could well produce a global recession and subsequent financial crisis by 2020, even if the US Federal Reserve and other major central banks pursue aggressive monetary easing.

Much, therefore, depends on whether the dispute does indeed evolve into a persistent state of economic and political conflict. In the short term, a planned meeting between US President Donald Trump and his Chinese counterpart, Xi Jinping, at the G20 Summit in Osaka on June 28-29 is a key event to watch. A truce could leave tariffs frozen at the current level, while sparing the Chinese technology giant Huawei from the crippling sanctions that Trump has put forward; failure to reach an agreement could set off a progressive escalation, ultimately leading to the balkanization of the entire global economy.

Viewed broadly, there are three scenarios for how the situation might develop between now and the end of 2020, when the United States will hold its next presidential election.

One possibility is that Trump and Xi will find a truce or modus vivendi in Osaka, paving the way for a negotiated settlement toward the end of this year. On the trade front, the US wants China to buy more American goods, reduce tariff and non-tariff barriers, open more financial and service sectors to foreign direct investment, and commit to maintaining currency stability and transparency with respect to foreign-exchange data.

On technology, the US is demanding that China strengthen intellectual-property protections, cease making the transfer of technology to Chinese firms a condition of market entry for US (and other) companies, and crack down on corporate cyber espionage and theft. A temporary deal could include any of the above, with the US offering medium-term (through the end of 2020, and possibly longer) exemptions to Chinese tech firms that use US components, semiconductors, and software. This would leave Huawei severely constrained, but not dead in the water.

The second possibility is a full-scale trade, tech, and cold war within the next 6-12 months. In this scenario, the US and China would adopt rapidly diverging positions after failing to successfully restart negotiations (with or without a truce). The US would follow through with import tariffs – starting at 10% but increasing to 25% – on the remaining $300 billion worth of Chinese goods that have so far been spared. And the Trump administration would pull the trigger on Huawei and other Chinese tech firms, barring them from purchasing components and software from US companies.

China, meanwhile, would take steps to protect its economy through macro-level stimulus, while retaliating against the US through measures that go beyond tariffs (such as expelling American firms). Huawei might survive within the Chinese market, but its growing global business would effectively be crippled, at least for the time being.

Beyond trade and technology, this scenario also implies increased geopolitical and military tensions. The possibility of some type of conflict over the East and South China Seas, Taiwan, North Korea, Xinjiang, Iran, or Hong Kong could not be ruled out.

Finally, in the third scenario, China and the US would fail to reach a deal on trade and technology, but they would forego rapid escalation. Instead of plunging into a total trade and technology war, the two powers might ratchet up their conflict more gradually. The US would impose new tariffs, but keep them at 10%, while renewing only temporarily exemptions that allow Huawei and other Chinese firms to continue purchasing key US-made inputs, while retaining the option of pulling the plug on Huawei at its discretion. Negotiations could continue, but the US would essentially hold a veto over Huawei’s bid to develop 5G and other key technologies of the global economy. Given that Trump could suddenly pull the plug on the company whenever it suits him, China’s leaders would probably abstain from blatant full-scale retaliation, but would still intervene to minimize the economic damage.

THE GOLDILOCKS OPTION…

The third scenario is the most likely for now, because China is playing a waiting game until November 2020, to see if the US elects a more even-keeled president. Even with a truce, therefore, any negotiations that are relaunched after the G20 summit will probably drag on indefinitely, with no real signs of progress. In the meantime, the Trump administration will want to apply additional pressure on China, while keeping its options open. Better, then, to start with a 10% tariff on that remaining $300 billion worth of exports. The US could always hike the rate to 25%, but at the risk of raising the costs of goods that many of Trump’s own lower-income voters rely on.

In the absence of a trade deal, the same modulated escalation is likely on the tech front. With Chinese firms already on a tight leash, the US could convince European countries and other allies not to grant Huawei tenders or licenses relating to 5G and consumer products such as smartphones, thereby undercutting Huawei’s current advantage in this market. That would buy the US a couple of years to cultivate its own national champions in 5G and related technologies, and to get a head start on 6G.

Moreover, a managed escalation has potential political advantages for Trump, and even for Xi. Trump will not be exposed to charges from Democrats that he got suckered or went soft on China. At the same time, the lingering uncertainty from an unresolved conflict will probably prompt the Fed to start cutting its policy rate in July – or September at the latest. Those cuts could reach 150 basis points if the slow rise in tensions starts to take a toll on business confidence. In fact, if the conflict is managed well, the US could avoid a recession altogether, albeit with a deceleration of annual growth from 2% toward the 1-1.5% range.

Whether the stock market would suffer a correction (a decline of 10% or more) or merely a sideways shift in the third scenario would depend on a variety of factors, such as investor confidence, growth trends, and monetary-policy measures. One also cannot rule out some type of fiscal stimulus in the US and other advanced economies. For example, Trump could try to broker a partial infrastructure-spending deal with congressional Democrats or seek to rebate tariff revenues to politically sensitive constituencies such as farmers and low- and middle-income households in the Rust Belt. Though Democrats would balk at granting Trump such favors, they would block rebates for the “losers” of the trade war at their peril.

The “managed-warfare” scenario also has advantages for Xi. The Chinese economy, after all, can be backstopped with monetary, fiscal, and credit stimulus, not to mention a weakening of the renminbi (above CN¥7 to the dollar). The government could also make a modest show of retaliation, such as by threatening to restrict (but not ban) exports of rare-earth metals, which are used in a wide range of high-tech products. At the same time, the authorities could make life harder for the hundreds of US firms with business and investments in China, not with a full boycott, but through a thousand small cuts and abuses.

… ISN’T REALLY AN OPTION

Because China and the US both know that they are in for a decades-long rivalry, they may well conclude that it is better not to risk a full-scale conflict and global recession in the short run. Only through proper preparation over the medium term can the two powers manage a long-term cold war and the de-globalization that will be necessary to protect their respective supply chains.

But this scenario is not particularly stable, and could easily morph into the first or the second after a few months. If China and the US are both motivated by concerns about growth and financial-market stability, they could overcome their immediate differences, which would allow for a temporary agreement that postpones the question of how to manage a larger cold-war rivalry.

In principle, both countries would be better off with a deal, which is why markets had priced in the first scenario up until this past May, when negotiations collapsed. For the US, an agreement on good terms would boost consumer and business confidence, and thus growth, while reducing inflationary risks from the tariffs.

The sequencing of a potential deal also matters. As matters stand, persistent uncertainty will lead the Fed to loosen its monetary policy one way or another. Suppose that Trump and Xi restart negotiations that then drag on until late fall or early winter of this year. The Fed would have to cut its policy rate by at least 50 basis points, after which point the Trump administration may agree to a deal. Because the impact of monetary easing takes time, the Fed would have to remain on hold until November 2020. (Even if the economy and inflation were to rebound, monetary policymakers would be hesitant to reverse course before the election, lest they appear to be acting politically.)

In this sequence, Trump’s re-election prospects would be doubly improved. The Fed would have locked in rate cuts as insurance, and a new agreement would have bolstered investor confidence and the stock market. But, of course, this could happen only by chance. Trump’s “art of the deal” does not involve such multistep, multidimensional thinking, after all.

As for China, an agreement would, at a minimum, prevent further damage to its economy, and particularly its tech sector. The government would secure a few more years with which to prepare for a longer-term conflict over trade, investment, artificial intelligence, 5G, and geopolitical dominance in Asia and beyond.

The Chinese tend to think long term, and they are well aware of the “Thucydides trap” – a self-fulfilling prophecy in which a hegemon and an emerging power end up at war. Still, they clearly need more time to prepare. A major short-term shock today would be hard for China to absorb, especially if it knocks the country’s national champions offline for the medium to long term.

And indeed, Trump now appears to be opening the door to a truce at the G20, tweeting that critical preparatory work for an extensive meeting with Xi will now begin. But that meeting may still fail, even if both sides pretend that a truce was reached. If there is no substance to the terms of an agreement at the G20 – only painted smiles and stiff handshakes – the subsequent negotiations may quickly fail and lead to a gradual escalation of the trade and tech war.

THUCYDIDES RETURNS

Unfortunately, an even more likely course of events is that the third scenario – a managed trade and tech war, which is my baseline of how the rivalry will evolve over the next few months – would then devolve into the second (a full-scale confrontation). A Sino-American trade and tech deal in the coming months is far from assured. The negotiations broke down in May as a result of substantial differences between the two sides. And now, the complex preparations needed to stage a successful Trump-Xi summit in Osaka are being rushed at the last moment, after six weeks were wasted with no contact.

Even if the Americans and Chinese can overcome differences in their negotiating style, the US will still want legislative commitments from China, and China will still view such demands as a violation of its national sovereignty. The Chinese are highly sensitive to anything resembling the imperial interference that weakened China in the nineteenth century. Like Trump, Xi cannot afford to lose face.

Moreover, as the war of words has escalated over the last month, the spillover of trade frictions into the technology domain has intensified. Once kept formally separate, the two issues are now inextricably intertwined, which will make a resolution even harder to achieve. The Chinese cannot agree to any deal that does not rescue Huawei, but now that Huawei has become a bargaining chip, national-security hawks in the Trump administration and Congress will force Trump to take a hard line on the company.

Each side seems to think that the other will blink first. For example, the US assumes it can inflict more economic pain on China than China is capable of returning, because US exports to China ($130 billion) are a fraction of China’s exports to the US ($560 billion). Hence, when it comes to tariffs, China seems to have more to lose.

Yet, as we have seen, the conflict is about much more than tariffs, and China can retaliate in a number of ways. In addition to imposing new non-tariff barriers, it can strike a blow against major US firms that rely on Chinese supply chains and consumer markets, while allowing the renminbi to weaken. And if tensions escalate too far, China could even resort to the nuclear option of dumping its massive holdings of US Treasuries; it has already started to reduce its holdings of such US assets.

Moreover, US leaders may be underestimating the costs of the conflict. According to the prevailing narrative, the tariffs now in place have had only a modest impact on US growth and inflation. But the latest economic data suggest otherwise, as the US and global economy are slowing. In fact, one reason why the Fed has started considering preemptive insurance rate cuts – likely to start in July – may be that it is worried that tariffs are hurting the US economy more than was initially anticipated.

Making matters worse, the US has nowhere near as many tools to respond to macroeconomic shocks as China does. In addition to massive stimulus and currency depreciation, China’s government can bail out private and public enterprises at will. The US, by contrast, must rely on traditional monetary and fiscal tools, all of which are already severely constrained. And while Trump must worry about re-election, Xi has abolished presidential term limits, faces few constraints on his power, and presides over a sprawling apparatus of social control, including the Great Firewall of online censorship.

THE ART OF “NO DEAL”

Politically, then, it is much easier for China to take the long view, which is what Xi has done by announcing a “new Long March” – a reference to the People’s Liberation Army’s long, painful retreat in the 1930s to a new stronghold in Shaanxi province, from which it broke out and took over all of China, under Mao Zedong, in 1949. By wrapping himself in the Chinese flag and fomenting nationalism at home, Xi is preparing Chinese society for a protracted struggle. If a full-scale cold war ensues, he will be able to remind the Chinese of the need to suffer today to achieve glory tomorrow.

In fact, it is possible that Xi actually wants a full-scale economic war as a means of damaging Trump’s re-election chances. A new Democratic president – even one who accepts the reality of a more contentious Sino-American rivalry – would almost certainly be a more constructive and honest broker for China to deal with. In the parlance of the foreign-policy establishment, Xi may see de facto escalation as the quickest route to regime change in the US.

Moreover, Xi is not an absolute ruler. While he controls most of the levers of power, there are still factions within the Communist Party of China (CPC) that could turn on him if he does not mount a sufficiently aggressive response to the US. He is not in a position to accept a deal in which he – or China – loses face or power. If America’s medium- to long-term goal is to contain China, as the Trump administration’s National Security Strategy clearly suggests, Xi cannot agree to anything in the short term that advances that agenda. In the grand scheme of things, it might be better to start a full-scale conflict now than to grant the US a tactical advantage for the next two years.

The danger is that Trump, too, would prefer a partial or full-scale trade and technology war to a weak deal. If Trump makes any notable concessions, he will be accused by both Democrats and right-wing pundits of appeasing China and betraying American blue-collar workers. Even if he can’t secure a favorable deal, at least he can say he remained tough. Among those who have Trump’s ear are national-security hawks – some of them modern-day Dr. Strangeloves – who believe that China is so fragile that an economic shock could precipitate a political collapse, and even regime change. This is a dangerous game to play, because it could lead to actions that turn a cold war into a hot war. The mere presence of such extreme voices in Trump’s orbit suggests that the administration’s intent is to contain China at any cost.

Worse, these hawks have the upper hand now that the “adults in the room” have long since departed. Secretary of State Mike Pompeo, National Security Adviser John Bolton, acting Secretary of Defense Patrick Shanahan, and Vice President Mike Pence all appear to be China hawks. And the situation is no better with respect to trade and economic advisers, where Secretary of Commerce Wilbur Ross, White House Trade Representative Robert Lighthizer, and Peter Navarro, Director of Trade and Manufacturing Policy, have sidelined moderates such as Secretary of the Treasury Steve Mnuchin (who is unwilling to stand up to the president anyway).

SUMMIT SIGNALS

Where does that leave us? If both Xi and Trump find the third scenario attractive, neither will be willing to meet halfway on a deal. That makes the second scenario – a full-scale trade and technology war – the most likely outcome, given that a controlled escalation is inherently unstable.

As matters stand, the probability of a deal eventually being reached is low (my colleagues and I put it at just 25%). Still, we will know more after the G20 summit later this month. If Trump and Xi fail to broker a truce or a temporary agreement regarding Huawei, the US will probably follow through with 10% tariffs on the remaining $300 billion worth of Chinese exports. We will then be in the initial stages of the third scenario.

On the other hand, if Trump and Xi hold a friendly meeting and agree to a truce, the US will probably withhold new tariffs, and we will be in the early stages of the first scenario. This would make the probability of the two sides reaching a deal slightly higher. But a lurch to the third scenario – a precipitous escalation of the current confrontation – would still be more likely, followed eventually by a descent into a full-scale conflict. Where it will end is anyone’s guess, but an escalating trade and tech war is, in my view, more likely than an eventual deal.

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