Trade War Progress Report

October 14, 2019 – On Friday, the White House announced what they called “Phase One” of a trade deal with China, artfully backing away from their “big deal or no deal” talk earlier in the week. I talked about the trade negotiations in two CNBC appearances last week. You can see a video clip of Wednesday’s Power Lunch interview by here, Thursday’s Worldwide Exchange interview here; and a recent conversation with Kelly Evans on The Exchange here. What follows are my thoughts on state of the trade war.

The bottom line is that the trade war is not going away before the next election and will continue to morph from a Trade War to a Cold War over the next year.

Phase One of What?
As I had expected, the Phase One deal announced at Friday’s press conference didn’t amount to much. The US agreed to delay tariffs that were due to kick in next week. China agreed to buy the same amount of soybeans they were already buying before the trade war started and said they would do more to open markets for financial services, which they have already been doing for two years. In fact, China upstaged the Phase One remarks the day before when the China Securities Regulatory Commission announced that foreign companies would be able to apply for 100% ownership of Chinese financial services firms starting January 1. And they talked about “progress” on other issues, including intellectual property, currency manipulation, and forced technology transfer. Missing: subsidies to state-owned companies (SOEs), new rules to liberalize China’s economy, structural reforms, the tariffs that kick in on December 15, and what to do about Huawei and other tech companies. In spite of the small potatoes produced by the agreement, stock markets liked what they heard.

So why announce a small agreement at all? After nearly two years of trade talks, the only thing the US and China have achieved to date is driving the global economy to the brink of recession, which has forced central banks to inject liquidity into financial markets and embark on new QE programs. My guess is that both sides felt they needed a little happy talk to support increasingly skeptical markets. Or maybe someone in the White House figured out that a long series of small positive announcements over the next 12+ months will help both the economy and their chances for re-election.

Until Friday, there was reason to be skeptical; the week was a vicious tit-for-tat. The White House floated rumors they were looking at ways to stop American companies and pension funds from investing in China, then blacklisted both Chinese companies and Chinese officials involved in China’s long-running campaign to “re-educate” the Uighurs in Xinjiang. But the main point of conflict was the growing confrontation in Hong Kong between pro-democracy demonstrators and the police. Some US officials voiced support for the demonstrators. China reacted by warning the US to keep its nose out of Chinese internal matters and by restricting visas for Americans who have expressed opinions the Chinese government finds to be ‘harmful to social stability.’ Then they kicked the NBA off of Chinese TV after a coach expressed support for the young people of Hong Kong and major Chinese sponsors quickly cancelled their deals with the league. Chinese officials objected to an iPhone app that allows the demonstrators to keep real-time tabs on the location of the police and Apple pulled it from the app store. People have finally figured out that the Chinese government has different ideas of the rules of play than ours. And companies have figured out that China’s GDP is the same size as ours and that money talks. Clearly, what started as a dispute over the US-China bilateral trade balance has now spread into every point of contact between the two countries.

Trade War, Tech War, Cold War
The reason the Trade War has morphed first into a Tech War (Huawei, ZTE, 5G) then into the early stages of a Cold War is that trade policy has fallen into the hands of the Neocons (right-wing nationalists) in both countries. There has always been a tug of war in the White House between the Neocons–those who oppose China’s emergence as a global power big enough to challenge US hegemony, and the advisors who favor market-oriented solutions. (I won’t mention names here as I have contact with all of them.) Policy has shifted as one group or the other has had Trump’s ear.

What many Americans don’t know is that President Xi has home-grown Neocons to deal with too. In China, they are known as the Shanghai Gang and are associated with former (1993-2003) President Jiang Zemin. They were the proximate cause of the abrupt shift in China’s trade policy in May, much to the surprise of the American team who thought they had a deal in hand. As I discussed with the US trade team some months ago, it is important to understand the pressures on the guy on the other side of the table before sitting down to negotiate a deal.

Who’s On First?
Make no mistake–the guy on the other side of the table in the trade talks is Chinese President Xi Jinping, not Vice Premier Liu He. While Liu He is the right man for this assignment, he is not “the” Vice Premier, he is  “a” Vice Premier. China has four Vice Premiers, each in charge of a specific portfolio, much like our Cabinet members. In China, however, they are ranked, and Liu He is #4, after Han Zheng (First-ranked Vice Premier), Sun Chunlan (#2), and Hu Chunla (#3). All 4 Vice Premiers report directly to the Premier, Li Keqiang (the first top official I met in China 15 years ago when he was head of the Communist Party for Liaoning Province.) The Premier is head of the State Council, and viewed as the head of the Chinese Government, i.e., the work of the bureaucracy. In contrast, President Xi Jinping is viewed as the head of the Chinese State. But wait, there’s more! Xi Jinping’s direct report is not the Premier, it is Vice President Wang Qishan. The Vice President takes over for the President should he become incapacitated and is a good bet for being the next President; both Hu Jintao and Xi Jinping served as Vice Presidents. Wang Qishan is a Xi Jinping loyalist. When Xi first came to power, Wang Qishan was his enforcer (like Luca Brasi for Don Corleone) as Vice Premier in charge of the anti-corruption campaign  who led the purge of both corrupt officials and political enemies to consolidate Xi’s power base. (Personal note: I first met Wang Qishan a decade ago when, as Governor of Beijing, he presented me with China’s Great Wall Friendship Award.)

A Trade Deal We Could Get Done
I have privately advised the White House trade team on China matters. I briefed them on the Chinese economy, financial markets, Peoples Bank Of Chine policy, RMB/$ inconvertibility, domestic and foreign capital flows, the difference between gross and value-added trade data, and Chinese politics. And I brought them the outline of a deal I thought they could get done. My recommendations are summarized below:

1. Getting them to say they will buy a bunch of our stuff (soybeans,…) is easy. Do it.
2. Getting rid of tariffs on both sides is easy. Do that too.
3. Intellectual property protection improvement is pretty easy if you take time to understand it from the Chinese perspective .
4. First, you have to understand the history of Chinese invention and the way ideas were transmitted and protected during the past 50 centuries.
5. There is now huge political backing for protecting intellectual property inside China today (think Jack Ma, Alibaba). Almost all new net worth created in China in the past decade has come from companies that rely on IP protection to make a profit.
6. China has been grappling with this issue internally for some time. They have passed new laws  in the past year to improve IP protection.
7. Stealing IP and forced technology transfers often occur at the local level, which is also where foreign companies negotiate incentives with local governments. Add the fact that China has historically tried IP cases in local courts and you have an almost perfect storm for corruption. For that reason, China created a new court in Beijing to oversee IP matters almost a year ago.
8. Changing institutions takes time and must develop organically from within.
9. Enforcing the agreement is very difficult.
10. There is 0% chance the Chinese government is going to let you wander around China with a clipboard checking on them. They would view that as an attack on their sovereignty. And, by the way, we wouldn’t let them do that here either.
11. Organize the 110,000 US business people living and working in China to feed information about violations back home so you can push back on violations.
12. Some things are simply impossible in China.
13. They will never give up Industrial policy. The place still operates with 5 year plans. It is a DNA issue.
14. They won’t stop subsidizing SOEs. It is both their social welfare system and one of the main channels for fiscal policy. Asking them to dismantle SOE’s is roughly like them asking us to get rid of Social Security and the Tennessee Valley Authority.
15. They won’t stop supporting technology. Huawei, ZTE, and the other Chinese technology firms are the means of executing China’s long-term economic strategy–transforming from a low-margin assembler into a designer and producer of branded, global high-tech products. And they are the point of the spear for China’s One Belt One Road initiative to improve China’s economic and political influence in the global economy. Critical there is the role Huawei plays in rolling out 5G telecom networks in emerging economies, which will allow China to be a leading player in the Internet of Things game.
16. Say goodbye to Hong Kong? Not a chance. Americans need to read the history of the Opium Wars to understand why.
17. They will not agree to outside meddling in what they view as internal sovereignty issues, even the ones we consider as human rights (Tibet, Falun Gong, Xinjiang,…).
18. One of our Cabinet members asked me what Xi Jinping wants out of a deal. “That’s easy,” I said. “He wants you to go away.” Barring that, his wish list would include:
19. He wants face, to be treated respectfully in public and have a seat at the adult table in global affairs.
20. He wants to improve his political position in China. Xi has internal political pressures too. That makes it very important how the story gets told in China.
21. He cannot be viewed as giving up Chinese sovereignty in any way.
22. All of this means that you have to approach trade disputes the same way you do business deals.
23. You have to know everything there is about your opponent and those around him before you meet at the table. We blew it on this one.
24. You have to have an achievable plan before you start.
25. You have to let your opponent win in the eyes of his own people. Give him something he wants that costs you nothing (face) in exchange for something you really want.
26. Negotiations are better conducted in quiet, not on Twitter. Conflicting messages from the President will only convince Chinese leaders they cannot trust him to live with any deal after it has been signed.

Time is Not Our Friend
The biggest enemy of a trade deal at this point is the clock. Unfortunately, the clock is winning. The Trump Administration has used up two years getting to Friday’s Phase One mini-deal. There is no evidence that they can get a big deal done. It’s also not clear that ending the trade war would be in their interest. A grand deal would mean giving up a valuable political asset–railing against China over the trade deficit–in the run-up to the 2020 election. That’s not going to happen.

It is also not in the interest of China’s leaders to go for a quick comprehensive solution. First, no major decision by the Chinese government happens quickly. Although it appears from the outside to be a one-man show, the opposite is true. Major decisions in China represent the consensus of the Politburo Standing Committee and other senior CPC members who all formally live in Zhongnanhai, the compound across the street from the Great Hall of the People. Second, the accepted view in China is that this is not just a trade war, but the beginning of a broad and long-lasting conflict between the US and China as the world adjusts to having two powerful states, not one.

Every major decision has to be tested against the possibility that there will be no rapprochement and that the world will have to divide into rival teams. From that perspective, Chinese leaders see little difference between 13 months from now (November 2020) or 61 months from now (November 2024). They are now simply running down the clock until the next election.