The China Problem

This week Trump accused China of “totally violating” a recent trade agreement, raising trade tensions between the two countries once again. The current agreement, which was reached mid-May, reduced US Tariffs on Chinese goods from 145% to 30%, while China lowered its Tariffs on US goods from 125% to 10%. With the world’s largest and second largest economies trading threats in the midst of trade negotiations, it is still questionable whether an agreement will be reached.  Clearly China aims to be a global competitor with the United States, and the Trump administration appears intent on leveling the playing field for US companies while the US still has the upper hand.  Likely there will be no quick easy fix, and this battle will merely be the first among many conflicts as China rises to power.  Nonetheless, an outright trade war is in no one’s interest and the most likely outcome is an uneasy truce.

China aims to be a global leader, and Chinese Premiere Xi has made no secret of his plans for China to become the world’s largest economy by 2050.  According to the U.S. Chamber of Commerce, these ambitions are built on local protections.  China’s strategy, as espoused in the Made in China 2025 plan, is multi-step.  Step one is to “Localize and Indigenize”, developing indigenous technology and control segments of global supply chains.  Step two is to “Substitute” foreign technology with Chinese technology throughout China by advancing domestic production.  Step three is to “Capture Global Market Share” by exporting products globally and competing with existing global suppliers.

While global competition is nothing new, the coordinated fashion in which China directs its industries, along with multiple documented instances of Chinese industrial espionage has prompted some to restate the above Chinese strategy as “Rob, Replicate, Replace”.  Thus, one of the primary objectives for the US trade delegation is increased intellectual property rights.  The Office of the United States Trade Representative claims that China seeks to introduce foreign technology by “collection of market intelligence by state entities for the benefit of Chinese companies”, effectively accusing China of state-run industrial espionage.

The problem for the US is what to do about it.  China’s induction into the World Trade Organization in 2001 was supposed to begin the process of opening China’s market to the rest of the world.  While some progress has been made, many western economists argue that China has been the primary beneficiary of the agreement has been China, whose economy has grown from less than $2 Trillion in 2001 to more than $17 Trillion in 2025 while successfully discouraging foreign penetration of its market.  With the Chinese economy slowing, and the US economy enjoying renewed strength, many see now as the time to push the ‘reset’ button on trade and negotiate a new deal.  On the other hand, the Chinese are notoriously tough negotiators and have a long-term view that allows them to sit out short-term pain.  Therefore, it is possible that tariffs are not a short-term, but rather a long-term strategy to blunt the competitive rise of China.

The US does have some leverage.  24% of the US trade deficit comes from China, and the US imported $438 Billion from China last year.  Chinese exports to the US comprise 2.5% of China’s GDP, while US exports to China comprise only 1% of US GDP.   As a result, US tariffs that reduce Chinese imports could hurt the Chinese economy with comparatively low impact to the US. China on the other hand, holds significant percentage of rare earth production that is critical for high tech manufacturing. They are using the threat of withholding key rate earth materials as a means to gain negotiating leverage.

As an investor, it is always difficult navigate these types of geopolitical risks. However, the Trump administration appears eager to declare victory in the tariff negotiations and appear hesitant to do anything that would damage the US economy and risk a loss of control in Congress during the mid-term elections.  As a result, we believe the most likely outcome is a tense compromise since neither party wins in an outright trade war.  A long-term view is still the best approach.