China's Trump cards in the coming trade war escalation

Financial Times opinion: December 13, 2024

A tit-for-tat between China and the US on trade this month hints at what could well lie ahead if Donald Trump delivers on campaign promises to up the ante on Chinese tariffs when he returns to the White House.

In a long overdue move, the US has just updated its export sanctions on China, focusing on high-bandwidth memory chips and semiconductor manufacturing equipment. Washington also added another 140 Chinese firms to the Commerce Department’s so-called “entity list”, effectively making it very difficult for those US companies to supply technology to them.

As has been the case since 2018, China has been quick to counterpunch, in this case by banning or limiting US purchases of several critical minerals while tightening controls on graphite. China’s retaliatory action is a surgical strike with important strategic consequences for key US industries, ranging from semiconductors and satellites to infrared technology and fiber optic cables, to lithium batteries and solar cells. These actions are comparable to what Washington is seeking with its “small yard, high fence” strategy aimed at restricting Chinese access to critical US technologies.

It is a reminder that retaliation is the high-octane fuel of conflict escalation. This is not well understood in US policy circles that seem to harbor the mistaken notion of a one-way dependency — that China is uniquely beholden to external demand and new technologies from the US. This leaves out the other half of the equation. The US is also heavily reliant on low-cost Chinese goods to make ends meet for income-constrained consumers; the US needs Chinese surplus saving to help fill its void of domestic saving; and US producers rely on China as America’s third largest export market. This codependency means the US depends on China just as much China depends on America.

Trump doesn’t buy this logic. During Trump 1.0, US tariffs on Chinese products were raised from 3 per cent in 2016 to 19 per cent by 2020. Trump held the mistaken view that there was a bilateral China fix for a multilateral trade deficit with 106 countries.

That backfired. Over the subsequent years, the overall US merchandise trade deficit widened from $879bn 2018 to $1.06tn in 2023. Predictably, in response to tariffs, the Chinese share of the overall US trade deficit fell from 47 to 26 per cent over this same five-year period.

However, the Chinese portion was simply diverted to Mexico, Vietnam, Canada, Korea, Taiwan, India, Ireland and Germany. And it turns out more than 70 per cent of the trade diversion away from China went to higher-cost or comparable-cost nations, underscoring that trade diversion is the equivalent of a tax hike on US companies and consumers.

Expect more of the same in a second Trump administration. And as US actions escalate, retaliation from China will likely broaden. For example, China’s latest actions on critical minerals open up the possibility of more wide-ranging constraints on rare earths, which are of enormous strategic importance to the US.

Then, of course, there is the ultimate financial weapon — Greater China’s $1tn in direct holdings of US Treasury securities (including $772bn by the PRC and $233bn by Hong Kong as of September 2024). Cavalier Americans typically dismiss this possibility, claiming China wouldn’t dare flirt with this nuclear option because it would hurt them more than us.

Oh really? There are a couple of “bad dream” options to consider: China could go on a buyer’s strike during upcoming Treasury auctions, or, even more extreme, it could start to unload its outsize position as America’s second largest foreign creditor. Either option would be devastating for America’s deficit-prone economy and would unleash havoc in the US bond market, with wrenching collateral damage in world financial markets. While it seems farfetched, almost suicidal, for China to spark such a financial meltdown, it is equally reckless to dismiss the “tail risk” consequences of a trapped adversary.

Much of the post-election policy discussion has focused on tariff initiatives likely to be forthcoming in Trump 2.0. Sino-American codependency urges us to think less about unilateral actions and more about the retaliatory responses to those actions. Trump’s nationalistic view of “America First” ignores how much a saving-short US economy depends on China for goods and financial capital. China has plenty of “Trump cards” to send a very different message.