How China Might Actually Handle a US Trade War

they'll have mass unemployment, et cetera. And again, by and large, the Chinese economy, from my outside perspective and I've never been there, continues to grow more robust.

going to impede China's technological development. But then you also hear that the export controls are speeding it up because China now is forced to build domestic capacity. So there are all these competing narratives. We should definitely talk about all of them. And I realize we haven't actually done a China centric tariff episode anyway. That's right.

on China. So it seems to be a special case in the overall trade crackdown for sure, and we should talk about it. And I am very very happy to say that we do, in fact have the perfect guest. We're going to be speaking with, Arthur Kroeber. He is the founding partner and head of research at Gavcal Dragonomics. So Arthur, thank you so much for coming on all thoughts.

that by their standards was very sluggish. So why would you take on an additional, not necessarily required hit to the economy at this time when you're struggling. So it's very good question. I think the basic answer is number one, because of the first trade war in the first Trump administration and the subsequent campaign of export controls and technology constraints by the Biden administration, they've been kind of girding themselves for a long time for more self sufficiency, to

insulate themselves against external shocks. So there's a kind of a baseline of confidence that they can take a lot of pounding and they'll still be okay. But then I think the specific reason why they alone, basically of all countries in the world, chose to retaliate against the Liberation Day tariffs was they were really mad. This is very

visible to me. When I was in last and Bidjing in late March, I got a lot of comments from people about basically how the Chinese had been trying since the beginning of the year before Trump was inaugurated to get messages to him to kind of lay out, you know, make it clear that they were interested in talking and suggest some things that could be on the agenda, etc. Asking for who's the person that we should talk to,

and they just hit a stone wall. Basically, they were unable to establish contact with anyone in the Trump administration who would tell them anything, and instead what they got was twenty percent tariffs, remember, in February and January, on the grounds that they hadn't done enough to control fentanyl flows, which they were also mad about, because they'd spend a lot of time in last year negotiating an agreement with the Biden administration, which they complied with, which made a

real dent in the export of fentanyl precursors out of China. It was not complete but they had really made a serious effort. So from their standpoint, they'd been trying to open a conversation and the door had been shut in their face time and time again, and they'd just been whacked with stuff that they thought was completely unfair. So I think they were just kind of fed up. They had a baseline sense of security that if we hit back, we know it's going to be bad, but we'll be

able to take it. Then. I think the other consideration was essentially political, which is that, you know, even if they hadn't retaliated, they were still facing tariffs of over sixty percent, so no matter what they did, it was going to be bad. So they had to have a story to tell their people, what are we doing about this bad thing? And it's a lot easier to mobilize domestic support if you're standing tall and pushing back, which actually is you know, it's like what Mark Karney did

in Canada. It's how he won that election was by being the guy who pushed back against the so called bolay So I think it was a combination of frustration, a sense of security that they could outlast the US, and war of economictrician and in a sense that this was the best way to get people in China on board for what was going to be a tough time no matter what.

for a long time. Rhetoric that you hear from Chinese officials will often talk about their very long history, going back thousands of years, and then Americans will parrot that and sometimes say it's like, well, you know, they have history going back a long time and they suffered a century of humiliation and etc. How real is that in the sense of like, it's a government that doesn't want to see unemployment go up in the short term, et cetera.

I think many Americans have really internalized this idea of they think really long term, they think in century, if they think in millennia.

things that are true about that. So, first of all, this century of humiliation idea that is number one. It's something that is played up by the Chinese educational systems, has drummed into people starting an elementary school. That's part of the nationalist narrative that the CCP has used for.

standing that China has achieved in the world. I mean, you know, up until the early nineteenth century, it was undisputedly this great empire, and people within China had the sense of being part of a great global power, and then that was all taken away and they had a pretty catastrophic hundred years of civil war and famine and

all kinds of stuff. So it has been a theme of Chinese elite since the eighteen forties, that they have to rebuild the nation, acquire the technological means to stand on an even footing with the West, and so forth. And the current regime is just the one that has been most effective at sort of realizing that vision. But if you changed the regime tomorrow, whatever came in its place would have the same I think underlying ambitions. So that,

I would say, is a common theme. I think. The other thing that is, I don't I'm not a real buyer in the super long term thinking thing. But you know, if you look at Chijinping's utterances, he took over in twenty twelve, and he started laying out some pretty long term stuff right away. He had these various goals that stretched out to twenty thirty five and twenty forty nine, which is one hundredth anniversary of the Communist Party, and

so forth. And so there is an ability of the Chinese state, because they don't have to face elections to organize kind of strategic plans that last a little bit longer than would typically be.

good job on a lot of them. So the planning is not I think there's often a mystique about it, but they are able sometimes to sort of point the ship in a particular direction and then get a lot of people in society on board with steering that ship where they want to go.

a bunch of things to get around the tariffs. Is that an option this time around, given that Trump seems to be cracking down on pretty much all of America's trading partners all at the same time.

to Southeast Asia. It wasn't the government saying please do this. It was just they said, well, we want to sell to the US. We can't do it from here. Where do we go? Oh, we can go across the border and it'll be fine. And it was now they've diversified they used to be just in a couple of countries, and now they're in a larger number of countries. It's if you try to go after this stuff, it's like

playing a game of whack themole. The other thing I would observe on that, just beyond the solar people, is China is now at a stage of development where they have very sophisticated companies that are very good at what they're doing, increasingly have markets in a wide range of places around the world. And what do companies do when they are in that situation, be they from China or Japan, or the United States or Germany, They invest abroad, They internationalized.

And so what we're in right now is kind of act one, I would say, of what is clearly going to be a very long process of Chinese companies turning themselves into multinationals, just like the companies of every other industrialized country have done. And so they don't need the government to tell them do this. They have their own reasons, not just teriff avoidance, but to be closer to different markets,

et cetera. So that process, I think is just going to continue because it has many many drivers, not just teriff avoidance.

they're in Hungary, right, they're elsewhere. But it also, like, I mean, this is one of the things that I guess confuses me about the US administration policy, you know, all these other It's like, oh, we're going to like split off Vietnam or gonna make it like it's hard for me to imagine that given the amount of cross border investment that we've seen over the last years and years.

There is not a clear policy. What you have basically is Trump's impulses, which are number one, I want to sort of demonstrate dominance over everyone and I want them to exhibit difference. And number two, I really like tariffs for some strange reason that I don't think any of us understand but he really likes them. But he also likes them specifically because they are a tool that as the president of the United States, he is the legal

authority to use without restraint. So if he wants to hurt people, he doesn't have to go to Congress, he doesn't have to ask anyone in Congress. He just does it. So it's very usef for him. And I've found a lot of the commentary over the last couple of months trying to explain the rational strategy behind this to be

completely off target because it isn't. And various people in the administration, like Scott Bessant, would like there to be a strategy, and they are desperately trying to corral the stuff into the semblance of a strategy, but they have to improvise. So that's sort of my general comment on that. And then specifically in the question is does it work. No, The reality is there are now I believe one hundred and forty countries in the world that trade more with

China than with the United States. China is now the number two source in the world, behind the United States of direct investment, and it's growing its economic relationships with many countries, including in the Latin America are much deeper than those of the United States, let alone Southeast Asia,

where their economies are completely tied to China. So there's no way, no way that any sane leader of any of these countries would sign on to a deal where they would say, oh, we'll get our teriffs on the US lowered from ten percent to five percent in exchange for which we have to sacrifice our principal economic relationship. It's not going to happen.

Do they show that there's potentially a path forward to a US China deal or is it just Trump trying to retroactively protect some pretty important industries.

like semiconductors and some key technology inputs. Despite all of their progress, they're still pretty dependent on global supply chains outside of China for a lot of stuff that goes into their tech ecosystem, and they could not afford to have this stuff cost a lot more. So I think in both cases it's roughly twenty percent or a bit more that has been exempted. As you said, it's very hard to know exactly when this is going into effect,

and blah blah blah. But both sides have sort of picked out the parts of their economies which are most vulnerable and said, okay, you don't have to take the pain. But it doesn't tell us anything about It's not like both sides are signaling to each other, hey, if you lower your tariffs, all lower mine, and then maybe we can get somewhere. They're just doing what they need to do to protect themselves.

low end stuff. A. Are we already seeing real in China un parts of the economy from these tariffs that's visible from what you're looking at. And B how much of that stuff is still in China as opposed to that's the low margin stuff that you probably quickly have it some cheaper destination. How important is stuff, the cheap stuff to China's economy these days?

So you are starting to see some softness in the industrial and manufacturing indicators. I mean, you've had an employment a pretty weak employment market since the end of COVID basically that they've been struggling to address. So this is going to have some impact. You know, the Chinese export

numbers have still been quite strong. Most people think that's because there's been some front loading, because people are anticipating tariffs, and we're expecting significant weakness, you know, in the coming months. I think that will happen. It will hurt, but I don't think any of that is going to hurt enough for China to feel like it has to make a move. They've clearly signaled Trump wants to have a deal. He has to make the first move. He has to initiate

show some good faith. They've laid out their position, they're waiting for him to pick up the phone and call basically. So yeah, this is going to cause some real difficulties, and I think they're going to have a real challenge meeting their growth target this year. If this goes on for much longer, but I think they're willing to wait it out.

some of the tensions in the economy. What's your sense of how much Chinese people might actually be able to boost their own consumption right now to offset the trade war.

they say, yeah, we want incomes to rise fast. We would like there to be a stronger services consumption and so forth, But they have never said that, we think we should fundamental out in the shop. Well, they haven't said that. But the other thing is, I think it's really important to understand these people are not They're not Americans, They're Chinese. They have a different concept of how an

economy grows. So we grew up in this sort of Canesian world where we believe that demand drives everything, and Chinese authorities don't believe that. They believe that investment drives everything. That progress, productivity, future income growth, it all comes from investing in the right things. So they have been very clear for as long as I've been studying it, including the last decade, on saying to secure the growth of the future that is stable, well balanced, whatever, we need

to invest in the right things. That is the principal job of government economic policy is to steer investment. So that's point one. They've never really had an agenda of substantially balancing. Second is, up until COVID, the fastest growing consumer economy in the world by an order of magnitude was China's for twenty years. There is no economy that comes even close to the rate of consumer spending growth

that Chin enjoyed between twenty twenty twenty. It was I think the total aggrig growth was more than triple what you saw in India, for example, and much faster than you saw in advanced economies that grows lower rates. So they didn't really have, in my opinion, a consumer spending problem, and I think they look at that, you know, much the same way they say, well, you know, we actually don't need to rebalance. Now I think that's changed a

little bit. I think they really in the last few months have started to say, oh, actually, we're going to be facing a lot of head winds in the export economy,

largely from the US, but not just the US. They're in a tariff battle with the European Union over electric vehicles, a lot of other kind are beginning to put up barriers, and I think they are beginning to realize that they need to both for the short term, you know, trade war issues, but also for just having a more comfortable place in the global economy, that they have to do a little bit more to boost the consumer part of

the economy. But they they're limited in their tools for being able to do that.

things don't show up in consumption. You know, they're not retail consumption, right, but as a form of lifestyle consumption, whether your city just has greater amenities and comforts and cleanliness and so forth, et cetera, are those all real?

You have a lot of first class urban infrastructure in places like Shanghai, Shunjan, Beijing, and increasingly in a couple of interior cities like Chungdu and so forth, and things work quite well. And you have large swaths of the country where people are still living fairly, you know, modest lives, one generation removed from the family farm that their parents

still live on, and so forth. There's parts in the northeast which are a super rust belt of these old sort of fifties and sixties areas industrial towns built around industries that really aren't that important anymore, mining or whatever. So they have an enormous variety of things. But I would say it is fair if you go around to sort of random Chinese cities in sort of eastern and

central China, most people now have pretty comfortable lives. They're not as shiny as you might see in these social media egos, but things work, their needs are taken care of pretty well.

care can vary quite a lot. I would say, on average, the situation there is quite a bit better than it was ten or fifteen years ago, with a lot of room for improvement.

so on. And I don't mean to single out China on this issue, because I think the US faces a very similar balancing act, but arguably the US is much more developed in its capital markets and has certain advantages in global markets that China just doesn't.

the economy stronger and able to weather the shock. So in retaliation, you know, clearly they have the countervailing tariffs. They have increasingly comprehensive export controls on rare earths and rare earth based technologies, which are actually not just rare earths, but a various sort of critical minerals, antimony being sort of the big example of the moment, and those are part of that is Yeah, that's actually.

a few things that they can do like that. They've singled out a few US companies operating you or selling into China for various kinds of investigations. Those are more kind of shots across the bow. They're kind of gestures. I don't think they're really that serious. They don't really want to make it harder for Nvidia to do business

in China than it is already. But basically what they're doing is they're picking out companies that may sell a lot to China but don't have a lot of investment on the ground in China and saying, if you don't basically help us get this guy in the White House to see reason, we might make it a little difficult for you. And they'll only do that if they think

there are reasonable domestic substitutes. So they're doing a little bit of that, but they're being very cautious because they are keenly aware that their economy still needs international businesses to participate in China at many different levels. They do not want to scare them away. So what they're mainly left with is response mechanisms, which is, you know, some of it is the usual stuff. They can lower interest rates and they'll probably do a bit more of that

this year. They were already planning a big fiscal expansion this year, one of the biggest budget deficits in history. They're probably going to expand that more. To get up consumption, they have this cash for Clunkers kind of trading program where you have an old appliance, you can trade it in, you can get a discount on the new one. That's for both households and for businesses. They can trade in old capital equipment and get new stuff at a cheaper price.

And then the other thing that they've been doing actually is to get more money into consumer pockets. They have started to expand pension payments, focusing on people lower in the income spectrum and just putting an extra five or ten bucks into their accounts every month so that they have a little bit more cash to spend. And by focusing on the lower income, those are people who basically spend most of what they have, so it has a

big impact. But yeah, so they can do all of these things and they will all work to some degree. The cash for clunquors thing actually worked a lot better than I thought it was. I was very skeptical, But at the end of the day, consumer behavior is pretty sticky in any country. The job market is still not terrific. They're going to have a lot of difficulty really really moving the needle on boosting domestic demand. They can get it up a little bit, but not a lot in the short term.

So the things I think that are largely unchanged is I talked earlier about this kind of view of how economies work, that they are driven by the investment cycle, and that the government has a important role to play in kind of identifying the key top areas for investment, not necessarily spending the money, but say pointing and saying go there, and then all the entrepreneurs in the country say, oh, we should go there, We'll go there. That has not

really changed. That is a and you can talk about people you know before she who were more quote unquote reformists and so forth, but if you look closely at what they were doing, they had the same objective. They wanted to increase state capacity. They wanted to strengthen the technological foundations of the economy. The first long term Science and Technology Plan actually came out in two thousand and six, which was six years before she jent Ping took over.

It had nothing to do with him, and it was very much the product of everyone else in the government at that time, so that I think general orientation has not changed. What she has done is that he has made the coordination of that strategy much more effective. So he's increased the capacity the same government to kind of

mobilize and guide resources. He has reined in what he thought were big excesses, notably in the property market, but also in the internet sector, where he thought a lot of investment was going to stuff that was actually not advancing the ball technologically, and it was also creating significant social and political risks for the Communist Party, and it

needed to be rained in. But you know, a lot of the concerns that you see expressed about social media and the power of internet firms in China totally indistinguishable from the discourse that we have here in the United States about the same problems. So part of what they were doing was try to say, let's have less resources to that kind of stuff and more to the kind of stuff that we think that will really generate long term growth, that is, will enhance productivity and social cohesion.

So he hasn't changed the sort of the basic orientation, but he's made the execution of that generally much more effective. And then the other big thing that he did do that is a major change, is that he overturned the foreign policy that dung Shaping had laid down, which is, you know, the idea that you stay quiet and stay behind and stay quiet and sort of hyde your capabilities or by your time and whatever. And he pretty aggressively

said no, no, China's great power. Now we have to act internationally, and so we're going to take a much more aggressive view. And I think you could argue that that's a real shift. You could argue that he moved a little bit too quickly on that and that has you know, created some unnecessary costs for China. Would have been wiser to hide and buy for a few years longer. But anyway, he did it, and that is a that is a material change, I would say.

the first move. And if you want to prolong this trade war, we think that we can sit with art deflation longer than you United States can stick with your stagflation, given your political system. So I think the ball is really in Trump's court to do something to figure out how to unstick this, and the difficulty is, I think what does he want. My theory of the case is that Trump is not really driven by specific policy outcomes. He is a guy who has very authoritary instincts who

wants to be recognized as the boss. It is basically all about power and so everything that he does, and I think this applies to a lot of the domestic policy too, is to demonstrate that he has power and that other people have to show submission and deference. So if you really want to get on Trump's good side, that's what you do, and the Chinese will not play that game. They are too big, they are too strong, they have too much at stake domestically in terms of

their own political credibility to play that. They will not do that. So that puts Trump in a bind because what he really wants they will not give him. So then people on Trump's team need to figure out, Okay, what is an agenda that we can put together of actual policy aims that could form the basis of a negotiation, and then how do we communicate that to China and how do we get them to start talking to us.

It's not an easy problem to solve, right, So what it means is that people in the administration who have actual policy aims somehow need to seize control of that process, and they haven't done that yet. So a couple other theories on how this could unwind. So one theory is that at the end of the day, nothing is going to happen until Trump and She get together face to face, because in both systems, no one really has the authority lower down to make a move, and so then you

have to think about, well, how could that happen. It's unlikely that you're going to have a trip of one leader to the other countries. So you have to start thinking about is there some third country that could be.

So that's one way of thinking about it. Another way of thinking about it is just to say, well, Trump is driven by markets to some degree, not quite the same way that he was in his first term, but right now you have this weird situation where basically, if you talk to people in the markets, they are convinced that a deal will happen. I keep telling them on

what basis do you hold this belief? I can see none, but they are convinced that essentially because it's impossible or they think it's impossible to maintain these high tariffs for too long. Therefore something must happen. So markets actually are doing okay right now because they're essentially pricing in there will be a deal. And if you look at this from Trump's standpoint, it's like, oh, markets are happy, I

have no incentive to deal. So the only way he can have more incentive to deal is if markets are convinced that there is no deal and the tank and then he says, oh, I really got to do something. So that's another theory. Full credit. That was suggested to be my colleague Andrew Batson, who runs our China team very effectively, and I thought that was a very good way of thinking about it. So market pressure in the

US could be a forcing mechanism. You could maybe have some kind of intermediary, but I think unless you have some kind of force acting like that, or some kind of revolution within the White House where actual policy makers take over and seize command of things somehow and start to work out how do they get a communications channel open to the Chinese, communicate some kind of mutual reduction of tariffs to a lower level as an opening thing, and then a negotiation but I think we're some ways

away from any of that happening.

economist here at Bloomberg. She thought, one possibility is maybe there's a deal that still leaves the sort of like Vietnam transshipment open that looks like something tough, and that there is some third party country that could still be a route for flows, keep high nominal numbers up on China, et cetera. Could that be a path out where it looks like you've maintained a hard line, but you allow an escape valve of some sort.

suppose there is a deal, what's in it? And my view on this is most of the deal structures that seem plausible are not very meaningful others from the standpoint of calming markets down. So you have the situation where the US and China very adversarial. Most people in Washington think we are already in another Cold war. And to me, a substantive deal would be one that makes a significant

change in the quality of the relationship. And so if you have something that's like a phase one trade deal plus where the China agrees to buy more stuff and they make some gestures towards more domestic demand support, and we cut tariffs a little bit, Okay, that's fine. Markets will be okay with it, but it doesn't really change the underlying dynamic, which I think is really bad. And I think the thing to look for, which is what

China really wants. One of the things that they really want that could be given to them is the ability for their companies to invest a lot more in the United States byd c ATL all of these Chinese hi tech firms, they would love to be able to invest in the UN States and tap into this market more directly. They would be very happy to accept. I think a lot of different potential structures for that investment, but effectively Chinese companies are shut out. And Trump on the campaign

trail said that he was open to this. So the interesting thing there is that basically no one else in the administration seems very interested in this, but Trump might be. And if you're serious about reindustrializing the United States, you cannot do that without significant participation by China. I'm sorry, China accunts for a third of global manufacturing production now going to forty They are close to or at the leading edge of many of the technologies of the future.

It is as absurd for us to think that we can ramp up our industrialization without China as it was forty years ago would have been for China to think that they could ramp up their industrialization without bringing the leaders then the US, Japan, and Germany. So there is in principle, it seems to me there is a deal to be done there where that's what you give to China and then you might be able to get something for it that could be quite transformational in terms of

the basic relationship between these two big economies. Am I betting on that.

seventeen or eighteen percent of our total global trade. Our trade with the Soviet Union and all of its successor states after the Soviet Union collapsed was more than about

one or two percent or so. We are linked. We have thousands of US companies that operate in China and generate somewhere between five and seven hundred million dollars a year of annual sales, which is triple or more the amount of exports that go from the United States to China, the global supply chains or lengthd I could go on and on, but the economic linkages are not the linkages

of countries at war. The reason you could call the Cold War a cold war was because it wasn't direct fighting, but many of the other conditions, particularly economic, were very, very similar to wartime conditions. And this just is not It is a completely different beast than I could go on.

But that's I think the principal thing and the reason I think that it's really not only not useful framing, but I think toxic framing, is that we have this kind of view in the United States that essentially, either if you're another country, you are or ally or we are at war with you. Those are the two possible states.

And I think these are conditioned by the fact that we thought these multiple wars hot and cold in the twentieth century, and our kind of national foreign policy ethos was defined by dividing the world into good guys and bad guys, beating the fascists, beating the communists. China is not a place that can be beat. It is a large country. It's not going away. It is very integrated, not just with the US but with the entire global economy.

They're heavily invested in the global order. So the only solution, it seems to me, is that you need to figure out what is a state of coexistence with China that you don't have to define in these martiall terms. It's like, and it doesn't have to be we're friends and can include we have some very serious adversarial components to the relationship in really deep competition, not just in economics of geopolitics that can be there. But describing it as war I think is not only.

of sense to me. It seems like that's distant politically, but it's certainly very intuitively logical to me.

China to be kind of interesting. Although I would argue that those two things, like they're starting to get mingled in both America and China, so you're seeing China kind of borrow a lot of policies or thoughts that would be very familiar to anyone who's lived in the US in recent decades, And meanwhile you're starting to see the US take gone some Chinese characteristics in various ways.

et cetera we import. It's really unclear to me why it's important at all to have significant domestic capacity in these low value, low margin, low strategic areas and what that benefits US. I get maybe there's an aesthetic appeal. Obviously we want to have a lot of jobs. But this is a really difficult thing to wrap my head around, which is like you have to make decisions right a worker on one line as a worker who's not on

another line. And so why you want to have more clothes manufacturing or more doll manufacturing at a time when there's an impulse to sort of build up in these higher value is very unclear to me.