With the imposition of 25% tariffs on $68 billion worth of their merchandise trade ($34 billion of exports each), the U.S. and China have fired the first salvos of their trade war.
If one were to borrow a military analogy, the first round of the U.S.-China trade war is either a skirmish or a probing attack, as the amount of the two-way merchandise trade affected by the tariffs is about only 10% of the total U.S.-China trade. But everyone knows that the main battle will be joined soon. Besides the additional $32 billion merchandise trade targeted for punitive tariffs ($16 billion of exports for each country), U.S. president Donald Trump has threatened to retaliate by levying tariffs on all Chinese exports to the U.S. ($505 billion in 2017).
Despite their outward firmness and rhetorical bravado (President Xi Jinping has vowed to "punch back"), Chinese leaders must be deeply worried. The rupture of Sino-American relations in the last few years is undoubtedly a strategically calamitous development few in Beijing anticipated. This is true even though Chinese foreign policy behavior since 2010, most critically its island-building in the South China Sea, bears most of the responsibility for turning the world's most important bilateral relationship away from engagement toward confrontation.
Even Chinese leaders privately acknowledge that the unfolding U.S.-China trade conflict is but part of a much larger geopolitical contest between the two countries.
Now faced with the most difficult challenge since he became the leader of the Chinese Communist Party (CCP) in November 2012, President Xi must decide soon how to mitigate the adverse consequences of not only a trade war with the U.S., but also a protracted Sino-American geopolitical contest that could, in an extreme scenario, descend into another cold war.
The smartest short-term decision Beijing can make is simply to absorb the next round of blows and hold its punches. For instance, if Washington moves ahead to impose 25% tariffs on $16 billion of Chinese imports, Beijing would withhold fire, in the hope of enticing Washington into a ceasefire, which in turn could create an opportunity to negotiate a face-saving way to avoid further and much more costly escalations.
The most compelling rationale behind this strategy of quick capitulation is to protect China's centrality in the global manufacturing supply chain. About 43% of Chinese merchandise trade in 2017 (totaling $4.3 trillion) is, according to the Chinese Ministry of Commerce, "processing trade" (which involves importing intermediate goods and assembling the products in China). What China gains from processing trade is the utilization of its low-cost labor force, factories, and some technological spillover. Processing trade generates low value-added and profitability. For example, Foxconn, the Taiwanese company that assembles iPhones in China, had an operating margin of only 5.8% last year.
One of the greatest risks China faces in a prolonged trade war with the U.S. is the loss of its processing trade. Even a modest increase in American tariffs can make it uneconomical to base processing in China. Should the U.S.-China trade war escalate, many foreign companies manufacturing in China would be forced to relocate their supply chains. China could face the loss of millions of jobs, tens of thousands of shuttered factories, and a key driver of growth.
However, capitulating to a "trade bully," as the Chinese media calls Trump, is hard for Xi, a strongman in his own right. Worse still, it is unclear what Trump wants or how China can appease him. The terms his negotiators presented to Beijing in early May were so harsh that it is inconceivable that Xi could accept them without being seen as selling out China.
Even if the trade war with the U.S. could be de-escalated with Chinese concessions, Beijing faces another painful decision. The trade war in general, and in particular the forced shutdown of the Chinese telecom equipment maker ZTE after Washington banned the company from using American-made parts have highlighted China's strategic vulnerability from its economic interdependence with the U.S. Before the two countries became geopolitical adversaries, economic interdependence was a valuable asset for China. It could take advantage of this relationship to build up its strength while the mutual economic benefits cushioned their geopolitical conflict.
But with the overall U.S.-China relationship turning adversarial, economic interdependence is not only hard to sustain (as shown by the trade war), but also is rapidly becoming a serious strategic liability. As the economically-weaker party, China is particularly affected. In the technological arena, China now finds itself at the mercy of Washington in terms of access to vital parts (such as semiconductors) and critical technologies (operating systems such as Android and Windows). Should the U.S. decide to cut off Chinese access for whatever reason, a wide swathe of Chinese economy could face disruption.
Xi and his colleagues now must decide on a costly trade-off. If they hope to ensure national autonomy and security, they will have to start a process of technological and commercial decoupling from the U.S. This process is certain to be inefficient since few countries can substitute the U.S. as China's export market and source of technology. Worse, decoupling will further reduce the incentives for each country to exercise self-restraint in their geopolitical competition, thus making conflict more likely.
The last difficult decision Xi will soon have to make is whether to roll back his ambitious -- and costly -- foreign policy agenda. Prior to the rupture of U.S.-China relations and the onset of their trade war, Xi launched a series of initiatives to accelerate China's rise as a global superpower. Among other things, they include an expansion of Chinese foreign aid and the Belt and Road Initiative, a $1 trillion global program of China-financed infrastructure projects. Since one near-certain outcome of a prolonged U.S.-China trade war is a significant decline in China's exports and foreign exchange income, Beijing will need to conserve its forex reserves to defend its currency and maintain its balance of payments. In other words, China can no longer afford such expensive foreign policy ventures.
However, retreating from these projects that are closely associated with Xi would be difficult for China. As they have already incurred huge "sunken costs," scaling down future investments could endanger the value of some existing projects. Politically, such a retreat would be a huge loss of face for Xi. It is hard to imagine that his underlings would risk their careers or personal security to propose such a policy.
A dispassionate analysis of these trade-offs may show that China has more to gain in the long term if its leaders are willing to make substantial, albeit humiliating, short-term concessions before its trade war with the U.S. escalates out of control.
But the costs of the concessions needed to stabilize Sino-American relations go beyond the amount of extra goods China pledges to import from the U.S. or even the perceived loss of face for Xi. Ultimately, China will not only have to give up its state-capitalist model, the root cause of Sino-American trade tensions, but also curtail its geopolitical ambitions and put on hold its challenge to American preeminence.
Minxin Pei is a professor of government at Claremont McKenna College and a non-resident senior fellow of the German Marshall Fund of the United States.