Will Xi Lose This Poker Match? – The US-China Trade Conflict

Trump has changed the game.

Chinese negotiators, led by Vice Premier Liu He, are in Washington D.C. hoping to reach a deal on trade matters before higher tariffs on Chinese imports kick-in on March 1, 2019.

If this was a poker game, President Trump has three aces while Xi Xinping has a pair of two’s.   The only question is how Trump plays his cards – and whether he resists that urge to “fold” as all his predecessors have done.

This is quite a turn of events.  Not so long ago, Thomas Friedman and other commentators reckoned Chinese leaders were brilliant and infallible at running an economy — wisdom of the orient, you know – while Americans were morons.  Tinker as necessary, play the “long game,” and presto — 6.5% growth (or whatever number desired) was guaranteed.

US Economy Doing Well While China Is Stumbling

Now, however, the US economy is doing well while the PRC is stumbling.  Chinese manufacturing is in trouble, business failures are up, debt is astronomical, their stock market has sunk, and unemployment is far worse than officially reported. Millions of people are being forced back to their villages to become “entrepreneurs.” The more likely reason – there’s no work for them and the authorities don’t want them around major cities. 

The Chinese population seems spooked, and even Xi Xinping appears rattled – warning a gathering of senior officials a couple weeks ago to get ready for crisis.

There’s a reason China’s domestic security budget is bigger than its defense budget.

But Xi doesn’t seem to have any brilliant ideas – beyond cutting taxes, pouring money into the economy, and telling banks to lend to private companies.  When a government tells bankers to lend, they can smell a deadbeat borrower. And Xi appears to be doubling down on inefficient, money-draining SOE’s (State Owned Enterprises) – a sure enough “Road to Perdition” – but easier to control than China’s private sector. 

Meanwhile, Xi assures the Chinese private sector they are loved – though they’ve heard that from the Communist Party before – since Mao’s day – and always come to grief.  The idea is to give the private side just enough oxygen to keep SOE’s afloat – sort of how the private sector funds Sweden’s welfare system.

Of course, the PRC will not collapse, but this is an abrupt shift from the “China is the future” narrative both Beijing and Western elites were trumpeting for years.

China’s economic problems have been brewing for a long time and were obvious, but Trump has been a catalyst.  His advisors – at least the ones who are not from Goldman Sachs – understand the PRC’s key economic vulnerabilities and are applying effective pressure.

A particular weakness is that the Chinese yuan is not convertible.  So the PRC must earn foreign currency (FX) to do everything it wants both in China and worldwide (and to keep people employed and reasonably content).  Beijing can of course print all the yuan it wants, but nobody outside China really wants it.  Rather, it’s dollars, euros, yen, or Swiss francs please.  Just like the old Confederate States of America, when Jefferson Davis wanted to buy Enfield rifles from Britain, he had to pay in Yankee “greenbacks” not Confederate money.  The same goes for Xi Xinping.

How does the PRC earn FX?  Mainly from exports or foreigners investing in China.  Chinese companies buying assets and operating businesses overseas are other ways.  And in the case of the Belt and Road Initiative – it’s getting foreign governments and organizations to pay for it rather than spending China’s own money.   The PRC also, and amazingly, still receives loans from the World Bank despite having three trillion dollars in cash reserves and boasting the world’s second largest economy.

Things were going well for a couple decades – until Trump came along.

How Trump Has Changed This Dynamic

Everything Trump is doing – tariffs, intellectual property theft prosecutions, pressure on major Chinese companies such as ZTE and Huawei, and tightened CFIUS restrictions on Chinese investment in the United States reduces Chinese access to convertible currency.  It also raises doubts – and outright suspicions – about China and Chinese investment.  This is a sea change from when US companies were falling over themselves to attract Chinese money or sell their corporate birthrights at a nice premium.

And as importantly, more than a few Europeans and even the Japanese are quietly cheering Trump on and souring on both the Chinese market and Chinese investment.  Even in the developing world, the PRC is increasingly seen as rapacious and corrupting.

China’s capital controls demonstrate how the need for foreign exchange dominates CCP leadership thinking.   According to the rules, individuals can only take US$50k out of China each year and companies need government permission to obtain foreign exchange.  Yet, for decades China’s most successful people — including CCP leadership and families – have tried by hook or by crook to get their wealth out of China – and beyond reach of the Party.  Remove exchange controls for even a month and the yuan would plummet as a torrent of money leaves the country.

According to one official PRC estimate, Chinese citizens have $21 trillion stashed overseas – and the CCP wants it back.  Good luck. 

In fact, CCP behavior suggests they’ve got a “case of the shorts” in Brooklynese.  Going after billionaires and tax-evading actresses to grab their money is the equivalent of looking under couch cushions for loose change.  Imagine the US Government kidnapping Bill Gates and taking over Microsoft because it needed his money to run the government. 

How The Negotiations Might Play Out

So given these problems, what sort of deal might China offer to satisfy Donald Trump?

The PRC will be delighted if Mr. Trump accepts an offer to buy more American products – particularly agricultural commodities – thereby, in theory, reducing the bilateral trade deficit.

But the US side wants structural reforms – to include ending Chinese strong-arming and discrimination against foreign companies. 

The PRC will make promises along these lines and offer further “opening up” – as it always does.  Unfortunately for Xi, fewer people on the US side or in American industry believe it.

One businessman who has worked in PRC for several decades remarked recently:

“The U.S. weekend-only edition of “China Daily” is distributed in my hotel.  I picked up a copy yesterday.  The bold print headline: “Xi Pledges Greater Opening-up.”

I can tell you with all seriousness, this same headline has been blasted out at least once a quarter ever since I started in China.  

I have been in China or doing business with China for a total of 133 quarters.

This means China has made 133 pledges to “greater opening-up.”

Each opening up results in “first-time-ever” streamlined procedures and new promulgations.  The rules change but the result is always the same….the “house wins.”

Chinese negotiators will also promise (sort of) to stop stealing technology – which they say they don’t steal anyway.  But such theft is part of Chinese modus operandi – and almost a cultural imperative – and it’s worth noting that Chinese companies steal from each other with equal enthusiasm. 

The US side is properly skeptical and talks of enforcing any agreement.  But that’s the hard part.  Besides requiring behavioral changes that might threaten CCP control, China won’t allow Americans to dictate Chinese behavior.  In fact, take US demands to their logical extreme and you have “regime change.” The CCP will drive the Chinese economy over a cliff before voluntarily letting that happen.

So the US and China won’t be solving their problems before March 1st – unless one side surrenders.

US Leverage And Playing The “Trump” Card

But by leveraging trade – or even pulling the plug on companies like ZTE or Huawei – and retaliating for decades of intellectual property piracy – the US can take some steam out of the Chinese economic juggernaut – as it comes to be regarded as a rigged market and dubious, even dangerous, investor.

And Washington can force CCP leaders to make some hard choices elsewhere as they run low on cash and their economy sputters.  They might, for example, lay off Taiwan, back off in the South China Sea and no longer bully the Japanese, and rein in IP theft in exchange for US restraint.  More worrisome, and a genuine concern, they might also lash out violently against Taiwan or Japan to distract public attention.  Dictatorships do that sort of thing.

The PRC has got a bad hand.  And while the Chinese have plenty of chutzpah and are master “bluffers” – that only works when the guy across the table doesn’t know what cards you hold.  Unfortunately for Mr. Xi, Trump’s people know the Chinese only have a “pair of two’s” – a very weak hand.

Indeed, bringing formal charges against Huawei just as the PRC delegation arrived in Washington suggests Mr. Trump might not fold like his predecessors, and neither Chinese bluffs nor flattery will work this time.

At least, one hopes that’s the case.  Mr. Trump – you’ve got three aces.  Play them.