China turning its back on reform and opening up would be the real tragedy of a trade war

28th April 2018

Beijing and Washington have, in recent weeks, engaged in commercial skirmishes, but the wrangling over the trade deficit is only a secondary effect of an emerging rivalry over technological primacy between China and the United States. The Chinese products the US has targeted with a 25 per cent tariff are mostly related to “Made in China 2025” – China’s effort to leapfrog the US and lead in technologies that will shape the economic infrastructure of the 21st century.

So pivotal has this competition become that the Defence Innovation Unit Experimental – the Pentagon’s unit in Silicon Valley – advised that restrictions be placed on visas for Chinese researchers in technical disciplines to counter China’s efforts to eclipse US technological eminence.

With Sino-US economic competition expanding to the technological strategic realm, the progression from trade skirmishes to a prolonged commercial war of attrition is a plausible outcome. Will the Chinese economy survive the stress and remain the locomotive for global growth?

While China’s economy is less dependent on trade than just a few years ago, trade dependency – the combined imports and exports as a percentage of Chinese gross domestic product – remains at 37 per cent, with the US market being the prime destination for Chinese exports. Obstructed access will affect Chinese GDP expansion and slow the Chinese economy.

With total debt increasing faster than expected, a slowing of Chinese GDP growth could lead to a liquidity scarcity for state-owned enterprises, private corporations and local governments, creating the risk of insolvency and a looming debt crisis. These are the fears of mainstream economists around the world who have long stressed that the debt-to-GDP dynamics in China cannot be sustained without adequate growth. Even the former People’s Bank of China governor Zhou Xiaochuan warned last year that hidden risks could lead to an abrupt sharp market correction.

Unlike Western economies which operate under a transparent legal framework demarcating politics and commerce, the nature of China’s political economy makes the impact of a trade war more difficult to evaluate.

A core difference between the West and China is that financial information is managed by the Communist Party. Information is a key input shaping the behaviour of economic agents and the overall aggregate direction of the market. In the case of a large state-owned enterprise or local government becoming insolvent, the party can stop the information from dispersing, providing ample time for regulators to act with the appropriate regulatory, monetary or fiscal remedies to keep the crisis from becoming systemic.

Western capitalism cannot emulate this, as free media will immediately report a liquidity crisis, making the government a post hoc actor with limited capacity to contain it.

Of course, the party’s ability to withhold information from the public creates moral hazard and does not contribute to market signals’ long-term efficiency, but it allows a crisis to be contained and could enable a transition towards a more mature market as agents eventually conform to higher governance standards.

Also, in China, property rights are arbitrary; a big financial corporation can be nationalised immediately and liquidity fixed by a capital injection from the central bank. The recent case of Anbang is a prime example, with the company nationalised overnight and its chairman arrested on the spot.

In the US, the Congress, the White House and the Treasury would have to fight a months-long legal war with lawyers, lobbyists, congressmen and special interests before deciding how to intervene. One may consider the 2008 2008 financial crisis, Solyndra’s insolvency or the bailout of the US auto industry.

Technology also empowers Chinese regulators. The big data revolution and the nascent social credit system optimise private capital allocation and ease the economy’s transition to a more sustainable model.

China is a global leader on cashless transactions, with its fintech sector outmatching US fintech by a factor of 10. This provides an enormous amount of data to Alipay and WeChat Pay, allowing them to create complete credit rating profiles for about 800 million users. This is a massive efficiency boost to private capital allocation as moral hazard and adverse selection – financial capital allocation’s two endemic problems – are minimised by sufficient credit profiling.

Moreover, China’s social credit system makes defaulting on loans more difficult by tying repayment to access to plane tickets, schools, hospitals and other social provisions.

This does not resolve the existing meteoric indebtedness of state-owned enterprises and local governments, but can alleviate pressure on the national government budget, because cashless transactions make taxes easy to spot and register. If China makes the shift to a cashless economy, the shadow economy would immediately be included in official statistics, with the extra tax revenues contributing significantly to the sustainability of China’s national debt, even if the national government had to bail out bankrupt banks and socialise loses from bad corporate debt.

There are other factors empowering China to sustain a prolonged trade war with the US. China’s closed capital account, its more than US$3 trillion in currency reserves, high national savings ratio and success in innovation allow the Chinese government to keep the system stable, even at a lower GDP growth rate than hypothesised in the 13th five-year plan.

The existential threat for China will thus result not from the economic impact of a trade war with the US but the potential ideological impact of a closed West, potentially slowing or even reversing reform and opening and even locking China into its own nationalist echo chamber.

At a moment when the global order demands cosmopolitan ideals and humanistic public sentiment, a Chinese transition to a neo-nationalist ideology could devastate the global order; China could outlive a protracted trade war but the world order would not.

In responding to US commercial unilateralism, Beijing should double down on efforts to tie China to the rest of the world, reform and open its economy and confidently engage with global ideas, however democratic, liberal and Western.

Source: SOUTH CHINA MORNING POST