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The Great Divorce: The de-coupling of China and the U.S.

Why it is happening, and what it really means

By Duncan J. McCampbell

The jury has returned from their deliberations and now the verdict is in: the U.S. and China are parting ways after a 40-odd year marriage that has been largely beneficial for both parties.  “De-coupling” is the term most frequently used to describe what is happening.  I prefer the term dis-integration, because it more accurately describes how the integrated web of interaction between the world’s two largest economies has begun to pull back, to dis-entangle.  To some the term dis-integration, however, sounds a bit too much like what happens when the Klingon ship takes a direct phaser hit: sudden, catastrophic, final.  In this case it won’t be sudden or catastrophic; it will proceed slowly, deliberately.  But I believe it will be final and irreversible—at least for my lifetime—and there will be no return to the “good old days” when China and the U.S. saw themselves, to one degree or another, as co-prosperity business partners.

The Chinese, sensing that perhaps the party is over, will carry on trying to assure the West that they are still open for business (translation: we want your money, but not your values).  Soon President Trump will herald an “incredible” phase one trade deal.  China will buy soybeans that they don’t need (their massive hog herd has been decimated by disease) and promise, in ever more earnest terms, to open up its financial services sector—something that China probably has to do anyway to get Trump off the tariff train and pump liquidity into its debt-burdened financial system.

As much as some of us would like to see China and the U.S. once again growing and prospering in relative harmony, we have to face facts.  The U.S. and China have irreconcilable political economies.  The problem for Westerners is two-fold: (1) the large, decisive and growing role played by the State in China’s economic system; and (2) the abusive commercial and trade practices which China has conducted for decades with almost no consequences.

China’s political and economic systems are both completely enmeshed, configured to serve not purely commercial ends, but the desires of the State and the people running it. The more an increasingly confident and assertive China comes into contact with Western systems and values, the more it becomes apparent that the two systems just don’t synch.  China’s system of State capitalism works just fine for China, and since there is zero chance that China’s system will be imposed on us, shouldn’t we wish China and its people every possible success, go our own way (as they, indeed, increasingly are), and make sure that we protect our property, our system and our values in the process?

Here is a simple illustration of our systemic incompatibility.  China’s national intelligence laws require Chinese companies and private citizens—wherever they are–to assist the government in gathering intelligence.  That may be just fine for Chinese people, but what American is going to feel good about using Huawei products knowing that the company has a legal duty to snoop on them or their business (to say nothing of the government or military) if asked to by the Chinese government?  Are things different in the U.S.?  Well, remember when the DOJ wanted Apple to unlock the San Bernardino terrorist’s IPhone?  Apple told them to go jump in the lake. (note: they found another way to access the phone).  Nothing I can say to my Chinese friends, incidentally, will ever convince them that the Huawei ban isn’t a pure political play meant to keep China down or to beat China in the race to global 5G dominance.

The China of my lifetime has achieved many remarkable things. But one of China’s most amazing achievements goes almost totally unheralded.  In the U.S. today there is very little upon which Democrats and Republicans agree. But lately the entire U.S. political establishment has unified around a new and very negative view of China.  China’s behavior drove that complete sea-change in thinking, like so many other amazing things China achieves, in record time–about three years.  The China hawks are now ascendant in Congress, led by Senators Marco Rubio and Ted Cruz.  China-bashing trade advisor Peter Navarro and arch-conspiracist Steve Bannon both have the president’s ear on the China “threat.”

But as China suffers PR and policy setbacks in Washington we mustn’t forget that China’s government is also taking very deliberate steps to decouple from Western influences.  China tolerated and even promoted outside ideas during its decades of opening up and reform. That period is drawing to a close, according to Carl Minzner, China scholar and a professor at Fordham Law School in New York. This month the Chinese government released a new code of moral conduct for its citizens.  Pledging especially serious treatment for “people who worship foreign things and harm the dignity of the country,” the new codes, according to Minzner, are “totally consistent with Beijing’s pivot toward nativism and political tightening over the past decade — a pivot which has steadily engulfed one field of human endeavor after another: law, media, culture and higher education. All of this raises deep questions of exactly how much further such trends might run. And that could have serious implications for a range of academic, economic and person-to-person ties binding China with the rest of the world.”

China’s rise has been going on for decades without any real controversy in the West.  What has changed?  Well, to understand how China behaves it helps to know a bit about its ancient history and its painful backstory.  The Opium Wars, the Boxer Rebellion, western religious missionaries, the Japanese occupation—these are recounted in Chinese histories for what they largely are: deep injuries to Chinese dignity at the hands of foreigners.  The century of disunity and “humiliation” came to an end, according to contemporary Chinese doctrine, when the Communists took over in 1949.  (We all know that the suffering didn’t end in 1949.  The Chinese people still struggled enormously for another thirty years with the Great Leap Forward and the Cultural Revolution.  But the difference, for the purpose of the Chinese narrative, is that these titanic struggles were internal “own goals” which didn’t implicate foreign forces.)

At the core of China’s narrative today, therefore, is a steely determination to remain unified (at almost any cost), to promote Chinese values, and above all to never again be pushed around by outsiders.  This manifests in what a social scientist might call “one-down” behavior–brusque, resolute assertions of sovereignty and, at times, over-wrought demands for respect—whether earned or not–in all manner of things.

Consider what happened to the NBA, which has invested tens of millions of dollars essentially making basketball China’s national sport. (My Chinese students know all the NBA stars and even some of the players on my perennially mediocre home town team, the Minnesota Timberwolves.) The fur flew when Houston Rockets executive Daryl Morley tweeted support for Hong Kong’s protesters. Never mind that in the American system Morley is a private citizen entitled to voice his own political views (however ill-advised the sharing of such opinions might have been for a man in his position).  And let’s forget, for a moment, that Twitter is banned in China and, therefore, what someone says on that banned platform should have no effect in China.

No, the Chinese government learned of the tweet and instead of letting it go (and thus not calling any further domestic attention to the increasingly fraught Hong Kong situation) over-reacted in a way that, to me, speaks much more of insecurity than of strength.  Cranking up the domestic outrage machine, the Party had Chinese social media on fire.  Several big Chinese companies canceled deals with the Rockets and severely criticized the NBA—which subsequently didn’t shower itself in glory by cow-towing to China.  President Trump even got into the act–of course saying nothing of substance about free speech, China or Hong Kong–but, predictably, taking a cheap shot at a couple NBA coaches who once criticized him.

Then suddenly, interestingly, someone in Beijing reckoned that maybe things had gone a bit too far. Trouble with American companies, they realized, might depress inbound investment–which the Chinese very much want to see continuing in the face of a little balance of payment problem that China is going to have rather soon as a result of the trade war and its debt-fueled economy.  Overnight, anti-NBA propaganda stopped transmitting from Party organs.  Calm, soothing noises issued from the previously the breathless Foreign Ministry spokesman.

* * *

The global economic system that made the 20th century so successful for the West and, eventually, also for China was hammered out at the Bretton Woods conference in New Hampshire near the end of the World War II. The World Trade Organization, the World Bank and the International Monetary Fund all arose from the Bretton Woods framework. Funds to rebuild war-ravaged countries, the promotion of free trade and stable national currencies (tied to the almighty Dollar)—this was what fueled, in the second half of the 20th Century, the largest economic expansion in human history.

The USSR chose not to participate in Bretton Woods, setting up their own, completely separate economic universe in the Soviet bloc.  So separate was this universe, in fact, that when the Soviet Union finally collapsed in December of 1991 the event didn’t even register on the world’s major stock indexes.  Analysts today like to draw parallels to the Cold War when discussing the West’s de-coupling from China. China, they say, is too integrated into western economic systems to be separated the way the Soviets were.  They are wrong, but back to our history.

China, as an ally of the soon-to-be victorious western powers, was represented at Bretton Woods. You may recall that when the Japanese bombed Pearl Harbor, China had already been fighting the Japanese for six years. Millions died in a brutal struggle that is only given passing mention in many western histories.  Despite their sacrifice, China’s influence at Bretton Woods was limited by two simple realities.  First, China was a largely agrarian country in 1945–not an industrial, economic or military power in any sense. More importantly, China was deeply divided, embroiled in a civil war between the Nationalists, who were supported by the Allies, and the Communists.  The people attending the conference were Nationalists, who eventually lost the civil war. The Communists took power in 1949 and they, like the Soviets, had no intention of participating in a capitalist economic system dominated by the West.

Why do I mention all this?  Well, nowadays I hear some Chinese people seeking to opt out various aspects of the rules-based international order by claiming that the West’s systems were all set up deliberately to disadvantage them–to keep them down.  In the case of the global economic system that China has leveraged (or in the opinions of some China hawks in Washington, abused) to its unquestioned benefit, such a view is, to be quite charitable, specious.  The Bretton Woods system was set up to (a) economically stabilize and rebuild a war-damaged world; and (b) provide an economic counterweight to the Soviets.  Did Bretton Woods favor the U.S.?  Well, it had better, given that at the end of World War II the U.S. was the world’s top military and economic power and the holder of the world’s largest gold reserves.  China, on the other hand, was an economic non-entity–internally divided, war torn, technologically undeveloped.  It would struggle, in isolation from the West, throughout the 50’s 60’s and 70’s until Deng Xioping unleashed China’s vast potential by participating—very selectively—in the West’s capitalist economic system.  Make no mistake: where China is today is a direct and deliberate consequence of their participation in that system—and a lot of hard work.

Now China is strong, its people justifiably proud of its remarkable development.  China has the world’s second largest economy (a fact which doesn’t prevent some Chinese people from claiming–with a straight face–that they’re still a “developing” country, which gives them, among other things, favorable trade treatment under the WTO rules.)  Are they playing fair?  Well, no, but as I have heard it argued, what great power does?  So they justify the common practice of forced technology transfer as a simple commercial transaction–table stakes that foreign companies must pony-up for access to the vast Chinese market.  But no such shake-downs greet Chinese companies investing in the open markets of the U.S. or Europe.  I have never heard a Chinese colleague deny rampant IP theft. But I have heard them try to justify it by claiming that the U.S. stole British technologies when Britain was an industrial power and the U.S. was a developing country.  Even if that is true (it isn’t), nothing that Americans might have done in the 18th or 19th centuries could compare to the gargantuan, state-sponsored apparatus of brazen industrial espionage that China maintains today.  Like so many other superlatives attached to China, the world has never seen anything like it.

What China’s leaders must certainly know (because China is governed by clever people) is that the deal they’ve gotten from the West, until very recently, has been quite good, but is entirely unsustainable.  China’s economic system cannot continue growing and delivering generation-to-generation improvements in its people’s lives—the basis for the legitimacy of an unelected one-party political system–without full access to the money, markets and technologies of the developed West.  That access is now in the process of being curtailed.

The Chinese, it turns out, are rather no different than you and me.  They want to have it both ways—if they can get away with it.  They want the amazing benefits of access to a vibrant, open, relatively unregulated free market system without opening up themselves, and without playing by many of the free market’s economic and political rules.  They think that their economic power gives them the right to get what they want, and lately that has been largely true.  The West, however, is slowly wising up.  And as George Will correctly reminded us in a recent Washington Post editorial, China’s rapidly aging population means that they have about 20 years to get where they want to go economically before demographics take over–permanently.

Assuming that in the coming weeks some kind of “mini” trade deal is achieved between China and the U.S., you can be happy that American farmers can once more sell their soybeans, and maybe their pork, to China.  But I advise you to immediately dismiss anything that the president or the U.S. trade negotiators say about changing China’s behavior.  China will never bow to foreign pressure and will mightily resist changing methods which are cooked into their system of political control—a system which has, for the most part, been working quite well–for China.

Tariffs now dominate the news.  But focusing on Trump’s desperately simplistic, shop-keeper trade calculus—how much China and the U.S. are buying of each other’s products—doesn’t get to the heart of how integrated these two economies have become, and what is going to happen as they separate.  Let’s look at two specific areas and discuss how they will be affected.

Financial Services

Perhaps in no other area are the U.S. and China running faster in opposite directions.

China is still the world’s largest exporter of goods but the trade war has crimped trade receipts and inbound investment from the U.S.  So the Chinese have turned to the financial services sector to bring investment dollars into the country and take up the slack.

As an example of the imbalance that exists today in the financial services market, consider how Chinese companies and individuals are enthusiastic participants in the West’s open capital markets.  Whether through IPO or reverse merger, Chinese companies have raised billions of dollars on U.S. stock exchanges.  No such access is granted to U.S. companies on China’s exchanges, however, as foreign companies are prohibited from listing on China’s stock markets.  What’s more, individuals and companies are prohibited from owning majority stakes in some 48 Chinese industries, ranging from energy and transportation to financial services and publishing.

But the Chinese government has proposed loosening restrictions on foreign ownership in several areas, including banking, insurance, credit rating, bond underwriting and brokerage. This isn’t happening because China reckons it is time to be fairer to foreign companies.  No, it is happening because China’s economy is growing at its slowest pace in 30 years and that is a big worry in Beijing.  So the Chinese will crack the door open just wide enough (and believe me, it won’t open one centimeter wider than it needs to be) in order to achieve five critical aims: (1) to show the world they are opening-up (sort of); (2) and thereby get Trump to back off some of his tariffs; (3) to attract foreign liquidity, which will help mitigate credit risks in China’s badly over-leveraged, state-owned banking sector; (4) to make up for the steady loss of manufacturing-related inbound investment; and (5) to moderate current account balance issues and capital outflows caused by a weakening renminbi.

While the likes of Morgan Stanley, S&P, HSBC and UBS clamor for lucrative licenses to operate in these spaces, one wonders how China’s massive debt—largely ring-fenced now because of China’s closed system—could spread risk to the rest of the financial world.  What isn’t being discussed very much, of course, is how the Chinese government plans to assert political control over these foreign enterprises operating in China.

Meanwhile, as China is taking steps to increase inbound investment, China hawks in the U.S. are moving in the opposite direction.  Florida Senator Marco Rubio has joined forces with Democratic senator from New Hampshire, Jeanne Shaheen, to re-examine the presence of Chinese companies in the stock portfolios of American investors. They want to block U.S. government pensions from investing in Chinese securities.  The risks are real, as Chinese companies don’t have the same auditing and financial reporting requirements as American companies.  Some Chinese public companies, furthermore, are engaged in activities like surveillance and defense, that would be problematic for American investors in the current climate.

The U.S. Committee on Foreign Investment in the United States (CFIUS) has blocked several proposed acquisitions of U.S. companies by Chinese investors on national security grounds.  Big Chinese tech companies and Huawei and ZTE have had their access to U.S. technologies and markets severely curtailed. If you lead and American technology company and you supply a Chinese company like Huawei or ZTE with technologies or components that they incorporate into their products, you have already come to grips and managed the IP risks of doing business in China.  Now, in addition, you need to be concerned that your sales to China could be eliminated overnight by a decision of the U.S. Department of Commerce.

Manufacturing

According to all the evidence I see in China, most U.S. (and many European) businesses are actively reducing their China sourcing/manufacturing exposure as fast as they can.   And why not?  Even before the trade war China’s rising manufacturing costs were pushing foreign companies to explore sourcing in other places.   What’s new, of course, is the ratcheting up of political risk with no end in sight.  Businesses are equipped to manage economic and market risk.  But political risk is hard to predict and doesn’t (legally) yield to standard commercial levers.  We have seen how President Trump can, with a tweet and a stroke of his pen, make the electronics or machinery your company imports from China instantly unprofitable.  President Xi, with plenary authority that Trump can only envy, abruptly halted China’s canola oil imports from Canada in retaliation for the lawful detention of Huawei CFO Meng–and then just for good measure jailed a few Canadians.  “President Xi and those at the highest echelon of China’s government can snap their fingers and thereby create a new business reality,” says attorney Dan Harris in his influential Chinalaw blog.  Nothing spooks a business leader more than arbitrary, political actions by all-powerful governments.  What has become perfectly clear is that if you want to do business with China, it’s not enough to be legally compliant.  You have to please the Chinese government in political terms that most Western businesses find quite unsettling.

Now we have the spectacle of the world’s two biggest economies engaging in regular, tit-for-tat arbitrary political action against each other.  So, if you are an American company sourcing components or finished products from China, and you are not getting your stuff made somewhere else, you likely fall into one of four categories.  (1) You sell a lot or all of what you make in China so the tariffs don’t affect you; (2) you still make or source components in China but have shifted final assembly to another country to avoid U.S. tariffs; (3) you are trying to source in another country but it is hard to find production capacity in other countries when everyone else is trying to do it also; or (4) you are not paying attention.

We have always known that the U.S. and China have quite different economic and political systems.  But it was always assumed throughout the 1990’s that by welcoming China into the WTO, some degree of political liberalization was certain to follow.  That assumption has proven false.

China still needs the West, though lately that fact seems to bother them more than ever. China got to where it is today because (1) the Chinese government decided in the late 1970’s to engage economically, if not culturally and politically, with the West; and (2) millions of people worked very hard.  Now China believes it has reached a point where it can go it alone.  I don’t think they have, and I think they are making a mistake, but I can’t see them reversing course.  That is why I think responsible people should now turn to the important task at hand, which is managing the divorce of these two erstwhile business partners with a minimum of unnecessary collateral damage.


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