Whether the US and China strike a new trade deal or not, this is not the time to get complacent about the long-term threat of conflict between the two countries, write Morningstar's Preston Caldwell and Stephen Ellis.

The threat of a trade war with the United States roiled China’s equity markets in 2018, with about a 30 per cent peak-to-trough decline in the Shanghai Composite.

Earlier in 2019, optimism about a deal between the countries led Chinese equities to recover almost all of their losses, but the most recent tensions have diminished those gains.

In this article, we discuss the key takeaways from our analysis, the main issues that are causing tension between the US and China, and our trade scenarios.

A US-China war is no longer unfathomable

Academic research shows that trade is a key driver of economic outcomes across countries, and in China we think this is especially the case owing to its uniquely trade-focused development model.

Therefore, we model that each 1 percentage point (of GDP) reduction in China’s gross trade will reduce the country’s long-term income level by between 0.75 per cent and 1 per cent.
The strong current US-China trading relationship doesn’t preclude conflict; the United Kingdom and Germany had as large bilateral trade shares of GDP on the eve of World War I as the US and China do today.

The key issues in focus today (such as intellectual property, cyberwarfare, or Taiwan) aren’t new and will be in contention for years to come.

Compared with historical great power conflicts, we think the US and China have only about average odds of resolving the key issues of dispute.

Although many would protest that US military dominance means China can’t risk war, we disagree. War with the US is no longer unfathomable for China, thanks to its vigorous military upgrading. Rand research indicates that China has reached parity with the US in several areas.

Consumption-leveraged stocks will see the most impact, as we think most of the economic impact will fall on consumption expenditure, which we now expect to grow at about a 5.4 per cent real rate versus our prior expectation of 6 per cent.

The issues we elaborate upon below are both present in the current dispute between the US and China and likely to remain relevant for years (if not decades) to come.

Intellectual property issues in China

Complaints by the US (and other nations) regarding China’s intellectual property policies come in three general categories:

  • China’s enforcement of legal protection of intellectual property (including patents, trademarks, and trade secrets) is insufficient.
  • China’s government is actively aiding intellectual property theft, especially via cyberespionage.
  • China’s government is “forcing” foreign firms operating in China to share intellectual property.

The real cost of cyber crime

Highlighting the scale of the threat posed by intellectual property theft, three separate studies completed between 2016 and 2018 indicate cyberactivity cost the US economy at least US$50 billion and as much as US$540 billion annually.

The Council of Economic Advisers estimates cyberactivity cost the US economy between US$57 billion and US$109 billion in 2016, with the vast majority of the losses attributed to China.

This estimate was derived by estimating the impact on an affected firm’s stock price following its announcement of a cyberattack. The report reviewed 290 cyberevents affecting 186 companies.

The IP Commission published a separate estimate indicating that the theft of intellectual property cost the US between US$180 billion and US$540 billion annually (between 1 per cent and 3 per cent of GDP), with the vast majority of the activity assigned to China.

This study was based on a 2014 methodology outlined by the Center for Responsible Enterprise and Trade and PricewaterhouseCoopers.

The study used several proxies to estimate the costs, including:

  • research and development spending as a percentage of GDP
  • US tax evasion costscopyright infringement
  • illicit financial flows
  • black-market activity.

Recovery costs, financial crime, security spend

A McAfee and Center for Strategic and International Studies report estimated in early 2018 that Chinese intellectual property theft cost about US$15 billion annually and US$115 billion when including recovery costs, financial crime, and security spending.

It also assumed the 2015 agreement between former President Obama and President Xi Jinping over “no commercial espionage” remained intact.

Assuming the 2015 agreement no longer holds, estimated Chinese IP theft would be around US$25 billion-US$30 billion annually directly.

The report’s estimates were derived using costs of crimes where the quality of reporting was reliable, including maritime piracy and pilferage rates (0.5 per cent and 2 per cent of national income, respectively), and the cost of transnational crime.

Transnational crime estimates have been reported by the United Nations Office on Drugs and Crime, the World Economic Forum, and Global Financial Integrity at 1.2 per cent-1.5 per cent of global GDP.

Can 'Made in China 2025' be reformed?

Made in China 2025 – China’s official industrial policy – is also a source of US-China tensions.

The initiative seeks to move China up the value chain across the economy. It focuses on 10 key industries, notably:

  • robotics
  • artificial intelligence
  • aerospace engineering
  • electric cars.

Beijing plans to achieve its goals through a combination of explicit target setting, direct subsidies, foreign investment, and forced technology transfer.

We see no issues with a country enacting policies to improve its competitiveness, especially given that China’s average per capita income is still well below that of many developed countries. Other countries have used subsidies and tariffs to support nascent industries, and in a case like South Korea, it resulted in rapid economic growth.

From China’s perspective, the country is being unfairly singled out in its pursuit of these policies.

The issue is that its self-sufficiency efforts aim to displace many of the existing leading economies – including those of Germany, South Korea and Japan – with large exporting high-tech centres, without offering them comparable market and investment access in China.

China’s economy is still firmly in middle-income territory, with a per capita gross national income of about US$8,700, below the middle-income ceiling of about US$12,500, according to the World Bank’s 2017 assessment.

Given the need for China to escape the “middle-income trap,” we think it is appropriate for the country to pursue initiatives like these to improve its competitiveness.

The range of outcomes that could be satisfactory to both the US and China, in our view, extends from a more cosmetic changing of the name to something less aggressive to opening up the Chinese market to more international firms, reducing the level of protectionism available for the domestic entities.

We believe the latter option is a particularly promising avenue of compromise, because reducing the level of domestic protections for the Chinese firms will force them to become more competitive faster, while still being encouraged to achieve the leadership goals set across the major industries.

Other points of conflict between US and China include:

  • Incompatible US and China goals for Taiwan
  • The South China Sea, an area of growing China-US tensions due to its strategic importance fo the US and its allies and partners in the region, including Japan, South Korea, the Philippines, Singapore, Vietnam, and Indonesia.
  • China's role as a major exporter of the drug fentanyl, which played a key role in more than 29.400 synthetic opioid drug overdose deaths in 2017, according to the US-based National Institute on Drug Abuse – up from less than 5,000 deaths in 2013.
  • North Korea, on which we think China and the US have an overwhelmingly strong shared interest in a stable (and, if possible, denuclearised) North Korea.

Our key scenarios

Hot war

Large-scale military conflict between the US and China. Military expenditures/GDP for both countries rise to historical wartime levels (around 15 per cent for the US during the Korean War and around 35 per cent during WWII).

New cold war

Severing of most economic relations between the US and China. Gross trade (combined exports plus imports) and foreign direct investment between the US and China falls below 20 per cent of current levels within the next five years and persists at that level.

This would be a state of extreme geopolitical tension yet falling short of active military fighting (although minor military skirmishes and heavy cyberwarfare wouldn’t be out of the question).

In contrast to the trade war scenario, where economic means are used on behalf of economic ends, in the new cold war scenario, economic means are used primarily for geopolitical ends.

Trade war

15 per cent-35 per cent (expected value: 25 per cent) average tariff rates on US imports of Chinese goods over the next 10 years.

This is already close to the default near-term outcome if the countries are unable to reach settlement: The average tariff rate is already set to hit 17 per cent by perhaps late 2019, failing an agreement.

Major concessions

Significant Chinese policy changes, such as a 50 per cent-75 per cent decrease in bilateral trade surplus with the US, a large loosening of investment restrictions, or a strengthening of foreign IP protection to developed country levels.

Face-saving settlement

Economically largely a return to status quo, but politically a win for the Trump administration and likewise acceptable to the Chinese.

The scenario with the largest (probability-weighted) impact is the new cold war. We think this scenario is about 16 per cent likely, driven chiefly by the historical evidence of the propensity for great power conflict. In this scenario, we think China’s GDP growth falls by 100 basis points, to 2.5 per cent on average over the next 10 years, due chiefly to a 21 per cent drop in China’s exports.

Our trade war scenario has a 14 per cent probability and a 40-basis-point impact on China’s 10-year GDP growth due to a 9 per cent drop in China’s exports. This is a manageable impact for China, although we caution that the short-term impact could be worse due to the time needed to redeploy unemployed workers and capacity out of trade-affected industries.

The real danger of the trade war scenario is that it boosts the conditional probability of a new cold war from 15 per cent to 30 per cent.

In our two key scenarios (new cold war and trade war), we focus on trade as a driver of economic impact on China. This is because trade is a primary grievance for the US, and trade would be the United States' most powerful weapon against China in the new cold war scenario.