Andrew Busch

Broken Supply Chains: US-China Outlook
04/17/24 | Economic Outlook

 

Broken Supply Chains: US-China Outlook

Quick note: China’s housing crisis coupled with a drop in the global economy has slowed their economy (don’t believe their headline 5.3% GDP), but China’s manufacturing production appears to keep rolling despite lower domestic consumption. This is making Chinese trade partners nervous over a potential flood of cheap exports coming from the world’s largest manufacturer.

Today’s announcement by the Biden administration to increase steel and aluminum tariffs on China is emblematic of this fear and why it’s a great time to review the US-China supply chain relationship.

Some Context

Few relationships will define the future of global supply chains and the world economy as much as the United States and China. The sprawling trade and investment relationship spans an annual exchange of around $750 billion in goods and services. Trade with China impacts nearly every industry and delivers mutual economic benefits for the two largest economies in the world. At the same time, the two nations are locked in a tectonic economic competition reverberating across the globe.

In the aftermath of Covid-19, the “just-in-time” manufacturing model honed during China’s rise is fracturing. US policy and the pandemic combined to accelerate the trend toward supplier diversification and resilience. Policymakers and businesses are nevertheless finding that decoupling from China is no easy feat. China’s central position in global manufacturing supply chains has proved resilient, even as the impacts of US tariffs and export restrictions are starting to be felt.

When China joined the World Trade Organization (WTO) over 20 years ago, optimism about the power of liberal trade and free markets to transform the communist nation was at an all-time high. That optimism faded as China steadily increased its share of global manufacturing and eschewed the WTO’s market-based system. China’s leaders have leveraged China’s natural advantages with intention, overseeing the largest expansion of infrastructure and industrial capacity the world has ever seen. The consequences for China’s middle class have been transformative. Nearly 800 billion people lifted out of poverty in the last 40 years. Yet the trade winds are shifting, especially as the consequences of China’s state-led, export-oriented development model have come into clearer view.

The US and allied nations are no longer willing to countenance China’s industrial playbook. Hawkishness on China is one of the few bipartisan issues in Washington, DC, and the outlook shows little signs of reduced tensions. The US is responding to the post-Covid world with muscular industrial policy of its own, embarking on major initiatives to spur domestic manufacturing and contain China’s rise. For their part, Chinese exporters are also responding to the new global realities. They are dynamic, hungry, and willing to draw on the full power of the state to achieve their ends.

The objective of this research article is to help investors make sense of the complexity and chaos in the world’s most consequential economic relationship. The deep dive tells the story of China’s historic ascent to the center of the global manufacturing supply chain. Next, we cover how the just-in-time manufacturing model is beginning to crumble in favor of a more fragmented, regional economic approach. The immediate aftermath of Covid is over. As the world hurtles toward the new normal, the clashes and cooperation of the world’s two largest economies will continue to shape global economic trends that are critical for investors to consider. Let’s dive in.

Early Trade Relationship and Pivotal Agreements

When Mao Zedong formally founded the People’s Republic of China (PRC) in 1949, he inherited an economy devoid of reliable industrial assets. The coming decades would see millions of Chinese die on account of violent conflicts and misguided development policies. The most notorious of Mao’s plans, the Great Leap Forward, attempted to transform China from an agrarian economy to a modern, industrialized nation. China’s industrial prowess failed to materialize in the short-term, and the resulting collapse in agricultural productivity caused widespread famine. Death toll estimates range from 15 million to 50 million people.

Mao’s rule was also marred by conflicts and tension in the Korean Peninsula, the Taiwan Strait, and Tibet. Tensions with the US were high during the early days of the PRC, with the US imposing a total trade embargo against China starting in 1950. The trade embargo would last more than 20 years, only thawing in the wake of ping pong diplomacy and dedicated engagement from President Richard Nixon and Secretary of State Henry Kissinger.

The Shanghai Communiqué and the start of economic rapprochement

The Shanghai Communiqué, signed in 1972 during President Nixon’s official visit to China, marked the start of diplomatic normalization and the end of the trade embargo. The communiqué set the tone for an economic rapprochement that would ultimately catapult China to the upper echelons of the industrial world, stating in part:

• “Both sides view bilateral trade as another area from which mutual benefit can be derived and agreed that economic relations based on equality and mutual benefit are in the interest of the peoples of the two countries. They agree to facilitate the progressive development of trade between their two countries.”

As China slowly began reintegrating into the global economy, China’s leadership began to undertake economic reforms that provided private businesses and entrepreneurs with more autonomy. Mao’s successor Deng Xiaoping coined the term “socialism with Chinese characteristics” to describe the newfound openness, which was intended to facilitate China’s development while remaining true to the Chinese Communist Party’s ultimate vision.

The seeds of China’s future economic might were contained within these reform policies. These reforms unleashed a wave of entrepreneurial activity, particularly evident in the establishment of special economic zones in coastal cities, in the mid-1980s, which served as incubators for export-oriented development. Today’s most well-known manufacturing centers in China, including Shanghai, Shenzhen, Guangzhou, and Qingdao, trace their modern manufacturing history back to the coastal cities’ effort.

Accession to the WTO and the apex of China optimism

Foreign trade partners viewed the development of Chinese economic reforms with great optimism. Political flashpoints, such as the Tiananmen Square Massacre, continued to rear their head. But the momentum of China’s manufacturing sector went full steam ahead. The US and other developed economies also relished the potential of China’s consumer market. While still relatively poor throughout the late 1990s, the sheer size and scale of China’s population could not be ignored.

Optimism about China’s economic reforms and the power of trade liberalization to serve as a democratizing force culminated in 2000 when President Bill Clinton signed the US-China Relations Act. The historic legislation cemented China’s emerging role in the global economy and paved the way for accession to the World Trade Organization (WTO) in 2001. China’s accession to the WTO marked a significant milestone, solidifying its position in the global economy and opening up new avenues for international trade and investment. With the Cold War in the rear-view mirror, US policymakers were convinced that the global, rules-based order would eventually meld authoritarian nations into free market icons. American businesses and consumers also benefited from a raft of investments and new product availability. The trade figures were simply staggering: Between 1980 and 2004, bilateral trade between the US and China rose from $5 billion to $231 billion.

China’s Role as the World Factory Floor

If Mao were alive today, he would not believe his eyes. China’s industrial capabilities have blossomed into the envy of the world. The depth of China’s manufacturing ecosystem earned the country the title of the “World’s Factory Floor” – a moniker that reflects the dominance of Chinese companies in global industry sectors ranging from steel to electronics and electric vehicles. China’s transformation into the “World’s Factory Floor” is not only a testament to its industrial prowess but also a result of deliberate economic policies, strategic positioning in global trade and bending WTO rules to its favor.

China’s industrial development model since joining the World Trade Organization is critical to understand, not least because it helped usher in the era of “just-in-time” manufacturing. The rising industrial capacity in China combined with advances in logistics, telecommunications, and cross-border finance to enable a lean system of goods production that could be delivered “just-in-time” for customer needs. Logistics networks were built to reduce inventory and maximize efficiency. Multinational companies were some of the biggest winners. The free flow of goods and capital enabled companies to shift manufacturing to low-cost jurisdictions. China’s industrial planners were waiting with open arms. In return, consumers around the world benefited from an explosion in product choice and a reduction in costs.

China was able to capitalize on the increasingly globalized economy by following a specific playbook that emphasized export-led growth above all else. Beijing ensured that companies operating in preferential trade zones would benefit from several factors, including low wages and a massive pool of manufacturing talent. China also lowered compliance costs and implemented favorable tax policies, including an export tax rebate initiated in 1985. Foreign manufacturers set-up operations in droves. The central government also helped buoy their competitiveness by artificially weakening the Chinese currency, the renminbi (yuan). The testament to this is the massive amount of FDI flowing into China plus the massive trade surplus they run with the United States. These strategic policies aimed at promoting export-led growth and attracting foreign investment significantly contributed to China’s emergence as a manufacturing powerhouse on the global

Another key aspect of China’s development playbook was close cooperation between the federal government and for-profit enterprise. The Chinese Communist Party, which continues to enjoy exclusive rule over the PRC, identified critical economic sectors and supported domestic firms with massive, supply-side stimulus. Chosen firms were provided with the full backing of China’s financial and diplomatic apparatus. China even engaged in aggressive economic coercion and intellectual property theft to benefit their preferred companies. In return, both state-owned and ostensibly private enterprises were expected to subvert pure profit-making interests to the broader economic development goals of the state.

China’s behavior clearly fell outside the spirit and letter of the WTO rules. As China continued eating global manufacturing and lavishing domestic subsidies on firms in strategic sectors, concerns among trading partners started to mount. In August 2010 – less than a decade after joining the WTO – China officially became the world’s second largest economy. That same year, the US trade deficit with China rose to an all-time high of $273 billion. Fears about the economic consequences of massive trade imbalances grew more and more intense. The rapid growth of China’s economy and its trade imbalances with major partners, particularly the United States, fueled concerns and fears about the sustainability of the global trading system and the fairness of China’s trade practices.

These fears dovetailed with mounting pressure from the “losers” of the just-in-time manufacturing revolution – namely manufacturing workers in the developed world. In the United States, over 1 million domestic manufacturing jobs were lost between 1990 and 2007. The so-called “China Shock” to the US manufacturing sector drove significant job losses after China’s WTO accession, particularly in labor-intensive manufacturing positions. Some estimates for US job losses in the post-China WTO era run as high as 3.7 million.

US policymakers were not blind to these realities. The US used both direct bilateral engagement and multilateral institutions to compel China to abide by WTO commitments. In addition, former president Barack Obama’s administration launched an ambitious trade negotiation strategy targeting Pacific Rim nations. The Trans-Pacific Partnership was intended to create a new template for trade with nations close to China’s orbit, with the ultimate goal of pressuring China to adopt new practices or forgo additional market access.

But an emergent China would not be easily cowed. In 2012, Xi Jinping’s ascendancy to the top leadership post of the Chinese Communist Party ensured that China’s policy direction would remain consistent with the preferred industrial development model. Xi is a strident Chinese nationalist who believes Western powers are intent on undermining China’s rise. During his years in power, Xi has stoked nationalist sentiment, centralized his authority, and aggressively clamped down on competing power sources within China. An anti-corruption purge against certain party officials and his overt targeting of China’s tech sector underscore Xi’s resolve.

Throughout the 2010s, the US-China relationship was characterized by rising tensions and outright economic conflict. Yet China has hardly modified their industrial playbook, drawing the ire of China hawks on the right and left of US politics. A 2022 report by the US Trade Representative concluded that even after years of bilateral and multilateral engagement,  “China’s state-led, non-market approach to the economy and trade continues to pose [a challenge] for the multilateral trading system.”

Current Tensions & Challenges in the US-China Relationship

Concern about China’s dominance of global manufacturing finally reached a crescendo in the lead-up to the election of Donald Trump. During the 2016 presidential campaign, Trump conveyed the “China problem” in clear, simple terms that resonated with the American electorate. In his view, China was “winning” the global economic competition against the United States and the ever-expanding trade deficit was proof.

Once in office, Trump and his lead trade negotiator, Ambassador Robert Lighthizer, followed through on their promise to flip the script. The US withdrew from the Trans-Pacific Partnership immediately, turning their back on the trade strategy that was drawn up to counter China’s manufacturing prowess. Instead of multilateral trade efforts, the Trump Administration pursued direct bilateral engagement (read: confrontation) with China on critical trade topics. Tariffs were the weapon of choice, with the United States pursuing several rounds of tariff hikes covering nearly $300 billion worth of goods. . The Trump Administration’s aggressive trade policies marked a significant shift in US-China trade relations.

Much has been written about the Trump Administration’s decision to impose tariffs (and the Biden Administration’s decision to keep them in place). Looking at the trade data, one trend is clear: direct US imports of Chinese goods have decreased. In 2023, the much-ballyhooed trade deficit with China dropped below $300 billion for the first time since 2011. Some of the drop is likely related to a general drawdown in US consumer spending, but the downward trend is still notable. According to the Wall Street Journal, China’s total share of US imports and exports is also dropping, hitting a 20-year low, reflecting the impact of tariffs and shifting consumer spending patterns.

A more granular Politico analysis of the 2023 trade data indicated a similar trend of reduced imports from China. Total imports have declined among 86 of 99 tariff lines targeted by the US tariffs in recent years. Industrial equipment and consumer electronics – pillars of China’s export strength that account for about one-fifth of US imports from China – were down 21 percent and 18 percent, respectively. Other categories also showed major downward trends, including clothing and footwear (20-35 percent drop), pharmaceutical goods (43 percent drop), plastics (29 percent drop) and toys, games, and sporting equipment (31 percent drop).

Tariffs are clearly having an impact. No matter who wins the next US election, they are likely to remain in place. But tariffs are far from the only irritant in the bilateral relationship. Economic ties between the US and China also feature conflict over intellectual property, technology transfer, and market access restrictions.

China consistently demonstrates a willingness to acquire leading intellectual property and technical expertise through a variety of means. In many industry sectors, a joint venture with a Chinese company is a prerequisite for market access. The joint venture structure ensures that the Chinese company can benefit directly from technological innovation brought into the country by a foreign investor. In addition, China often engages in industrial espionage and state-sponsored cyber operations to acquire information. Well-known cases include a Chinese national stealing proprietary agricultural seeds and a cybersecurity breach of US Office of Personnel Management records that US officials tied back to the PRC.

In the US, government policymakers are employing new techniques and tactics to prevent China from acquiring leading technology. The US has pressured allies to freeze Chinese electronics giant Huawei out of information technology infrastructure. In addition, the Biden Administration implemented major restrictions on exports of semiconductors to China. The administration has even mused about restricting outbound investment toward China to deprive the PRC of outside capital and know-how in critical sectors.

Market access restrictions and regulatory barriers to trade also continue to pose challenges for US exporters selling to Chinese buyers. US companies complain about a lack of regulatory clarity, inconsistent requirements, and other forms of pressure. China also maintains an expansive “negative list” of over 100 industry sectors that foreign companies are not allowed to participate in.

The direct bilateral irritants are taking place against an increasingly volatile geopolitical landscape. The US and China have largely failed to jointly address global conflicts in any meaningful way. Often, the two economic giants find themselves with opposing viewpoints or incentives.

The fate of Taiwan is an obvious example. While the US continues to officially recognize the One China policy, it has also made no secret about its intention to continue supporting Taiwan’s national defense. China views Taiwan as a breakaway province and refuses to concede any independence to the island. Given the increasingly tight grip of the PRC on Hong Kong, many analysts fear that a forced reintegration of Taiwan could be next. An outbreak of war in the Taiwan Strait would be disastrous for the global economy. In addition to disrupting supply chains, open conflict would also likely place immense pressure on American and European companies to cease operations in mainland China.

In other geographies, China and the US will continue to compete over diplomatic and economic influence. These include the South China Sea, where China’s expansive territorial claims frustrate other Asian nations; Africa, where both nations are competing for control of natural resources and access to growing consumer markets; and Latin America, where China is eager to make inroads to contest US interests.

COVID-19 and Supply Chains: Accelerating the Drive to Decouple

With the more aggressive trade posture of US policymakers as a backdrop, the Covid-19 pandemic threw more fuel on the fire between the US and China’s strategic economic competition. Covid-19 accelerated the US desire to decouple by further revealing the utter dependence of the US and many Western allies on manufacturing in China. The pandemic highlighted the vulnerability of global supply chains, prompting renewed scrutiny of the reliance on manufacturing in China. Stuck without access to new supplies of surgical masks, hand sanitizer, and other critical medical goods during the pandemic, Americans questioned the wisdom of relying on just-in-time manufacturing located in distant nations.

China’s pandemic lockdown was swift and harsh. Lights went out in factories and ports across the country, with exports falling nearly 17% at the onset of the pandemic. Legendary delays piled up in industries like construction equipment, machinery, and medical goods.

Given China’s central role in global trade, the snarls on China’s coast spurred disruption and inflation throughout global supply chains. According to the U.S. International Trade Commission, the rapid collapse in demand “led container shipping firms to cancel scheduled sailings and consolidate shipping routes.” Globally, the number of 20-foot equivalent units (TEUs) handled per month – a key gauge of shipping volumes – declined by 17.5% in the first few months of 2020. But just four months later, as government stimulus started working its way into the global economy, the number of TEUs spiked. June through October of 2020 saw a 34 percent increase in volume, from 3.3 million TEUs to 4.4 million. The whiplash caused serious delivery delays and major price increases. During 2020, the weekly price of shipping a standard container from China to the North American West Coast hit $2,676, an increase of 178%.

As the immediate crisis began to subside and economies slowly started to reopen, the policy debate in the US latched onto the vulnerabilities of the just-in-time system. The global manufacturing platform with China at the center suddenly seemed shaky.

The risks of relying on China came into particularly sharp relief as China’s harsh lockdown measures dragged on for years. The central government exerted intense control over the industrial apparatus, often forcing the closure of foreign-owned assets or key ports on account of the so-called “Zero Covid” policy. In addition to causing financial impairments and economic contractions, the lockdown underscored the control that the Chinese central government exerts on manufacturers.

For US policymakers and businesses, the entire episode accelerated the drive for long-term changes to improve supply chain resiliency and sustainability. The viewpoint found ample support in Washington, DC, where skepticism about international trade and economic globalization morphed into one of the few areas of bipartisan agreement. Frustration with China and the just-in-time manufacturing system has only hardened in both parties as the pandemic gets further in the rear-view mirror.

When Joe Biden assumed office in 2021, he left the Great Wall of tariffs in place. His administration also emphasized domestic economic policy over international trade, opting not to ask Congress for a renewal of Trade Promotion Authority, a key piece of legislation that provides the White House with a mandate to negotiate foreign deals. Instead of striking new agreements and opening new markets, the Biden team focused on enforcement of existing trade laws, with a special eye towards China.

Take the apparel industry for example. From 2016-2020, the US generally imported anywhere from $45-$50 billion of textiles and apparel from China. However, in recent years, US Customs and Border Protection has acted aggressively to seize shipments of goods thought to contain cotton products from China’s Xinjiang region, where mass imprisonment of the Uyghur ethnic population continues unabated. The tenor of relations and increased enforcement is starting to take its toll. According to Dr. Sheng Lu, an expert in the trade of apparel products, “about 61% of apparel retail CEOs have stopped using China as their primary supplier, up from 30% before the pandemic.” Strikingly, almost 80% of the CEOs surveyed plan to reduce their sourcing from China over the next two years.

Strategies for Mitigating Supply Chain Disruptions

In the aftermath of the post-Covid world, the US and China are both responding to a global trade landscape fundamentally altered by the events of the last few years. With confidence in the just-in-time manufacturing system shaken, new approaches are emerging to mitigate risks and respond to government incentives. The actions in both the US and China are instructive for understanding the new outlook. A wholesale replacement of China’s manufacturing capacity is not feasible. However, the policy and business decisions taken today are setting the stage for permanent changes to the global trading system. The goal for leaders in both nations is to set themselves up to win the future. China and the US share a desire to lead and capture maximum value from the new frontiers of economics and technology.

In the new environment, US policymakers and businesses are increasing their focus on sustainability and resilience – trading some of the benefits of lower cost and maximum efficiency for enhanced operational security. The public and private sector in China is also responding in kind, working to secure their own supply networks, reorient their manufacturing footprint, and contend with a slumping property sector and low levels of domestic consumption.

The domestic situation in the US

In the US, the robust tariff wall, and actions to restrict China’s access to leading technology are being complemented by massive public sector investments in the industrial sector. US policymakers have chosen to emulate some features of China’s industrial model, namely injecting supply-side stimulus to support domestic manufacturing. Justification for continued deficit spending on these initiatives is aimed explicitly at countering China.

Three signature pieces of legislation passed within the span of three years indicate the newfound commitment to using the government purse to incentivize private sector investment. The Inflation Reduction Act, CHIPS and Science Act, and Infrastructure Investment and Jobs Act, all provide generous subsidies for targeted industrial sectors. For example, the CHIPS Act earmarked almost $50 billion in investments to grow US semiconductor manufacturing capacity.

The sustained direction of trade policy toward China is clearly starting to incentivize US businesses to diversify their sources of supply. Many firms are working to regionalize production, setting up operations closer to local markets they want to access. The regionalization trend – and the free flow of government incentives – has been a boon to manufacturing construction in the US. Manufacturing facilities are being built at a higher rate than any other property type. In 2022, annual spending topped $100 billion and represented a 62% increase compared to the previous five years.

The domestic situation in China

China’s leaders are dealing with serious economic challenges largely by falling back on the established industrial playbook. The Chinese Communist Party continues to focus on building up domestic manufacturing and innovation capabilities. At the same time, a slumping real estate sector, high levels of youth unemployment, and weak domestic consumption continue to pose problems.

Consider that the real estate sector (including construction) once accounted for nearly 25% of China’s gross domestic product. Now the government is cracking down on excessive debt financing for real estate and seeking to channel government stimulus into export-oriented industries. The balance sheet of China’s central bank tells the tale: loans to the property sector fell 0.2% year-on-year but lending to the manufacturing sector jumped 38.2%.

China is clearly trying to apply the same tactics used in the development of traditional industrial goods to high tech manufacturing. China’s emerging dominance in electric vehicles demonstrates just how effective the playbook can be. In the years after China’s accession to the WTO, Japanese automakers began to focus on production and sales in China. Consistent with China’s playbook, joint ventures with local Chinese firms were required.

At one-point, Japanese automakers held 20% of the passenger car market in China. But today, Nissan and Honda are planning to slash their production in China. Chinese brands have slowly eroded Japan’s presence in the market, using the technical and business expertise they gleaned from joint ventures in the process. Chinese brands saw their share of the domestic market rise to 36% in recent years, and China is securing a niche in low-cost electric vehicles.

The critical question facing China’s leadership moving forward is if they can successfully stimulate domestic consumption to create enough demand for manufactured products. China currently accounts for just 13% of world consumption, despite attracting 32% of world investment. Historically, China has relied on strong exports to address this imbalance. But the US and other developed nations are no longer willing to countenance China’s industrial model. If the US can successfully reduce opportunities for Chinese exports, a sharp rise in domestic consumption would be one of the only paths for the Chinese Communist Party to protect the nation’s vaunted economic growth.

Many Chinese companies are also responding to global economic realities by making investments into strategic export platforms that do have positive trade relations with the US. Instead of shipping directly from China, setting up operations in a third-party nation can help protect Chinese value chains and ensure more predictable market access to the US. Mexico, Vietnam, and Chile are expected to be some of the major beneficiaries of this trend. No wonder the Mexican peso is surging over the last year, appreciating around 20% against the dollar. Investors understand that low-cost manufacturing nations that lie within the US orbit will be increasingly attractive locations for manufacturing expansion.

How supply chain mitigation strategies are playing out on the world stage

As the US and China navigate the new landscape, two critical developments are occurring on the world stage.

First, both nations find themselves in an all-out competition for setting technology standards and gaining market share of technology exports. China’s goal of applying its standard development playbook to emerging technology is being met with an equally resolute response. The US Export-Import Bank even maintains a dedicated program to counter China, offering US exporters in 10 strategic sectors favorable financing terms and dedicated deal advocacy.

Second, the US and China are in a race to secure critical natural resources to use as inputs in their supply networks. China’s Belt and Road initiative has long sought to build an integrated, closed value chain for critical minerals and other raw materials. Chinese firms have been busy building infrastructure in Africa and other developing nations as a way of controlling procurement and processing. The US and other Western nations are doing their best to catch up, particularly with critical minerals that are necessary to produce electronics, green energy goods, and batteries. The US now has pacts for securing access to critical minerals in place with Japan and Canada.

An Eye to the Future

For now, the US and China seem content to invest in separate spheres of influence and supply chain networks. The major consequence will be more fragmentation, regionalization, and diversification in the real economy. The hopes of US economic nationalists’ intent on a total reshoring of manufacturing will prove fleeting. But a healthy combination of reshoring and “near-shoring” – where production moves to lower-cost producers within the US orbit – will be the new normal. Moving forward, investors should be betting on continued inflation in global transportation, activist diplomacy from China on economic issues, and a reckoning over the current direction of industrial policy on both sides of the Pacific Ocean.

Start with the inflationary impacts in global logistics networks. Continued investment and resources will be required to successfully manage the transition away from the just-in-time system. Reshaping global supply chains would prove costly in the best of circumstances. In 2024 and beyond, central trade arteries will face other external challenges, such as Houthi violence in the Red Sea and low water levels in the Panama Canal. When combined with the other factors at play in the post-Covid world, the realities of moving goods around the world only appear more challenging.

Second, expect China to ramp up diplomacy and seek to overhaul the current structures of the global economy. An increasingly confident China will challenge US hegemony in international institutions and frameworks, seeking to remake the global order to their benefit. China is already pressing ahead with regional trade agreements, such as the Regional Comprehensive Economic Partnership (RCEP) that does not include the US. China is also eager to reduce the central role of the US dollar in global trade, teaming up with other nations to consider alternative models to using the greenback. China is delicately pursuing opportunities to capitalize on Russia’s isolation from Western nations on topics including de-dollarization of trade and energy supplies. Bilateral trade between China and Russia hit an all-time high of $240 billion in 2023, with Chinese exports up nearly 47% compared to 2022.

Finally, both the US and China are likely to see pressure and resistance to the current direction of industrial policy. In the US, the battle for the soul of America’s economic policy is far from over. The pendulum has swung heavily toward the proponents of state-directed industrial policy. There is no guarantee it will stay there. US history is replete with oscillation between isolationism and global engagement. If continued government stimulus leads to sustained inflation or the US deficit becomes a concern for investors, support for the current engagement approach could subside.

In China’s case, the nation must balance the drive for self-reliance with an openness to foreign investment. Eager to secure access to foreign capital and critical technology, China cannot afford to alienate Western investors completely. At the same time, the relentless focus on promoting domestic champions is making foreign investors increasingly leery, especially in critical sectors like artificial intelligence and space technology.

Resigned to conflict?

With all the factors driving the US and China apart, it would be easy to predict doomsday scenarios. Volatility and spiralling relations cannot be ruled out, but both the US and China have shown a conscious recognition of the risks that could come from violent conflict. Despite a reticence to cooperate on major global conflicts, space for collaboration and cooperation remains. Private sector diplomacy from western companies with major stakes in China is also an important wildcard.

Even amidst all the recent challenges in the US-China trade relationship, the competitors have been able to maintain forward movement in a few areas. Countering the illegal production and sale of narcotics is one promising arena. Another is potential cooperation on artificial intelligence. Both nations share an interest in limiting the use of AI applications in the military and setting standards for transparency around generative artificial intelligence. Some existing bilateral fora, such as the US-China Economic Working Group, could help facilitate these discussions.

Cooperation on green energy is another potential off-ramp from tension. With US ambitions to transition to a clean energy grid as soon as possible, and China’s critical role in the green energy supply chain, cooperation may be able to yield some win-win scenarios. Perhaps that is one reason why the US and China agreed to operationalize the Working Group on Climate Action last year. Of course, both nations share an interest in dominating the green energy goods market over the long-term, but strategic cooperation, rather than competition, may be able to help commercialize clean energy technology more quickly.

Finally, one of the biggest forces that could help reduce tension between the US and China is private sector diplomacy. Whether from US companies with China operations, or German industrial giants who continue investing heavily in mainland China, there are plenty of Western stakeholders who are not shying away from the Chinese market. China has even made some exceptions for foreign firms in the auto sector, allowing Tesla to set-up wholly-owned entities and giving BMW and Volkswagen the greenlight to serve as majority partners in their joint ventures. A range of companies have enough clout in both Washington and Beijing to mediate behind the scenes.

Concluding Remarks

In just a few short years, the landscape confronting the Chinese and American economies has radically changed. From the depths of Covid despair, both nations have emerged with clear priorities and policy approaches. The ongoing reorientation away from just-in-time manufacturing and China will take time, but the course looks set to continue.

Difficult questions remain for policymakers, investors, and executives. Balancing the opportunities and risks inherent in the world’s most consequential trade relationship is not easy. The good news is that many stakeholders on both sides show a desire to keep the relationship stable and prevent further escalation. An eruption of open conflict would be disastrous for the world economy, which still relies heavily on China to provide critical industrial capacity. Even US actions are unlikely to change that fact, as dynamic global supply chains change and adjust to deal with new regulatory realities.