TITLE FIGHT: U.S. vs. CHINA

"Oh, you don't like being treated the way you treat me?"

I’m a man formally educated in economics and finance. I don’t like tariffs and I believe in the importance of free-trade. In fact, I once believed so strongly in those subjects that you could have called me a "purist." Not anymore. Today, I believe that Donald Trump is right to impose tariffs on China. 

In researching this topic, I have fallen down a rabbit hole. The story about China is deep and dark and it is frightening. I worry about the future of our democracy. 

For all ye who enter here, beware…

China's Modern History
Since the end of World War II, the world’s economic growth has been incredible. For example, economic activity increased from $2.94 trillion in 1970 to $80.684 trillion in 2017. That means that the economic activity on our planet increased 2,644% - on an inflation adjusted basis – in less than 50 years. During the same time frame, the world’s population only increased 105%. Capitalism is awesome. Capitalism is also messy though, especially when it involves trade between nations. That is why we now have the World Trade Organization. Formed in 1995, it is an international governing body that promotes free trade and adjudicates trade disputes between member countries. China was not one of its founding members, but it wanted to be. 

So where does China fit into this story? Well, from 1949 to 1978, China was a communist country in both stated identity and socialistic behavior. Mao Zedong, commonly known as Chairman Mao, was China’s leader and he was a powerful political figure. It is telling that the majority of today’s Chinese citizens view him positively while the West views him with horror. The Chinese remember Mao as the man that pushed out imperial powers and gave China its rightful place in the world. There is a portrait of Mao at the gate of Beijing’s Forbidden city and his image can be found in homes, restaurants, and taxis. Thousands of people still go to see his embalmed body in Tiananmen every single day. The West portrays him very differently. It remembers him for socialist policies that led to the starvation deaths of forty-five million – yes, 45,000,000 - Chinese citizens between 1958 and 1962. To the West, Mao is ranked alongside Hitler and Stalin as a very evil man. 

As an old school communist, Mao believed in centralized authority and the top-down planning of economic affairs. As reason might indicate and as the starvation of millions of people showed, that approach did not work very well. In 1978, two years after his death, new leadership came to power and it began shedding China’s socialist behaviors. It did not shed the authoritarian behaviors, however. By the 1980s and 1990s, China emerged as a major player in the global economy. Its foreign trade grew from $20 billion in the late 1970s to $475 billion in 2000.

Because of its growing economic influence, and because America and the rest of the world saw the opportunity to access a huge new market, China was admitted into the World Trade Organization in 2001, but with strings attached. In general, that meant that China was to reduce its tariffs, open its markets to foreign competition and investment, and modernize its system of protection for intellectual property. History shows that China began doing what it promised and between 2001 and 2004, the number of state-owned enterprises decreased by 48% and tariffs were dramatically reduced as well.

The increased competition from foreign firms caused social disruption in China however, and workers laid-off from state-run enterprises made their displeasure known. As a result, in 2005, a new political regime came to power. This new government halted privatization, adopted a loose monetary policy to spark the economy, and began subsidizing Chinese businesses (particularly stated-owned businesses) so they could compete more aggressively with foreign companies. In 2012, the government further increased control over state-owned and private businesses. Since then, nearly 300 companies in China have amended their corporate charters to give the Chinese government more influence over corporate management. Because Hong Kong is again owned by China, companies there have had to follow suit, too. 

China Today 
We know that China is a powerhouse. It’s the 2nd largest economy in the world behind the US when the numbers are calculated using current exchange rates. When looking at the two countries in terms of purchasing power parity however, both countries have nearly the same GDP, with China having the edge. Today, China is the world’s biggest producer of concrete, steel, ships, and textiles in the world, and manufacturing is at the heart of it all. Manufacturing makes up 1/3 of China’s GDP and 25% of all products globally are made by China. How did China grow so quickly in our highly competitive world environment? One reason is that China is a huge country with more than a billion people – many of them very, very smart - and it has the good fortune of having a lot of natural resources. Another reason is that China cheats.

• Government Subsidizes Industry – By subsidizing many of its companies, China can target a market with low-cost products, capture market share and drive competitors out of business. Just look at the 50% market share China has in steel. The US Commerce Department found that imports of steel from China were subsidized by 256%. 
• Currency Manipulation – China pegs its currency to the US dollar, rather than having the Yuan "float" on exchange markets like the US does. That is a form of currency manipulation and it gives Chinese companies as much as a 30% to 40% cost advantage relative to US goods. 
• Stealing Intellectual Property – While China is stepping up intellectual property enforcement efforts, as recent reports from the United States have found, there remain many deficiencies in China’s protection of trademarks, copyrights, and patents. IP enforcement in the case of piracy and other breaches is often inadequate. Either there is no prosecution of breaches, no positive finding that a breach has occurred, or the penalty applied is too light to have any deterrence value. In response, the U.S. Senate passed The Defend Trade Secrets Act in 2016 to allow companies victimized by theft of trade secrets to sue in federal court. On May 11, 2016 however, Chinese state-owned entities, backed by their government, said that they have a sovereign immunity and can’t be sued.
  
  To put the size of this problem in perspective, US losses from China’s intellectual theft amount to $300 billion per year. President Trump wants to impose 25% tariffs on $50 billion of Chinese imports. That will generate $12.5 billion in fees. That is a huge difference!

China is a communistic country, but in a different kind-of-way. In the West, we usually think of the socialistic aspects of communism and how they affect the ownership of private property. We rarely consider the degree of control communistic government has over the economy. In China, the government has enormous control, and it is highly effective with it. It is authoritarian in the extreme. There is a merger of political power, business leadership, and military authority within the Chinese system that is so foreign to American thought and experience that it is difficult to conceive. In the West, individualism is primarily thought of as uniqueness and autonomy. In China, individualism stresses individual achievement in the context of a larger family, social, or cosmic whole.

Interesting Insights
In my research for this article, I came across a reference to Christopher Balding, PhD, in a Forbes article about China’s debt. It turns out that Dr. Balding is a US citizen that was a professor of business at Peking University from 2009 thru April of this year (2018). While he thoroughly enjoyed his time in China and has many friends there, what follows are quotes from his blog about Chinese culture. They do not paint a pretty picture.

"There is a complete and utter lack of respect for the individual or person in China.  People do not have innate value as people simply because they exist. This leads most directly to a lack of respect for the law, rules, and norms. One thing I began to realize over time is how norm abiding Americans are (even though) there is a minimal fear of enforcement. Cutting in line is considered extremely rude (in America) because there is a sense of fairness and that people have equal rights. In China, line cutting is considered nearly standard operating procedure. In a way, I sympathize with Chairman Xi’s emphasis on rule of law because in my experience laws/rules/norms are simply ignored. They are ignored quietly so as not to embarrass the enforcer, however, frequently, the enforcer knows rules or laws are being ignored, but so long as the breaker is not egregious, both parties continue to exist in a state of blissful ignorance. Honesty without force is not normal but an outlier. Lying is utterly common, but telling the truth is revolutionary. I rationalize the silent contempt for the existing rules and laws within China as people not respecting the method for creating and establishing the rules and laws. Rather than confronting the system, a superior, or (making) good faith attempts to change something, they choose a type of quiet subversion by just ignoring the rule of law. This quickly spreads to virtually every facet of behavior as everything can be rationalized in a myriad of ways. Before coming to China, I had this idea that China was rigid, which in some ways it is, but in reality, it is brutally chaotic because there are no rules. It is the pure rule of the jungle with unconstrained might imposing their will and all others ignoring laws to behave as they see fit with no sense of morality or respect for right."

I believe that culture explains a lot about China’s behavior with respect to international trade.

Subsidization by China
Over the past decade, China’s credit boom has been the largest factor driving global growth. In reality though, it is a shell game that makes Enron look like child’s play. Because so many companies in China are directly or indirectly state-owned, those companies receive loans at near zero rates of interest. The most impressively negative assessment concerning China's debt problems can be found in a reading of documents published in 2017 by the People’s Bank of China "Financial Stability Board." For the first time, well known and reasonably reliable "on balance sheet assets" were combined with "off balance sheet" assets and measured. According to the People’s Bank of China’s own figures, its total assets are "more than double" what had previously been reported. In other words, China’s debt to GDP ratio is 833%. 

Will that debt eventually crush China? I simply do not know. China has a chronic current account surplus and has been a net creditor to the rest of the world for decades. The balance sheets of the Chinese state-owned banks, the government and the People’s Bank of China are all under control of the government. To paraphrase Winston Churchill, "I cannot forecast to you the action of China. It is a riddle, wrapped in a mystery, inside an enigma…"

Why Have We Allowed It?
The limited response to China's aggressive trade policy has many origins. First, multinational corporations and Wall Street spend a lot of lobbying money on both the Congress and the administration to avoid confrontations and to maintain the status quo. In 2008, as a presidential candidate, Barak Obama said, "China’s current trade surplus is directly related to its manipulation of its currency value." Once in office however, the rhetoric changed. In 2015, Treasury Secretary Timothy Geithner praised China’s announcement that it would move to a more flexible exchange rate. While there was movement to a more liberal direction, China has moved back to its old ways. Later, Obama's next Treasury Secretary, Jacob Lew, said doing anything about currency manipulation "would have the unintentional consequences of stopping global banks from buying bonds to combat weak growth." Kurt Campbell, who was assistant secretary of state for Obama, argued for a more conciliatory policy to avoid the clash of two militarily strong countries. Every administration is worried that if we upset China, they may quit loaning us the money to finance deficits. 

In summary, we have been running scared. 

Closing Thoughts
It is profoundly misguided and short sighted to view the rise of China as merely the tension developing from a major state’s economic development. China represents a clear and present threat to liberal democracies, open markets, and international systems.  We see the world slowly being divided into China supported authoritarian regimes that support its creeping illiberalism. Modern American foreign policy is a history lesson in active ignorance and a Neville Chamberlain-like ability to avoid confrontation. Many people are critical of President Trump, and they have reason to be. On the issue of trade, Trump should be much more strategic in his approach. We are who we are however, and given the behavior of previous administrations, I give him credit for making this issue front and center in world affairs. China presents a fundamental threat to the liberal democratic order.

China must be stopped.

Author

Bruce Wing is the president of Strategic Wealth, LLC, a fee-based Registered Investment Adviser located on the north side of Atlanta.