This article first appeared in Forum, The Edge Malaysia Weekly on October 1, 2018 - October 7, 2018
Something important has changed in US-China relations in recent months. The strategic rivalry between the two now dominates over other issues, making the things that matter to the rest of Asia, such as the tariff war, more difficult to resolve. It may be premature to term the tensions between the two big powers as a new cold war, but the relationship between the two is becoming more of a zero-sum one and less a cooperative one. The net result for Southeast Asia cannot be good, given the likely political and economic fallout for the region — but we should also recognise that there could be some positive implications as well.
What has changed?
Several important policy documents earlier this year presaged a shift towards the US viewing China as a strategic competitor rather than as a broadly benign power. The US is now actually acting on that shift. US President Donald Trump’s administration has imposed penalties on China’s Equipment Development Department, a unit of the Chinese military, for purchasing high-technology Russian weaponry in violation of US sanctions on Russia. This action was followed by the US authorities arresting a young Chinese student for allegedly spying for China.
In the week before these actions, US officials had taken on an overtly hostile tone when discussing China. In mid-September, Federal Bureau of Investigation director Christopher Wray identified China as the FBI’s top priority in counter-intelligence. A few days earlier, William Evanina, director of the National Counterintelligence and Security Center, had labelled China as “the largest threat to our national security, bar none...”
Trump’s announcement of a 10% tariff on US$200 billion of Chinese imports with effect from Sept 24, and his threat to raise the tariff rate to 25% next year if no US-China trade deal was struck by then, must be seen in this context. Nearly half of all Chinese exports to the US now face higher tariffs. Underlining how much worse relations could get, Trump warned that any Chinese retaliation against these tariffs would prompt him to extend tariffs to another
US$267 billion worth of Chinese imports, bringing virtually all of Chinese exports to the US under tariffs. Since China has now indeed retaliated, with counter-tariffs of US$60 billion on US imports, the tariff war will escalate and the implications are likely to be damaging.
First big implication: Short-term risks contained as China will be careful
The extraterritorial nature of the US sanctions on China, punishing it for violating laws that are not legally recognised outside the US, made it impossible for China not to react forcefully. China cancelled scheduled talks between high-level defence officials of the two countries, even going to the extent of recalling the People’s Liberation Army navy chief Shen Jinlong, who was already in the US. Chinese officials have threatened further retaliation if the US persists with the penalties. China has also disengaged from negotiations on their trade differences, saying it would not negotiate “with a knife at its throat”. China is unlikely to resume talks with the Trump administration until the congressional mid-term elections are over in early November and the political landscape in the US becomes clearer.
Such a lack of high-level engagement when multiple political and economic troubles are brewing in the world raises the risk that a misunderstanding between the two big powers could aggravate a particular flashpoint. Beyond that, however, other risks are likely to be contained as China will be pragmatic, choosing to fight battles in areas where it can win rather than escalating tensions simply out of pique. China realises that, while it has many options to inflict pain on the US, all those actions would hurt China as well — particularly at a time when China’s economy is losing momentum and threatened by serious financial imbalances:
• Selling down its holdings of US Treasuries is not much of an option since the hit to the US in terms of higher US bond yields will be slight while the loss to China from the reduced value of its remaining Treasuries holdings would be sizeable. Anyway, China’s foreign exchange reserves are so huge that there are few alternative asset classes where these can be redeployed.
• China could make it tougher for US businesses to operate in China’s lucrative market, but these could undermine foreign investor confidence in China at a time when it needs foreign investment to help offset a declining current account surplus and for it to move up the value chain.
• China could allow a sharper depreciation of the renminbi, but this could spur potentially destabilising capital flight out of China.
Second big implication: Shift in China’s immediate priorities at expense of long term
US tariffs will hurt China’s export growth, the last thing China’s slowing economy needs. China’s immediate task is therefore to support the economy through short-term stimulus measures, expanding on the measures taken so far such as increasing the size of its fiscal stimulus and easing restrictions on local government infrastructure spending. Furthermore, the central bank will need to keep injecting liquidity into the system to ensure that credit flows remain unperturbed.
In doing so, Chinese authorities have little choice but to step away from policies to promote corporate deleveraging and reduce industrial overcapacity. But that means that these imbalances could accumulate again and become more threatening to China in the longer term: China’s policy trade-offs are now much more painful than before, raising its risk profile in the longer term.
Third big implication: A recrafted development strategy for China
China’s clash with the US has exposed some weaknesses in its economy and points to a need to rethink development policy:
• It has to accelerate moving up the value chain to become technologically independent: The US’ sanctions on China’s ZTE Corp that almost caused it to collapse reminded China of the US’ continued technological dominance and how dependent China remained on critical supplies of high-tech components from the US. There will now be a massive investment in R&D as well as efforts to build up its own indigenous companies in key technologies.
• Offer more inducements to foreign investors: Premier Li Keqiang has pledged to cut taxes, unlock financing for private businesses and commit to a level playing field between Chinese and foreign companies. More such policies will follow.
• Make its development strategy more palatable to trading partners: Its “Made in China 2025” programme had upset the Europeans more than the Americans, while the theft of intellectual property by Chinese entities and Chinese state policies to force technology transfer had aroused deep resentment among its economic partners.
Fourth big implication: Recalibration of China’s international engagement strategy
Under President Xi Jinping, China had become bolder in its external conduct, with the result that it had alienated many others. Its seizure of territories in the South China Sea claimed by others had deepened resentment in a region that is crucial to its geopolitical position even as Southeast Asian nations had little choice but to accept it. China will now try to downplay these strategies and step up efforts to woo Europe, Japan, South Korea and Southeast Asia. Even its widely welcomed Belt and Road Initiative had been implemented in a manner that has produced strong reactions even in countries that are strong Chinese allies such as Pakistan. Recent elections in Malaysia and Maldives, where Chinese investments became an issue, resulted in new governments less supportive of China coming to power. All this reinforces the need for China to modify its approach to one that is more sensitive to other countries.
Fifth big implication: Production relocation out of China
Now that companies with export-oriented production facilities in China realise that the trade war is part of a longer-lasting geopolitical confrontation, many will start moving production out of China. In the near term, larger production quotas will be allocated to plants in other countries rather than China, where the companies have multiple locations. But, over time, it will be increasingly a case of actually shifting production lines out of China completely. Recent reports in the media revealed a few important trends:
• Large companies with multiple production facilities had already started relocating some production even before recent developments. Smaller companies with a single production location in China have hesitated to make the move, but there are signs that these companies are now stepping up plans to relocate.
• In most cases, it is production meant for the US market that is being relocated. Many companies still find China the optimal location for all other export-oriented production.
• In many cases, relocation has been to developed countries that are the home bases of the companies rather than to developing economies. For instance, some Japanese and South Korean electronics manufacturers are moving manufacture of certain components back to their home countries. Taiwan’s Minister of Economic Affairs Shen Jong-chin observed that at least 20 Taiwanese businesses were thinking of relocating production back to Taiwan from China.
• The emerging economies being considered to receive relocated production from China were typically Vietnam, Thailand, Mexico and Brazil.
Despite this, we believe Southeast Asia could be a big winner as the production relocation accelerates. One reason is that both Taiwan and South Korea are investing considerable resources in developing stronger integration with Southeast Asia.
Taiwan is making a more concerted effort through its New Southbound Policy, which is a comprehensive strategy to deepen Taiwan’s political, cultural and economic integration with Southeast Asia. The Taiwanese government has created new institutions and foundations to spearhead a range of initiatives that are now gathering momentum. Since there are about 100,000 Taiwanese firms that have placed manufacturing plants in China, what the Taiwanese plan to do will make a huge difference.
Similarly, but on a smaller scale, South Korea President Moon Jae-in is also moving forward with a “new southern strategy” that targets Southeast Asia as a key diplomatic and economic partner. Even as the Moon administration has been preoccupied by domestic economic challenges and the ongoing North Korean diplomatic initiatives, it has been revamping its trade strategy agencies while pushing for a speedy conclusion to the negotiations for a Regional Comprehensive Economic Partnership, which places
Asean economies at the centre of a web of trade agreements. Large South Korean corporations have also been holding strategy meetings and stepping up engagements with Southeast Asian nations.
Conclusion
The coming few months will see more trade skirmishes that would disturb the region’s export potential while possibly hurting the supply chains their manufacturing sectors are plugged into. Countries in the region could also face more pressure from a US that is confident its aggressive trade tactics work. In some cases, there will be political pressures to take one side against the other. All that makes for an uncomfortable outlook. The one silver lining is that we are likely to see some important shifts in the manufacturing supply chains across Asia and we suspect much of that will benefit Southeast Asia, especially Vietnam.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
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