See the latest Gavekal book Avoiding the Punch: Investing in Uncertain Times

Click here Close
Gavekal Dragonomics

What's Really At Stake In The US-China Rivalry

American and Chinese negotiators are now working overtime to secure a deal to dial down economic tensions between the world’s two biggest economies. Following last week’s visit by seven senior US officials to Beijing, Vice Premier Liu He will travel to Washington next week for further talks. It is possible that all this back-and-forth will allow a reduction or delay in the tariffs that the two sides have threatened, which would affect US$100bn or more of bilateral trade flows. Beijing is likely anxious to achieve some kind of agreement ahead of a planned trip by Vice President Wang Qishan to Washington in early July.

Any such deal will be welcome, but it will also be cosmetic. The rivalry between the US and China is not principally about trade, and is only marginally about Donald Trump. It is really about China’s emergence over the last five years as a formidable bidder for economic and political influence, an aspirant to technological leadership, and a major global investor.

These developments have caused the American security and foreign policy establishment to conclude that the US is now in a long-run strategic competition with China for technological and military superiority, and for dominance of the global economic system. There is an increasing tendency to characterize this competition in quasi-Cold War terms, as a struggle between the US-led “rules-based liberal international order” and a China that is trying to “make the world safe for authoritarianism.”

Clearly today’s situation is far more complex than the Cold War. The Soviet Union was an autarkic economy that had few linkages with the US, little economic influence outside its client states, and not much technology beyond its military hardware. China by contrast is the world’s largest manufacturer and exporter, lies at the heart of global high-technology production chains, and is entangled to an extraordinary degree with the US economy, by virtue of the 70,000 American companies that have invested US$256bn there. Even if the US and China manage to avoid sliding into an economic cold war, it will be a tough task for both nations to strike a balance between promoting commercial opportunity and protecting national security.

Xi’s strategies are the source of the friction

Washington’s strategic freak-out is largely a response to  Xi Jinping’s successful leadership. In his first term, Xi was surprisingly effective at both bringing the country’s fragmented political elite under his control and stabilizing the economy. When he took office in 2012, Communist Party insiders appeared to believe that rampant corruption and political infighting might bring the regime down (see Putting The Lenin Back In Leninism). And in 2015 it seemed likely that deflation, soaring debt and capital flight might drive the economy off the rails (see Avoiding The Japan Trap).

Today both political and economic problems are, if not solved, firmly under control. As a result, attention has shifted to three long-run strategic priorities that Xi has been working on since 2013. These are the Made in China 2025 industrial policy; a program of “civil-military fusion” that aims to upgrade China’s defense-industrial complex; and the Belt and Road Initiative, which is a grand strategy for increasing China’s global influence through improved economic connectivity.

Made in China 2025, which was initially announced in 2015, aims to ensure that China is not just the world’s largest manufacturer, but also its most competitive. The plan’s focus on improving manufacturing and industrial productivity through more effective use of information technology is largely uncontroversial. Many other countries are pursuing similar aims, either through state policy or private-sector initiatives.

Interactive chart

Other goals are more contentious. The policy aims to ramp up the capacity of Chinese firms in about 20 technology-intensive industries grouped in ten “strategic sectors.” These include semiconductors, robotics, aircraft, maritime and aerospace control systems, high-speed rail, new-energy vehicles, pharmaceuticals, and high-tech materials. A separate policy for artificial intelligence, published in 2017, proclaims the goal of making China the global leader by 2030 (see Seizing The Moment For Artificial Intelligence).

In addition, Made in China 2025 sets specific targets, generally in the range of 50-80%, for the domestic market share to be controlled by domestic firms by 2025. There is also an overall objective of 70% domestic self-reliance in “basic core components and important basic materials.” In theory a “domestic” firm could mean any company incorporated in China, even if foreign-owned; but as a practical matter most foreign companies and governments believe that when Beijing says “domestic,” it means “Chinese-owned.”

Import substitution leading to export dominance?

From the standpoint of foreign companies and governments, these goals are troubling for several reasons. First, they clearly have the immediate aim of substituting domestically-produced equipment and components for goods now imported from foreign suppliers. Second, China has a history of creating excess capacity in “strategic” industries (notably steel, solar panels and wind turbines), leading to a collapse in prices and hard times for foreign competitors. This pattern suggests that the import substitution phase could be followed by one in which low-cost Chinese producers begin to dominate high-tech export markets.

Third, these concerns are amplified by the vast financial support Beijing is giving to these strategic industries. By the end of 2016, central- and local-government “venture funds” (essentially vehicles for subsidies) had been authorized to the tune of US$330bn. These funds, if they actually materialize, are greater than total national spending on research and development (US$292bn in 2016). About US$120bn of this venture-fund cash has been earmarked for semiconductors, and about US$35bn of this has already been put to use in three new memory-chip fabs in central China (see The New Challenger In Memory Chips).

Finally, all these industrial policies—which seem to discriminate in favor of Chinese firms at the expense of foreign ones—occur in the context of a country which, according to the OECD, already has the highest barriers to foreign investment of any major economy in the world.

An additional layer of concern for national defense planners in Washington is the program of “civil-military fusion” which Xi launched in January 2017 with the creation of the Central Commission for Integrated Military and Civilian Development. Essentially the aim is to replicate the success of the American military-industrial complex, which since the 1950s has proved highly effective at creating military applications for private-sector technological breakthroughs.

A new world order?

The last piece of Xi’s strategic edifice is the Belt and Road Initiative, announced in late 2013 and widely misinterpreted as a wish-list of China-financed and -built infrastructure projects. It is more properly understood as China’s grand strategy for gradually increasing its geopolitical influence. The right analogy is to the economic component of the grand strategy pursued by the US following World War II.

After emerging as the world’s leading power in 1945, the US defined two broad strategic aims: avoiding another world war, and containing the spread of communism. A key part of the strategy was the creation of a community of shared economic interest, via networks of trade agreements and global institutions such as the World Bank, IMF and OECD. The central idea was that once countries were embedded in an economic system that generated rapid gains in wealth, they would also accept the American security leadership that guaranteed this system, and form a reliable alliance against the Soviet Union.

This system proved spectacularly successful on all fronts. The Belt and Road is in essence China’s effort to pull off a similar geopolitical coup. Its strategic aims are more limited: to guarantee China’s security, and establish itself as the central power in Asia. China wants to gradually ease the US out of its position as top dog in the region, without triggering an armed conflict. The goal of the Belt and Road is to create economic interests that encourage countries over time to align themselves more with China than with the US.

The American and Chinese concepts of economic connectivity, however, differ in important ways. The postwar US-led economic order was at its heart a set of legal agreements—most notably the trade-expanding pacts under the General Agreement on Tariffs and Trade, which evolved into the World Trade Organization in 1995. China’s vision of economic connectivity is essentially physical: roads, railways, ports and pipelines that will supposedly spur economic development in much the same way that infrastructure has knit together China’s fragmented local economies into a single, massive national market.

Behind this difference in vision lies an even more fundamental difference in concepts of law. The US-led system is based on the Western concept of rule of law, in which constitutions and legal principles are superior to the government. Domestically, this means that government agencies and officials can be held accountable for disobeying the laws, and can be disciplined by the court system or elections. Internationally, it means that participants in the system agree to be governed by rules and treaties, not by the exercise of raw power.

In China, the law is an instrument of the party-state, and state agencies and officials are not accountable to the public for upholding the law, but to their superiors for maintaining discipline. In the past several months Xi Jinping has made this long-standing philosophy even more formalized and explicit (see Emperor Xi Is Not So Far Away).

A sense of threat

Adding all of this up, it is easy to see why Xi’s strategy has created deep alarm in Washington. In the view of many US strategic planners, Xi is undertaking a massive industrial policy, funded by hundreds of billions of dollars in subsidies and led by gigantic state-owned enterprises, to squeeze out American firms from the Chinese market, substitute Chinese-made goods for American imports, and to seize global leadership in the high-technology sectors which form the backbone of the US economy.

With this new technological might, China aims to achieve military superiority over the US, displace the US as the main political and economic power in the Asia-Pacific, and establish a new regional economic order governed not by American values of the rule of law and open markets, but by Chinese values of might-makes-right and state-controlled markets.

From this vantage point, the US dispute with China is not about small matters like trade deficits and imperfect market access. These are merely symptoms of two much larger problems: China’s challenge to US technological and military superiority, and China’s propagation of an international economic order to rival the existing US-led order. So even if a short-term deal is struck to delay or mitigate tariffs, the US will almost certainly continue to pursue policies aimed at countering or containing China’s efforts to gain power.

Time to take a deep breath and calm down

This perspective is a powerful reality in Washington today, but to assess its likely impact three observations are in order. First, as I have pointed out several times before, there is broad agreement in Washington that China poses a big strategic challenge, but there is not much agreement about what to do about it (see After Constructive Engagement). President Trump, who does not think strategically, remains obsessed with reducing the trade deficit. Trade and defense officials want China to roll back its industrial development policies to a less threatening level. And the powerful US business community, with its vast investments in China, would like their government to stop hyperventilating about strategic rivalry and take practical steps to increase their access to the lucrative China market. It is far from certain which of these contending forces will win out.

Second, most Chinese officials and analysts argue plausibly that the US security establishment is wildly overreacting to Chinese policies that are understandable and of limited scope. They claim that China does not seek to supplant the existing global economic order, but to add new elements to it. They argue developing technology is necessary for China to make the move from a middle-income to a high-income economy, and that many other countries have used some kind of industrial policy to do that.

The US has also engaged in state-led infrastructure and technology development programs in the past, including the interstate highway program, the space program that consumed 4% of federal government spending at its peak in the mid-1960s, and the whole Cold War defense-industrial system under which universities and defense contractors used vast infusions of public funds to develop key technologies.

Finally, whatever China’s true aims may be, it is far from a sure bet that it can achieve them. By most objective measures China’s technological capacities are still well behind those of the US, Japan and Germany. Indeed, this gap in capability is precisely why Beijing feels it must spend so much state money to catch up. But there is no guarantee that all this spending will translate into the output of high-quality research. Under Xi the Chinese state is becoming more centralized and coordinated, and this may seem scary—but in fact highly centralized systems have a poor track record of delivering sustained gains in productivity and innovation over time.

Interactive chart

And the supposed threat from the “China model” of authoritarian, state-led economics is almost certainly far less dire than alarmist predictions now make out. China has made impressive gains in the past two decades and now accounts for 15% of the world economy. But the members of the OECD—basically the constituents of the “rules-based liberal order”—comprise about 57% of the world economy. None of them shows the slightest inclination to flip to a Chinese style of economic management. The same goes for the major emerging economies—such as India, Brazil, Indonesia and so on—that produce most of the rest of global output. The acolytes of the “China model” are fairly poor countries like Ethiopia and Rwanda. These are unlikely to be the founders of a new global order.

In short, the US-China strategic rivalry is here to stay. Objectively, there are good reasons to think that this rivalry can evolve into a vigorous but basically peaceful competition, rather than a zero-sum economic cold war. For that to happen, though, the balance of US policy needs to shift away from paranoia toward pragmatism.

1 Comment

  • >Anonymous



    This piece is indeed quite insightful. To a degree, China is paying the price for prematurely sticking its head out to stake claims in international following of a 'China model'. The slogan, though, has almost no real substance and of whatever its mainstream proponents put out there is more self-contradiction than meaningful guidance. In a sense, then, reaction from the Trump admin serves as a timely correction for China to be cool headed.

    The U.S., meanwhile, risks over-estimating its international following, too. China today is not Japan of the 1980s. U.S. efforts to contain China are unlikely to generate a lot of real and long-term following precisely because 'America First' tactics are quite abusive and not only towards China.