The U.S.-China Economic Conflict

The U.S.-China Economic Conflict

Implications for Indo-Pacific Security

Dr. Shale Horowitz/University of Wisconsin-Milwaukee

U.S.-China economic relations seem to have reached a turning point. As the People’s Republic of China’s (PRC’s) development and General Secretary Xi Jinping’s leadership heighten economic and security challenges, what are the most realistic and effective policy responses? One approach is to use economic bargaining and diplomatic engagement to convince the Chinese Communist Party (CCP) regime to continue down the road to a Western-style market economy, while coexisting under the geopolitical status quo. It is argued below that this option no longer exists. The PRC’s economic and security policies have developed too far in the direction of upending the economic and geopolitical status quo, and Xi is markedly more committed to such disruption than his predecessors.

Xi’s Economic and Security Policies
When Xi came to power in 2012, he inherited a fast-growing, state-led market economy, alongside a rapidly modernizing People’s Liberation Army (PLA). Although the PRC’s roughly 10% annual economic growth since 1979 increasingly depended on markets and on a dynamic and innovative private sector, the CCP preserved a leading state role to safeguard control and stability in both economics and politics.

While Xi was widely expected to reemphasize market-based development, he has instead doubled down on state control. He has used regulation and credit subsidies to favor state-owned enterprises and large, well-connected private companies over small and medium private enterprises and foreign companies.

A woman clad in a red jacket walks past a new shopping mall decorated with an eye design in Beijing. The Associated Press

Xi has also intensified his predecessors’ efforts to use the state’s deep pockets to upgrade the PRC’s economy. The U.S.-China Economic and Security Review Commission highlights “an ambitious whole-of-government plan to achieve dominance in advanced technology.” Thus, the Made in China 2025 plan seeks self-sufficiency across almost the entire array of high-tech industries — from computing hardware to artificial intelligence software, from biotechnology to transportation equipment. Self-sufficiency is to be followed by penetration of foreign markets.

This plan has two important implications. First, Xi does not envision the PRC entering the decentralized, constantly evolving global division of labor in high-tech products, such as exists among the United States, Western Europe, and Japan and other Indo-Pacific countries. He intends to use subsidies and regulation to reserve the Chinese market increasingly for domestic suppliers and then to leverage the resulting price advantages to dominate foreign markets. Second, the targeted high-tech industries have dual-use military applications, which can be used to close or even reverse the technological advantage enjoyed by U.S. and allied militaries.

Externally, Xi has continued his predecessors’ military buildup, while adopting more assertive rhetoric and policies. As has been true since the early 1990s, defense spending has risen at double-digit rates, and the PLA continues its impressive qualitative modernization. At the same time, Xi has definitively abandoned Deng Xiaoping’s foreign policy of “concealing strength” and “never being the highlight.” Xi’s China Dream covers not only rising living standards but a return to China’s traditional central role on the international stage. This rhetoric has been matched by more aggressive policies along China’s entire eastern and southern periphery — from the Japanese-administered Senkaku Islands to Taiwan and the nine-dash line claims, and on to India’s Himalayan frontier. There is also One Belt, One Road, a worldwide effort to use subsidized infrastructure construction to buy political, economic, diplomatic and military influence.

These policies are designed to have maximum impact in the Indo-Pacific region. Again, rather than entering into the existing economic division of labor and coexisting within the existing security architecture, Xi seeks to substitute a new order dominated by the PRC. Just as the high-tech industries of the U.S., Japan, India, South Korea and Taiwan would be displaced from their regional markets, the lower- and middle-income economies of the region would be prevented from moving up the value-added chain as their economies mature. If Xi’s vision comes to fruition, there will be a unified regional supply chain, with China at the top and other regional economies at the bottom. Similarly, once the U.S. military has lost its qualitative edge, a mixture of economic and military carrots and sticks can be used to deter regional coordination and to extract substantive concessions and diplomatic obedience, if Xi gets his way.

Protesters gesture with five fingers, signifying the “five demands – not one less” slogan, in a Hong Kong shopping mall June 1, 2020. The Associated Press

Unsustainable Status Quo
As Deng’s market reforms took hold, China’s economy looked to be converging toward a Western-type market economy. While the state took a leading role — using financial and regulatory discrimination and technology theft to favor well-connected large firms, and in the process running up artificially large trade surpluses — the U.S. and its allies could afford to bide their time. The PRC specialized in producing labor-intensive manufactured goods — industries already in steep decline in the U.S. and other advanced countries. At the same time, if the PRC were to continue down the road toward an ordinary market economy, its huge domestic market promised irresistible opportunities for the West’s capital-intensive, high-tech sectors.

This status quo policy of patience and engagement has been cumulatively undermined by fundamental geopolitical and economic changes. The 1991 collapse of the Soviet Union eliminated the greater common enemy that had been the basis for Sino-American security cooperation since the 1970s. After facing a near-death experience at Tiananmen Square in 1989, a shocked CCP turned to Chinese nationalism (so-called patriotic education) to revive its legitimacy and began to pour huge resources into modernizing the PLA. Meanwhile, the PRC’s continued rapid growth and technological modernization increasingly created direct competitors for foreign capital-intensive industries. Chinese state patronage tended to reserve the domestic market for its own companies, while its subsidies eased their conquest of foreign markets. More recently, Xi has ramped up these assertive security and economic policies through aggressive actions including the use of military force.

Over the past decade, these changes have shattered the old China policy consensus in the U.S. Few political leaders and policy elites seriously debate anymore whether the PRC is a military threat. Most capital-intensive, high-tech businesses feel shut out or marginalized in the Chinese market. Their Chinese competitors meanwhile use subsidies and stolen technology to gain unfair advantages abroad. These realizations have become more bipartisan and penetrated public opinion. While U.S. President Donald Trump’s Indo-Pacific national security strategy and his use of tariffs to bargain for greater adherence to fair trade norms and access to the Chinese market have sped the process, they are more a consequence than a cause. Such a policy turn was made inevitable by changing conditions, and future presidents are unlikely to deviate significantly from the new course. 

What Does the Future Hold?
Structural political characteristics and personal inclinations make it unlikely that Xi will alter the PRC’s course. To stay in power, the CCP must exercise direct control over politically sensitive sectors such as telecommunications, social media, internet services, and related hardware and software inputs. To guarantee economic stability — also seen as necessary to avoid political instability  — the CCP must also control the largest banks and other financial services companies. Apart from defense industries, a range of dual-use technologies attract state support for national security reasons.

Fundamentally, the CCP supports market development, not by using a Western-style rule of law that strives to guarantee equal protection and rights to all economic actors, but by a complex series of local partnerships between party elites and large enterprises. Thus, the CCP cannot stop providing connected companies with special treatment without transforming its entire regulatory approach in a way that would threaten political control and entrenched economic interests.

The flags of the People’s Republic of China, left, the Chinese Communist Party, center, and the U.S. are displayed in a flag stall at the Yiwu Wholesale Market in Yiwu, Zhejiang province, China. REUTERS

Xi’s own inclination is to deal with every problem by heightening CCP control. This means not increasingly open competition but a more determined drive for self-sufficiency. The need for such self-sufficiency is further heightened by Xi’s desire to cultivate the dual-use high-technology industries necessary to build the PLA into a peer competitor of the U.S. military.

Thus, the bargaining between Chinese and U.S. leaders does not lead to a future of free and open competition and trade. Xi will continue to seek a unitary world supply chain in China, which continually absorbs more capital-intensive and high-tech sectors. The U.S. and its allies can only respond by protecting crucial components of their domestic markets from Chinese competition, thus preserving a second, largely independent supply chain. What are some important principles to follow to make this response most effective?

First, the U.S. and its allies and partners must use tariffs and research and development subsidies to preserve technological independence and, if possible, leadership in important dual-use high-tech sectors, such as artificial intelligence, high-performance and cloud computing, avionics and robotics. The same is true for militarily strategic capital-intensive sectors, such as telecommunications, computing and pharmaceuticals. Critical infrastructure — such as telecommunications networks, electronic banking and payments networks, and electrical grids — must be protected with Huawei-style restrictions. Continued Chinese competition in many high-end markets is desirable, but it should be conditioned on better access to Chinese markets and retaliation against Chinese subsidies and technology theft.

Second, such measures will be far more effective if they are negotiated and implemented multilaterally. Parallel supply chains will be less efficient and coherent if built in countries or regions. They will be most robust if built on a broad, open and competitive division of labor, which includes the U.S., the European Union and Japan, along with other allies and partners, particularly from the Indo-Pacific region. Protecting independent supply chains will give allies and partners access to large markets that are not dependent on Chinese control. This in turn will maximize the productive capacities and bargaining leverage of allies and partners as they continue to seek maximum access to the Chinese market. The alternative is a more unitary, PRC-dominated supply chain in which each country bargains separately from a position of lower capacity and greater dependence.

Third, such common economic policy efforts are bound by a common geopolitical threat, which is best addressed collectively. Economic dependence on Chinese markets, technology and infrastructure will imperil military capabilities and independent diplomacy and strategy. A good example of these dangers is provided by the PRC’s reaction to South Korea’s deployment of the Terminal High Altitude Area Defense missile defense system. The PRC protected and assisted North Korea’s increasingly capable nuclear weapons capability and then retaliated against South Korea’s defensive response by blocking tourism and sanctioning informal boycotts of South Korean products. While South Korea will always want to maintain maximum access to China’s market, securing a parallel supply chain uncontrolled by the PRC not only protects South Korea’s capacity to compete effectively outside China but also its freedom to choose the most effective national defense strategies. “China’s retaliation is undermining Korea’s sovereignty, and there can be no bigger threat to any country,” according to an editorial in South Korea’s Chosun Ilbo newspaper. More recently, China responded to Australia’s support for an investigation into the origins and transmission of the COVID-19 virus by restricting imports of Australian barley and beef and threatening broader restrictions and a consumer boycott. The trade-offs are the same for India, the Association of Southeast Asian Nations member states and Taiwan. China has repeatedly used economic leverage to pressure other countries to compromise their diplomatic independence and military security. Countries that work together economically will preserve the strength and independence necessary to act together to protect their security.

Broad economic and security cooperation among the U.S. and its allies and partners, particularly in the Indo-Pacific region, is the only realistic response to the economic challenges and geopolitical threats posed by Xi’s China. Economically, protecting a broad, open and competitive supply chain largely independent of China will preserve economic autonomy and strength. This best protects military capacities and strategic and diplomatic flexibility, maximizing the capacity of regional coalitions to deter military threats. Such economic independence and military security are necessary to preserve Indo-Pacific governments’ freedom of action to define and protect their national interests as they see fit.