This article first appeared in Forum, The Edge Malaysia Weekly on July 9, 2018 - July 15, 2018

The US is likely to go ahead with tariffs on US$34 billion (RM137 billion) worth of Chinese exports on July 6, with a further US$16 billion worth of Chinese exports at risk once public hearings are completed. China has made it clear that it will retaliate in kind, which prompted US President Donald Trump to vow even heftier tariffs in return. Canada has already imposed tariffs against US exports in retaliation for US tariffs on steel and aluminium. The European Commission has told the US Commerce Department in no uncertain terms that if the US persists with planned tariffs on European Union cars and auto parts, the EU would enact counter-measures that would hit a broad swathe of US exports to the EU.

So, trade tensions are escalating into trade skirmishes. These may end up in a full-blown trade war if misjudgements are made by leaders such as Trump or Chinese President Xi Jinping. If the issues were purely about trade, this risk would be low. But, trade is highly politicised and, certainly as far as the US and China go, the issues extend beyond the economic domain into big power struggles for strategic advantage. That makes a straightforward resolution of trade squabbles harder to achieve, but not impossible.

US-China strategic rivalry is set to worsen, complicating the trade issue

Trade tensions are worsening just as some of the fundamentals underpinning the US-China relationship have deteriorated:

• China’s new foreign policy framework: Xi presided over the China Foreign Affairs Work Conference earlier in June, only the second such conference in recent years. At the conclave, he signalled a hardening of China’s foreign policy approach, reflecting his confidence that history was on China’s side and that the country had an opportunity to reshape the international order. Xi said China should “lead the reform of the global governance system with the concepts of fairness and justice”. Basically, this means that China has more at stake than just exports in this clash with the US — it is Xi’s more muscular foreign policy that is at stake. China cannot back down unless the US also compromises.

• High-level meetings yield no progress: US Secretary of Defense James Mattis, on his visit to China, got a taste of this new Chinese assertiveness. He insisted that his talks had been “very, very good”, but Xi’s statement suggested otherwise. Confronted by Mattis on Chinese militarisation of the South China Sea, Xi pointedly restated his view that there would be no concessions from China. “We cannot lose even one inch of the territory left behind by our ancestors.”

• Warning signs of more bugbears in US-­China ties: The Taiwan issue could again become a source of tension. China has rebuffed the US State Department’s request to discuss China’s demand that US airlines refer to Taiwan as a part of China. The Trump administration is also reported to be considering sending US Marines to guard its de facto embassy in Taipei, the American Institute of Taiwan, treating the institute on par with its embassies around the world, something that is bound to annoy China. The Chinese have always maintained that a sound US-China relationship depended on the Americans appreciating their sensitivity on Taiwan. Media reports that the Trump administration is considering sending an aircraft carrier battle group to transit the Taiwan Straits add to the growing sense of a widening gulf between China and the US.

China is preparing for the worst

Over the past few weeks, China has introduced a series of measures that will strengthen China’s buffers in the face of the US administration’s aggressive trade actions. Reserve requirements have been cut, the renminbi has been allowed to depreciate at the fastest pace since 2015 and personal taxes are to be cut so as to boost domestic consumer spending.

But China is also signalling a willingness to reform its economy so as to meet some of the demands from the US, Europe and other trading partners. It will ease, ahead of schedule, caps on foreign ownership that are part of its much-criticised “negative investment list”, which limits foreign investment in several industrial sectors. A slew of tariff cuts has also been announced by the authorities, who appear keen to highlight the difference between a China that is opening up and a US that is closing itself off. Chinese policymakers have been pushing its companies to step up purchases from abroad, resulting in a surge in imports that led to China’s first quarterly current account deficit in at least 20 years in the first quarter of the year — a development that undercuts the Trump administration’s claim that China is a mercantilist trading nation only interested in accumulating surpluses at others’ expense.

We should expect China to demonstrate over the next few weeks that it has more options to respond to further US trade restrictions than the Trump administration thinks. China knows that there is a limit to how many more tariffs it can place on US exports to China, since it has few substitutes to replace US exports such as soybeans, Boeing aircraft or high-tech components. So, it will have to use other measures such as further renminbi devaluation, measures to impede the operations of US companies in China and limits on US services exports to China. China can also ease up on its sanctions on North Korea, which would ­strengthen the latter’s bargaining position vis-à-vis the US.

But, whatever China does will have costs for its economy, which is why it will remain open to a face-saving compromise.

Will there be a compromise eventually?

In short, there is now a complex negotiating game going on between China and the US, with each testing to see how much it can push the other, not just on trade but on other matters such as Taiwan. That will make for a tense few months ahead. Whether that morphs into a much more dangerous confrontation is made less likely by the high price that both the Chinese and the Americans know they will pay if they allow the conflict to escalate. In fact, Trump’s record suggests that a compromise is possible.

China would have noticed a pattern in Trump’s negotiating behaviour. While noisily opening a negotiation with big demands, he tends to backtrack when he faces strong opposition from within his own support base or if the likely costs of his actions turn out to be greater than he anticipated.

This is why he backtracked from previous plans to impose stringent restrictions on Chinese investments in US tech firms. Instead, the US will widen the powers of the existing Committee on Foreign Investment in the US: The net effect will still be to toughen foreign investment controls but without explicitly targeting China.

The Trump administration also has to contend with US corporations that are mobilising resources to pressure the administration into reversing its hostility to trade. For example, the American Institute for International Steel has lodged an action in the US Court of International Trade to have the 1962 statute that Trump used to impose steel tariffs ruled unconstitutional. Harley Davidson’s decision to shift production abroad in response to worsening trade tensions embarrassed Trump, who had originally praised the company. The corporate reaction has encouraged the few remaining moderates in the administration to resist an escalation of trade confrontations, creating divisions with the administration.

Over the next few months, the US administration will find that its trade policies have succeeded in uniting allies such as Europe, Canada and Japan, emerging allies such as India as well as strategic rivals such as China against it. That is an untenable position for an overstretched superpower facing challenges in many areas of vital strategic interest, from the Middle East to North Korea. Unless it steps back from its confrontational stance, it would find it difficult, if not impossible, to manage these flash points.

So, barring a gross error of judgement, a full-blown trade war is still less likely than some form of compromise.

What should Southeast Asia do?

Even if an all-out trade war is not likely, it is clear that protectionism will grow. Because this region runs a trade surplus with the US, it is vulnerable to this protectionism. And since it is so integrated into value chains that include China, its interests could be hurt in many other ways.

First, it needs to step up economic integration within Asean itself so that it can stand up to the big powers with a stronger bargaining position. This means giving more teeth to the Asean Economic Community, which was declared effective two years ago but has fallen far short of its promise. Smaller-scale integration initiatives such as cross-border partnerships (for example, the Iskandar region between Malaysia and Singapore) should also be encouraged. However, for Asean to regain its capacity to produce meaningful economic integration, more leadership is needed from core members such as Indonesia.

Second, regional countries should also work harder to ensure that broader trade agreements are concluded. Negotiations on concluding the Regional Comprehensive Economic Partnership have stalled, for instance, as a result of deep disagreements over issues related to movement of people and intellectual property. But, the RCEP will create an East Asian and Pacific trading region independent of the US, which could give some buffer to the region in the case of worsening US protectionism, so compromises need to be found to expedite the RCEP. Those regional countries involved in the Comprehensive and Progressive Trans-Pacific Partnership should hasten to ratify it, as that will strengthen their hand in any trade negotiation with the US.

Third, efforts should be made to boost domestic demand in case trade conflicts limit exports as an engine of growth. The big infrastructure push already underway can be further accelerated while fiscal incentives can be used to stimulate private investment. Existing fiscal resources can be used more effectively through measures to cut back on wasteful spending, as the new government in Malaysia is doing.

Finally, growing concern among multinationals about protectionism directed at China could make them more open to shifting production to Southeast Asia, at least in some sectors. The region should take advantage of such shifts in corporate strategies — its investment promotion agencies should be stepping up incentives to attract such foreign investment into the region.

The bottom line: The region cannot sit passively in the face of expanding threats to the international trade that has nourished its economic rise.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

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