The US-China relationship has deteriorated in the midst of the COVID-19 pandemic. What does this geopolitical rivalry mean for the global economy and markets?
In 1971, US National Security Advisor Henry Kissinger secretly flew to Beijing to meet Chinese Premier Zhou Enlai. It was the beginning of a thaw in US-China relations that culminated in Richard Nixon’s historic summit with Chairman Mao the following year.
During the meeting, Kissinger asked Zhou for his views on the French Revolution of 1789. Zhou replied, “It is too soon to tell.” Reported later, the comment became famous for revealing the long-term vision of China’s leadership – but it was actually the result of a misunderstanding. Zhou thought Kissinger was asking about the more recent civil unrest of 1968, which started in Paris before spreading around the world.1
The anecdote is worth pondering today, as US-China relations plunge to their lowest point since the Cold War. As in 1968, a flu pandemic has inflamed existing social and economic tensions. The relationship between the two powers is once again clouded by rancour and misunderstanding. So what are the implications for the global economy and financial markets as the world emerges from the COVID-19 crisis? And what are the chances of a new geopolitical détente?
Geopolitics and COVID-19
Geopolitical risk in 2020 is not limited to the US-China dispute. Before the coronavirus crisis, headlines were dominated by the threat of war between America and Iran. In early January, the US assassinated a prominent Iranian general, Qasem Soleimani, in retaliation for an attack on its embassy in Iraq. An armed conflict – or at least an acceleration in Iran’s nuclear programme – looked possible.2
The US-China relationship has deteriorated in the midst of the COVID-19 pandemic
The fragile situation in the Middle East was further destabilised by Saudi Arabia’s decision to ramp up oil production to win market share from other suppliers in early March, a move that caught global markets by surprise and sent the price of crude tumbling.
The pandemic has diverted attention from these events. Iran is among the countries worst hit by COVID-19 and has had to focus on its domestic health crisis rather than foreign policy. Saudi Arabia agreed a deal with the Organisation of the Petroleum Exporting Countries (OPEC) to cut oil supply once the scale of the virus-related collapse in energy demand became clear.
Meanwhile, the US-China stand-off has taken centre stage. President Donald Trump has blamed the Chinese government for the outbreak, dubbing COVID-19 “the China virus” and disseminating the unproven theory that the pathogen was created in a Chinese lab. For its part, the Chinese government has claimed the coronavirus is the result of an American plot.3
With both powers intent on deflecting scrutiny from their handling of the pandemic at home, the war of words threatens to grow to the point where it materially affects their economic relationship, hampering the global recovery from the crisis.
This is no longer simply a trade dispute. It’s much broader than that
“Trump has fallen in the polls, the economy has been hit and being tough on China is a vote winner in the US: that’s a large part of why this has come to the foreground now. This is no longer simply a trade dispute. It’s much broader than that,” says Harriet Ballard, senior multi-asset strategist at Aviva Investors in London.
Spheres of influence
The trade war started in 2017, when the new Trump administration started putting tariffs on Chinese goods; ostensibly to rectify a trade imbalance and to retaliate for the supposed theft of intellectual property from American firms.
After intensive negotiations, the two countries reached a bare bones “phase one” trade deal in January 2020, under which the US cut some tariffs in exchange for a Chinese promise to increase its annual spending on American products by $200 billion. Beijing also pledged to do more to safeguard the IP of foreign firms operating in China.4
Pundits expected the two sides to build on this pact with a more comprehensive deal that Trump could tout to his voter base in the run-up to October’s presidential election. But the coronavirus pandemic has put paid to this view: there is now “a near-zero chance” of a phase-two deal this year, argues Ballard.
A major point of contention between the two countries is the planned US investigation into China’s handling of COVID-19
A major point of contention between the two countries is the planned US investigation into China’s handling of COVID-19. On May 12, Republican Senator Lindsey Graham introduced the Chinese Government COVID-19 Accountability Act, legislation that would authorise Trump to slap wide-ranging new sanctions on China if it failed to give a full account of the events leading up to the emergence of the virus in Wuhan in late 2019.5
On May 31, Trump provoked China further when he announced his intention to expand the next meeting of the Group of Seven countries (Canada, France, Germany, Italy, Japan, the UK and the US) to include Russia, India, Australia and South Korea – all nations that have sought to resist growing Chinese influence in Asia. The move was seen by many commentators as an attempt to coordinate regional efforts to contain China.6
“The main objective is to bring together like-minded countries in a coalition that will handle high technology, pharmaceuticals, defence cooperation and intelligence sharing, to diminish the dependence on China and China’s supply chains,” says Parag Khanna, managing partner of consultancy FutureMap and author of The Future is Asian (2019).
This strategic approach is not new; it builds on previous administrations’ efforts to develop the Quadrilateral Security Dialogue (or “Quad”), an informal strategic alliance between the US, India, Australia and Japan. This sort of multilateral approach to containing China would probably continue if Trump’s Democratic rival Joe Biden becomes president, but tensions will persist whatever the outcome of the election.
“Should Biden win, his advisers are likely to try to pursue a limited reset in the relationship, but expectations of what could be accomplished are low,” says Jeffrey Wright, senior analyst in US foreign affairs at Eurasia Group, a political risk consultancy. “There is simply a structurally higher level of tension between the two [countries] than there was in the Obama years.
“A Biden administration would presumably be more interested in multilateral solutions on issues like climate change, which opens some new avenues for cooperating with Beijing. But on issues like tech competition, geopolitical disputes, and some trade issues, there’s not much Biden can do to put the genie back in the bottle,” Wright adds.
For its part, China is seeking to build a parallel network of strategic alliances through its ambitious Belt and Road Initiative, a series of infrastructure projects across south and central Asia.
A new Cold War?
So where could this manoeuvring lead? Harvard professor Graham Allison has argued the US-China rivalry is an example of the “Thucydides Trap”, which occurs when a rising power threatens the established hegemon. The historian Thucydides observed this scenario in ancient Greece, when Sparta challenged Athens, and the dynamic has been repeated throughout the centuries. Allison argues war is often the result, sometimes due to the unpredictable actions of third parties.7
There is a risk a flashpoint may occur as a consequence of territorial sabre-rattling between China and a US ally
In the current situation, there is a risk a flashpoint may occur as a consequence of territorial sabre-rattling between China and a US ally such as Japan, Taiwan or India, especially if certain key resources become scarce due to virus-related supply chain disruptions. In early June, the disputed Himalayan border between China and India was the site of a brutal confrontation that resulted in the deaths of at least 20 Indian soldiers.8
Michael Hirson, practice head of China research at Eurasia Group, says a military confrontation between the US and China is a realistic possibility, but probably only as the result of an accident or a miscalculation.
“The US and China have naval forces operating in close proximity in the South China Sea and Taiwan straits, so that risk is ever present,” he says. “As the relationship deteriorates, the risk becomes that the channels to deescalate a mistake have broken down, leaving leaders on both sides without an easy way to communicate in a crisis.
“That said, both sides want to avoid war at nearly all costs. The costs of such a war would be tremendous, so neither side would contemplate going to war unless a core interest is at stake,” Hirson adds.
China has become more bullish in seeking to expand and defend its territory under President Xi Jinping, building armed fortresses on reclaimed land near major shipping routes in the South China Sea. On the US side, there may be bipartisan support for policies that would escalate the conflict. Indeed, a recent Pew survey found 66 per cent of Americans have an “unfavourable” view of China, with more than 60 per cent seeing rising Chinese power and influence as “a major threat”.9
Khanna acknowledges the risk of a “localised conflict” between the two powers, if not all-out war. But he argues other countries will have a big say in the outcome, which is likely to be very different from the Cold War between the US and the Soviet Union, when the world was carved into two ideological blocs. Many nations in Asia are much more politically independent and economically powerful now than they were then.
The difference between the old Cold War and the new Cold War: there has been a learning process
“The world is not going to allow itself to be subsumed by a new US-China Cold War,” he says. “That’s the difference between the old Cold War and the new Cold War: there has been a learning process. Countries that are [said to be] ‘caught in the middle’ are not caught in the middle because they are too smart for that. They are going to play both sides. The losers probably wind up being the US and China, or one of the two.”
A more indirect risk is that the US-China rivalry undermines international institutions and frameworks that might have helped defuse future crises, making the global system more vulnerable.
“The one thing this pandemic should have taught us is that there is no wall high enough to keep out the great risks we face,” says Ian Goldin, professor of globalisation and development at the Oxford Martin School at Oxford University.
“What the US-China tensions are doing is further undermining those global institutions. No global problem can be solved without the collaboration of China and the US; not least pandemics or climate change. There is also the likelihood of lower economic growth, less likely reform of the World Health Organisation, greater poverty and rising inequality in the world.”
Colossal economic shock
What of the risk of an escalation in hostilities on the economic front? The US owes China around $1.1 trillion in Treasury bonds and could theoretically refuse to pay the debt.10 Similarly, China could sell its Treasury holdings en masse, which would cause a spike in the US government’s borrowing costs and unleash mayhem across financial markets.
Both courses of action would be enormously counterproductive. Cancelling US debt would precipitate a loss of confidence in US assets and destabilise the Treasury market. And China’s Treasury holdings are a vital plank of its macroeconomic management; it uses its vast US debt portfolio to hold down the value of the yuan against the dollar and keep its exports competitive.
The US owes China around $1.1 trillion in Treasury bonds
Ballard argues it is “highly unlikely” either side would go down this route, even though Trump has occasionally threatened to default on the debt. “Cancelling China’s holdings of Treasuries would be a colossal economic shock that would have a huge impact on the US Treasury market and global financial system,” she says.
In fact, the exchange of threats may make the overall economic and financial system more robust if it means both countries are motivated to identify and mitigate the risks of relying on the goodwill of the other side. That process might involve the US seeking to diversify its supply chains away from China, or China seeking to internationalise its currency to curb reliance on a potentially weaponised dollar.
“There should never be one point of failure in the system. Whether its America and the US dollar or China and supply chains, building a more distributed system is always a good idea,” says Khanna.
In the short term, a further decoupling of the links between the two countries is likely to bring economic costs. A World Trade Organisation study, published in February 2020, found continued US-China trade uncertainty could hit global GDP growth by 1.7 per cent over the next three years, due to knock-on effects on investment.11 Total Chinese investment in the US has already fallen sharply from recent peaks: in 2019 it stood at $5 billion, down from $45 billion in 2016.12
Supply chains are being unwound and key strategic industries brought home. Both the trade war and the pandemic have highlighted the vulnerability of complex supply chains to sudden disruption, which can hamper delivery of essential goods. Anecdotal evidence suggests some production of active pharmaceutical ingredients, or APIs – which are predominantly based in China – is already being re-shored to the US due to political pressure.13
Global investors will need to constantly monitor the status of these political relationships to ensure their portfolios will stay resilient
As these trends accelerate, global investors will need to constantly monitor the status of political relationships, trade pacts and supply chains to ensure their portfolios will stay resilient. New winners and losers will emerge. Southeast Asian economies such as Vietnam and Indonesia have successfully attracted business from companies seeking to move factories out of China, for example.14
On the corporate side, “a diverse set of customers and suppliers can help companies withstand sudden shocks”, says Alistair Way, head of emerging market equities at Aviva Investors. He cites China-based Apple supplier Hon Hai as an example of a company that has taken care to ensure its customer base is properly diversified amid rising political and economic uncertainties.
“Hon Hai’s core business – assembly of Apple’s iPhones – may be vulnerable if demand for consumer gadgets slumps. But the company also makes telecoms infrastructure, servers and medical equipment, thanks to a concerted effort by its management to increase the scope of its business in recent years. This strategy now looks spot on.”
Where there’s a will…
Other technology firms may be more vulnerable to an escalation in the US-China stand-off, notably Chinese tech giant Huawei, which is at the centre of a controversy that encapsulates many of the points of contention between the two powers.
The US has accused Huawei of technology theft (or “forced technology transfer”) and political surveillance; its critics argue it is effectively a pawn of the Chinese government. For others, the firm symbolises China’s emergence as a sophisticated, tech-savvy superpower. Huawei is a global leader in artificial intelligence and 5G technology and files more cutting-edge patents than any other firm.15
The US has long sought to curtail Huawei’s influence
The US has long sought to curtail Huawei’s influence and sees the company’s supremacy in 5G telecommunications infrastructure as a security risk to itself and its allies. A new law announced on May 15 imposes stricter export controls on companies doing business with Huawei to limit its access to advanced US semiconductor technology. In response, China announced new restrictions on tech firms operating within its borders, including Apple, Cisco and Qualcomm.16
The full implications of the new US law for overseas firms – and American companies that supply chips indirectly to Huawei – are unclear, and enforcement of the new rules could be difficult, opening up some wiggle room for companies that can stay agile.
Some industry giants have already started shifting operations. Taiwanese chipmaker TSMC – which earns 15 per cent of its revenue from Huawei – announced in May that it would build a $12 billion factory in Arizona, perhaps as a way of circumventing US sanctions.17
“Taiwanese companies in particular are being forced into quite a difficult position, given their close relationships with both the US and China. In the shorter term it is probably easier to go along with the American rhetoric, given the unpredictable nature of Trump this year, but over the longer term, countries and companies need to set that against the huge economic importance of China,” says Way.
“Does it make sense to pick sides with the US? For the bulk of the world, the benefits of being compliant with the US while alienating China are not clear,” he adds.
A better tomorrow?
As well as industrial disputes, rising tensions could lead to fractures in the financial networks that have proliferated between the US and China in recent years, as the Asian power has sought to open its markets to foreign investors.
The picture is complicated by the ongoing civil unrest in Hong Kong, traditionally the gateway to mainland China for overseas institutions. A new security law designed to assert Beijing’s control calls into question the territory’s autonomous status, and Trump has threatened to revoke Hong Kong’s special trade privileges on that basis. In retaliation, Chinese officials accused the US government of hypocrisy, pointing to Washington’s crackdown on domestic protests following the killing of George Floyd, an African American man who died in police custody.18
Ballard argues that while Trump’s threat is creating uncertainty among US businesses operating in Hong Kong, and could lead to targeted sanctions on certain individuals or businesses, “it is unlikely to bring about any substantive change in the territory’s position, either as an export hub or as a financial access point to mainland markets. It’s not clear whose interests that would serve”.
Given the precarious nature of Hong Kong in the current environment, the picture could change quickly
In fact, the territory may benefit economically over the longer term from the tensions between the US and China if mainland companies are forced to delist from US exchanges and move their primary listing to Hong Kong. The implications for emerging-market investors could be significant.
“A forced delisting of a large swathe of the Chinese equity market away from Nasdaq to Hong Kong would be massively beneficial for trading volumes on the Hong Kong Exchange,” says Way. “It would shift the centre of gravity of emerging market investing much more locally. But given the precarious nature of Hong Kong in the current environment, the picture could change quickly.”
With the direction of the future uncertain, Way argues investors in the region would do well to ensure their portfolios are resilient in a range of adverse scenarios, and not simply geared to benefit from a specific geopolitical development.
As for the longer-term consequences of the hazardous US-China rivalry, the smartest response may be to follow the lead of Zhou Enlai and conclude it is too soon to tell.