The Pieces Are in Place for a Grand Bargain With China

Trade war is hurting everyone, but it has a geopolitical solution.

The South China Sea (C) is seen on a globe for sale at a bookstore in Beijing on June 15, 2016. 
(GREG BAKER/AFP/Getty Images)
The South China Sea (C) is seen on a globe for sale at a bookstore in Beijing on June 15, 2016. (GREG BAKER/AFP/Getty Images)

When Chinese President Xi Jinping and U.S. President Donald Trump meet for the third time in Buenos Aires this week, it will be the culmination of many intense months of work on both sides to try to overcome the current economic, political, and security tensions. Both sides have paid a sharp cost for these tensions, as have many of the countries caught in the conflict. The size and complexity of the relationship, and the sheer number of areas it touches on—from soybeans in Iowa to island-building in the South China Sea—demand a “grand bargain” between the two powers: a deal that involves multiple areas for an outcome that ultimately benefits both sides.

Based on my conversations with senior figures on both the U.S. and Chinese sides, the key elements of this bargain are likely to be both boringly predictable in the directions the situation would have to move toward and potentially surprising in how some of these directions manifest themselves.

First, it is likely that we will see substantially reduced military tensions in the South China Sea, through less confrontational U.S. Navy activities and plateaued Chinese installations on rocks and islands.

By now, through intensified construction of maritime structures over the past few years, China has almost fully achieved its goal of firming up its presence in the disputed areas, which was paused by Deng Xiaoping in the late 1970s when the Chinese leader decided to “set aside dispute and pursue joint development.” In other words, while Deng intentionally paused the effort to maintain and to strengthen China’s long-standing historical claims to the “nine-dash line” area of the South China Sea during the initial decades of Chinese economic development, Xi caught up.

It’s true that China has measurably intensified its quasi-military island-building activities in the South China Sea. While China’s claims are based on sovereignty, and there are some security interests, China’s main intention and interests in the region are principally economic. While it is perfectly normal for the United States to use “freedom of navigation” as the reason for its naval presence in the region and a seat at the table on the disputes, and Chinese rhetoric has sometimes been worrying, there has been no actual attempt by China to impede freedom of navigation in the South China Sea. China places a lower emphasis on the strategic significance of the South China Sea than it does on the Taiwan Strait or the Korean Peninsula.

The most beneficial solutions to all parties that have claims in the region are under the umbrella of joint exploration and economic development, not through military confrontation. To further understand Beijing’s perspective, it is useful to highlight that it understands well that military solutions never solve political or economic problems. China had spent a big stretch of the 19th and 20th centuries on the receiving end of colonialism and foreign military invasions, from the Opium Wars to the Japanese occupation during World War II. While nationalists use this history for a narrative of national humiliation, the real consensus in China is that while military superiority might temporarily prevail, it does not bring long-lasting solutions.

From the U.S. perspective, its superpower status has been built on far more than its past willingness and ability to supply a security blanket to the rest of the world. Its dominance has also been grounded on the weight of its economy, the centrality of Wall Street in global financial markets, the use of U.S. dollars as the world’s main reserve and trade currency, the universal reach of its ideology and culture, and the advanced technologies accumulated in its defense industry, Silicon Valley, and research institutions.

The supply of a security blanket to the world—especially to faraway territories with no direct strategic or security relevance to the United States— is the most expensive and least effective way to maintain its superpower status, as evidenced by the pointless interventions in many parts of the world. Softening such a stance in the South China Sea would cost the United States nothing and would in fact trigger a regional grand bargain among the claimants and neighboring countries based on shared economic interests.

In short, to China, military presence in the South China Sea is a means to an end. To the United States, it is a means to no end. Reduced tensions, by both sides shrinking their military presence, serves both sides.

Second, China has to stop the prevalent theft of intellectual property, but less so because of moral reasons and more because it is now in China’s self-interest to do so. Since the opening up and reform started in the late 1970s, the Chinese economy has operated for many years using “late-mover advantage” and by copy-and-paste rather than through innovation. The running joke in China is that the best Chinese business model is not B2B (business to business) or B2C (business to consumer) but C2C (copy to China). Such a development model no longer suits China’s next stage of development and its ambition to become a high-income country by 2025.

China has consistently recorded double-digit patent application growth since 2003. In 2017, China was the second-largest filer of patent applications, with the United Nations forecasting that China would overtake the top spot from the United States in three years. While the quality of some of these patents is questionable, the efforts that China has put into technological innovations are clear. The three Chinese technology giants—Baidu, Alibaba, and Tencent—have a combined market cap of $1 trillion, with Tencent surpassing Facebook in valuation last November. It is now in China’s self-interest to strengthen protection of intellectual property, whether foreign or Chinese.

Third, the U.S.-China trade deficit will almost certainly come down, because it is the interests of both China and the United States to rebalance the trade dynamics. Additionally, it is long overdue for China to further open up its markets for foreign investments. For example, I believe the Chinese banking sector will open to 100 percent foreign ownership in the near future.

China has been trying for years to promote domestic consumption, and the role of increasing domestic consumption in its economy is finally becoming visible. The savings rate came down from 52 percent in 2010 to 46 percent in 2017, and household leverage ratio—the ratio between debt incurred by families and gross domestic product—has increased significantly from 18 percent in 2008 to 49 percent in 2017.

Chinese consumers have woken up to their spending power. These consumers range from retirees, who are now more confident of their pensions and health care as retirement, social security, and health care systems slowly mature, to millennials, who just want to spend and to experience life before they save. As the Chinese middle class continues to consume more and to improve their living standards, buying more American goods, sending more tourist dollars to the United States, and paying more for U.S. education is only natural. The Belt and Road Initiative will also create additional markets for Chinese goods and capacity in Africa, Central Asia, and other such markets, hence reducing China’s dependence on exports to the United States.

Additionally, rather than manufacturing more iPhones in Chinese factories and receiving a miniscule share of the profits, China would be better off producing Xiaomi phones in the United States or in Vietnam, owning the design and core technology and getting a bigger piece of the economic pie. Upgrading Chinese industry is a bigger priority than keeping all productions domestic. As a result of all of these factors, China will buy more from and sell less to the United States.

Fourth, while Trump’s economic team has repeatedly assailed Premier Li Keqiang’s “Made in China 2025” plan, I argue that it is here to stay. While the United States sees the state’s role in the Chinese economy as inefficient and the main basis for creating an uneven playing field between Chinese and foreign firms, China sees the role of state differently.

The power of free markets fundamentally lies with the signals and feedback markets create. Such signals and feedback in turn improve the efficiency of resource and capital allocation. The Chinese political and economic system, however, has historically centralized far more power at the top and also has in practice installed elaborate feedback loops for both political and economic signals. The Chinese economic system after Deng took control in 1977 is also notoriously agile, allowing trial and error at all levels of government economic policy, without ideological baggage.

Accompanied by these feedback loops as well as trial and error, the state’s role in China’s economy is thoughtful and intentional. The state also directs resource allocation that may look economically inefficient but is socially necessary, for example to manage unemployment in a phased fashion.

The Chinese economic system is a powerful one that combines a long-term mindset, top-down intentionality, bottom-up feedback loops, local experiments, and agility. It has worked for China for over four decades. This is not something Xi would abandon.

A grand bargain that involves less tension in South China Sea, enhanced efforts by China to respect intellectual property, increased market access in China, and a reduced U.S. trade deficit without China having to fundamentally alter the role of the state in economic planning in the short term seems to be a reasonable package of give and take. The global economy and many countries in this region are better off with this deal than enduring continued uncertainty from the trade war.

Dr. Kevin Lu is a Distinguished Fellow at INSEAD and a member of the Financial Centre Advisory Panel (FCAP) of the Monetary Authority of Singapore.

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