Have Beijing’s mercantilists met their match?
Trump government places China in check.
View from China with an Austrian School of Economics Perspective
Last night China time, master showman Donald Trump announced on his Truth Social account that starting today April 8th, the United States would be raising its tariffs on Chinese products by another 50%, i.e. from 54% previously to 104%.
Though a stretch, last week’s announcement of a net 54% tariff (20% + 34%) might somehow be plausibly in the realm of possibility. 104% clearly is not, at least not long-term. This ought to confirm that this is nothing other than a Chess move, and this last move surely qualifies as placing China in check.
With that in mind, let’s look at the bigger picture here.
What is in play?
First of all, while it may seem that this is USA versus the world, recent events point to a different conclusion; namely, that the real target is China and its mercantilist policies.
US administration officials such as Treasury Secretary Scott Bessent have said as much, and are worth listening to. By theoretically imposing tariffs on the whole world, the underlying message is that the US will block the efforts of China’s exporters to redirect their exports via third parties such as Vietnam and Mexico, what is typically called “转口出口” in China.
These efforts in conjunction with the tariff exception for goods priced at under US$800 led to the previous set of Trump tariffs ultimately having very little effect on the net flow of goods from China to the US. Moreover, as Bessent said in his recent talk with Tucker Carlson, the events of 2020 made the complete dependence of the US supply chain on China utterly impossible to overlook. Though he didn’t say it, we can also guess that the ongoing war between the US and Russia reaffirmed the stark implications of this dependency. In reality, if China were to cut off the US, its wars on Russia, Yemen and Gaza would quickly become unsustainable.
The conclusion seems to have been a decision that something had to be done about this, cost what it may.
The problems with re-shoring
The #1 problem of course is that this “re-shoring” or reindustrialization plan is easier said than done, especially when one is extremely skilled at (and used to!!) depending on financial wizardry to keep the economy running.
Many observers fail to appreciate the incredible talent of the financial engineers behind this, who manage to keep things going despite levels of trade imbalances which – with one possible exception – are probably historically unprecedented. That exception was the enormous trade deficit accumulated by the Spanish Empire in the wake of its massive imports of silver into the European economy 500 or so years ago. That deficit ultimately led to mass poverty in Spain and its collapse as a European power. It bears remembering that it took Spain 400 years to recover.
It’s important to realize that efforts to reduce Western dependence on China-based production sites have been in place since the Obama Administration days. That’s when the first directives arrived at Japanese, American and European MNC headquarters in Asia to relocate a significant share of their production out of China. Needless to say, none of those directives panned out in any lasting fashion. Yes, some production was set up outside of China, and some trade flows were redirected via 3rd parties, but none of these efforts could change the basic facts:
China controls the supply chain for most industrial, chemical and manufactured goods. So even if you move your factory to Mexico, India or Vietnam, you’re almost certainly still going to be dependent on inputs coming from China.
China has by far the largest internal market of any country in the world.
China has the most efficient production in the world, with over 50% of all industrial robots.
China has more skilled labor than any other country in the world (by far!!).
China’s exchange rates are currently set at a level which make the production of most industrial and manufactured goods everywhere else in the world uncompetitive.
These facts make relocating production to places outside China difficult, regardless of what orders come down from above. Given the current exchange rate, the enormous financial incentive to simply move around and camouflage Chinese production is usually too powerful to resist. Nonetheless, the Western PTB seem determined to try it anyway.
While extremely difficult and perhaps arguably hopeless, it is worth mentioning that one country has recently proven that “re-shoring” is doable, albeit under very very unusual conditions. That country is Russia. Russia accomplished this thanks to three years of war + a lot of help from the West in terms of strict sanctions enforcement. Without the West’s help, Russia could never have accomplished this. Reindustrialization means investing in factories, and this requires entrepreneurs. Governments cannot replace them. But entrepreneurs don’t invest their time and money without confidence in the future. It turns out that the anti-Russia sanctions, most of which were de facto supported by China, created precisely the conditions needed to give entrepreneurs the confidence to make reindustrialization a reality. Can the United States possibly reproduce such conditions to engineer its own reindustrialization?
The situation on the Chinese side
Before we consider that, let’s take a look at the situation in China.
Within China, we have a government which has heavily invested in infrastructure, perhaps not always with high immediate levels of return, but mostly with real positive effects on standard of living, productivity and property values. Despite recent stagnation, average wages have risen almost 150% in the past 10 years, with manufacturing sector wages now around 3 times the levels in neighboring countries such as Vietnam or Thailand.
China has to an extent (though less so than prior to 2013) retained its decentralized structure and permits cities and provinces to continue to compete against each other in terms of policy framework. It has avoided many of the awful destructive policies rolled out by Western countries such as the promotion of mass illegal immigration which have led to high levels of crime and decreased quality of life. It has also avoided the type of concentration of corporate control over the economy which has been attained in the West by BlackRock and its associated funds. And despite some highly damaging bouts of interventionism and a renewed affection for central planning, on average it still offers its entrepreneurs higher levels of predictability and stability than the West.
Yet at the same time, we have a national government deeply committed to what is effectively a starkly mercantilist trade policy, maintaining an external exchange rate which values its currency far under what would be a market-clearing level. As a result of this policy, China is now running an annual trade surplus of 1 trillion US dollars, tendency rising. Exports make up approximately 20% of GDP and foreign countries are finding it increasingly difficult to compete with Chinese companies within a wide range of sectors.
Despite this absurdly high gap between imports and exports, the central bank, the People’s Bank of China (PBoC), stubbornly refuses to consider any adjustment to a more realistic level. Basically the message to the rest of the world is: we plan to continue to dominate production of essentially all industrial goods and give away the stuff in return for vague promises of repayment in the form of increasingly worthless US dollars.
Why? Well, we can only guess, but the most plausible explanation is probably that it’s ultimately due to a failure of imagination. This is a very common phenomenon among central planners, and we clearly have a number of these in China. They come up with industrial development plans, for example for the solar power industry, or for the electric vehicle industry, and provide a combination of directed venture capital funds (行业引导基金) and other preferential conditions to foster investment in that industry. In combination with China’s highly competitive entrepreneurial class and world-leading supply chain, this typically leads to the complete dominance of these industries worldwide and in many cases overproduction. Investment in other industries is crowded out. To be clear, this is not a case of the “CCP” running these companies, as it is often laughably characterized in the West, which would never work. But it is a case of companies responding to incentives, in this case effectively government handouts.
The result? Huge government deficits, rapidly rising government debt, lots of money printing for internal spending and to buy up all those dollars, a real estate price bubble which eventually collapsed, depressed conditions outside of the favored industries, widespread reluctance to hire new staff and generally terrible business sentiment. Instead of investing domestically, private sector funds have tended to either go to non-productive sectors (like renovating luxurious homes), or to Wall Street. There they can pursue the higher interest rates on offer and/or play the world’s leading casino for capital. This is despite the fact that China’s highly mechanized production machine continues to churn out the widgets and dominate industry worldwide.
If we look back to the past 20 months since we published our gloomy business outlook in August of 2023, not much has changed.
China’s Economy – The Good, the Bad and the Ugly (Part 1)
View from China with an Austrian School of Economics Perspective
At the time we wrote that Keynesian policies and interventionism are ultimately at the root of China's economic woes. One might add to that artificially low interest rates. Banks and second tier loan intermediaries are desperate to lend out funds, but aren’t finding many takers. Last year it often seemed that half of all the small offices in Shanghai were filled with call centers hawking loans, though since then many of these have gone bankrupt. As any Austrian economist could tell you, artificially low interest rates rarely lead to flourishing economies; on the contrary, they tend to lead to funds flowing elsewhere. In a way, one could say that China seems to be doing its best to replicate the disastrous policies adopted by Japan over the past 20 years, albeit on a much grander scale.
The analysis we supplied in 2023 is just as much the case today, except that – to its credit – in the wake of the Deepseek shock the central government seems to have finally realized that it depends on its private sector champions – both on its established companies like Alibaba and as well as on its upstarts like Deepseek – to keep the economy chugging and foster innovation.
Cutting-edge innovation is not the product of money alone, and in fact it’s often a relative lack of money which encourages radical ground-breaking progress. We saw this in the case of Deepseek versus ChatGPT. As mentioned above, the past few years have seen China primarily recycling its massive surpluses back to Wall Street, thus depriving local innovators of capital and forcing them to rely on ingenuity instead of massive investment. Ironically it turns out that there has been a real upside to this, while by contrast the far easier access to capital has arguably made Silicon Valley inefficient.
Unfortunately, at least thus far, this acknowledgement of the key role played by the private sector has not been accompanied by a willingness to allow that same private sector to decide what best to invest in.
How can China respond to the West’s “check” move?
Unsurprisingly, China’s initial response has been to pledge to counter the American tariffs with tariffs of its own. The problem with this is that China doesn’t import much stuff which is produced in the United States. It imports quite a few products made by American companies, but these are mostly made in factories outside the US, and thus not subject to counter-tariffs. What China does import are high value medicines, such as chemotherapy cocktails, as well as airplanes and agricultural goods. A company like Boeing might well be impacted, but high-priced medicines are basically immune to price adjustments, and as for the soybeans and alfalfa, well, they are unlikely to be decisive. Moreover, alternate suppliers for alfalfa may well prove hard to find.
So such face saving measures are unlikely to accomplish anything, a fact which no doubt Beijing is completely aware of.
So what can Beijing do?
The world economy does seem to be at a juncture in the road. At any juncture there are never only a few choices. There is no “either or”. Nonetheless we can arguably make out a few possibilities:
1) In the short term, the most likely response is for China to effectively do nothing, and wait for the US economy to start choking as prices begin to rise. Keep in mind however that many US importers are sitting on significant levels of stocks, so the impact of tariffs on prices is likely to be more gradual than immediate. There is of course already the usual rhetoric about focusing on other markets, propping up internal consumption and the like, but it doesn’t contain anything substantial.
We can guess that the Chess masters on the other side have already considered this possibility, and have some potential follow-up moves in the pipeline. At this point we can only speculate as to what those might be, but one of them might be to move towards building a new Western “free trade zone” which excludes China. Elon Musk already mentioned such a possibility with regard to an EU-US free trade agreement, though he left the part about excluding China unsaid. That is however the obvious implication. Such a united front would be quite difficult for China to ignore.
2) Looking a bit further down the road, one possibility is that China can essentially opt to eat the tariffs, primarily by further devaluing the yuan. This would mean reducing the exchange rate to an even more unrealistic level, say, 9:1.
This is along the lines of what US Treasury Secretary Bessent mentioned in his talk with Tucker Carlson.
Bessent mentioned a 4-4-2 split, with China paying for 40% via an adjusted exchange rate, the producers coughing up 40%, and the US consumers paying the remaining 20%. Such a split is probably fantasy, since there is no way that producers can pay this. However, the first part makes sense, since a fat currency devaluation by China with the proceeds diverted into US government coffers would obviously be attractive to a government like the American one with a $2 trillion annual deficit. Whether or not it would be likely to lead to the re-shoring the US is looking for is another matter, but it would be a way of further kicking the can down the road.
It bears noting that this is more or less what happened after the first round of Trump tariffs during the Trump 1.0 Administration, albeit on a much smaller scale, and notably without any progress towards re-shoring whatsoever.
3) There is however a more promising possibility, namely that the leadership in Beijing agrees to scale back its mercantilist policies. This would necessarily mean a major yuan revaluation, perhaps to something along the lines of 5:1 or maybe even 4:1. (The current exchange rate is around 7.34:1, i.e. one US dollar can be exchanged for 7.34 Chinese yuan.)
Any mention of a major yuan revaluation invariably leads to squeals of denunciation in China, with claims that this would inevitably result in disaster for China’s exporters. The prior experience of Japan and Germany, the world’s previous export champions, proves otherwise. High wages and rising exchange rates are in no way correlated with low exports. On the contrary. While adjustments to economic structures are inevitable, high wages and rising exchange rates can more than be compensated for by efficient structures and supply chain dominance. Prior to the advent of the Euro, the Deutsche Mark rose steadily in value vis-à-vis the other European currencies for decades, and during that same period, Germany came to dominate the European economy. Nor did a strong yen seem to interfere with Japanese export prowess prior to its introduction of Keynesian policies with low interest rates and a depressed exchange rate in the 1990s.
Moreover, for many industries there are no non-Chinese competitors with significant capacity, and even where they exist, they are typically dependent on Chinese inputs. This will not change regardless of where the exchange rate is set.
Would such a move be sufficient to reindustrialize the United States? Taken alone, certainly not. The supply chain issues will remain, and the United States has a long list of internal challenges it needs to deal with to make itself attractive to investors, one of most critical of which is the need for stability and predictability. Yet even under ideal conditions, all structural adjustments take time. Overnight changes are simply impossible, as even the most avid tariff advocates surely know. Nonetheless, a yuan revaluation would be a good start in right direction, and would help the world to gradually readjust to a more sustainable division of labor than what we have now.
In other words, both the historical record and the situation on the ground show that in reality, China has nothing to fear from permitting a market-driven exchange rate. But do the policy makers in Beijing realize this?
Quo vadis, Xi Jinping?
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