May 15, 2019
U.S-China Trade: Strategy
The real issues at stake
Odd about the trade talks with China is the failure, so it seems, of so many to see what’s really going on. Economists think it’s an economic battle (it’s not), while political analysts (e.g. everyone) think it’s about external politics or power (it’s not), while Jane Goodall thinks it’s about monkeys (ok, made that one up … but seriously, she probably does).
One time at IBM I sat with a V.P. who was negotiating a $100M deal, and he was apoplectic about what was happening. It was the last Friday in September — to people in business, that’s usually called “end of Q3” — and he wanted/needed to close the deal so it could be announced. The other side had just proposed a dozen changes to an agreement that had been in the works for months. Obviously the V.P. agreed to everything and (per IBM standard) big announcements and unreasonable promises were made. I explained to him the following, which happens to be what China pulled last week on Trump.
11 o’clock terms
So you’re almost at the end of a deal and the big picture is firmly in place, then you ask for several small changes that the other side wouldn’t usually agree to but … it’s so late in the game and they’re psychologically exhausted, so they’ll just agree. You bring up these terms at the last minute because earlier in the process they could have caused problems.
At the last minute, the Chinese reversed course on intellectual property protection. They thought they had an advantage because it was so late in the game — many news outlets reported that the two sides were preparing for the logistics of an announcement (you know, so both sides don’t accidentally wear the same dress to the big trade party).
11 o’clock terms work about 90% of the time and blow things up about 10% of the time — there’s often not much middle ground. It really is throwing a grenade into the conversation (well, no, not really). The key to making it work is that the terms introduced at the last minute can’t be fundamental to the agreement. In the IBM situation above, it was about some run-time cost details, uptime guarantees, etc. The fundamental project specs and numbers remained the same.
China simply misidentified IP as a non-fundamental term. (Sure, one could wonder how that’s possible, but consider how the Chinese treat IP and one can imagine that they couldn’t think it’s that important — they assume the issue for the U.S. is all financial).
Of course, the Chinese 11 o’clock strategy blew up. Trump didn’t bite. He assessed that time was on his side, which appears to be the correct assessment. Consider that 2019 U.S. GDP (a little above 2%) may actually be fairly close to real China GDP (actual probably close to 3%). Go back just a few years and suggest that U.S. and China GDP in 2019 will be very close to each other, and people would have congratulated you on your successful lobotomy. And Trump has waited out the clock on the WTO; the terms of all but one justice has expired, and the U.S. has blocked any more appointments. This effectively shuts down the WTO judicial process, which means that Trump is free to be tariff man without any international resolution mechanism.
Leverage
All deals are about leverage, and if you asked me to list the greatest levers in a deal, I’d say:
1. Willingness to walk away
2. Brand/Audience
3. Cash
4. Tech
I preached that list at IBM, mostly because IBM was always so desperate to sign anything — desperation is the opposite of “willingness to walk away.”
The willingness to walk away is very effective if (1) the other side isn’t willing to walk away and (2) your willingness is clear and present. On the other hand, if the other side is willing to walk away and you’re not — and both sides know it — then prepared to get screwed. That’s how you sign a deal for $250M that costs $300M to deliver (yeah that happened).
Trump knows this. He telegraphs it to the Chinese. He’s in no rush. That’s exactly the correct position (whether it’s true or not is irrelevant). The Chinese know this too, so while they seem desperate at times, they are very cautious about telegraphing it.
Endgame
China’s end game is social stability. That’s it. That may be achieved through financial success or nationalism or anything else, but China has had a very unstable few centuries and the powder keg of Chinese discontent ignites quickly, so Beijing is seeking internal stability above all else.
The U.S. position is property rights — it’s so fundamental to Western civilization that, after a certain point, a disregard for our property rights produces cognitive dissonance beyond repair. The West spent the better part of the 17th and 18th centuries elevating and deifying property rights as the paramount concern of government. (You may ignore the property rights of your own people, of course. FYI you know when you buy a building in China, you’re actually leasing the building for 70 years — you never actually own the building and you never own the land….)
Do note that economics may be a means to an end, but it isn’t the end in either case.
Finally, the advantages that no one discusses.
China has strict capital controls; China may offset tariffs by devaluing the RMB, but that would increase capital flight. That’s an existential threat … because that’s how economies collapse. Trump knows this.
Further, instability in trade causes manufacturers to source outside of China. That usually has no effect over a few months but starts to become a problem over a few years. Companies build relationships in Malaysia and the Philippines, source a few things … after a few years, a significant part of their business is in those non-Chinese countries. For the record, many of those non-Chinese factories are owned and operated by Chinese — so individual Chinese business people may not care or may actually encourage moving sourcing outside of China because that means they’re developing revenue streams outside of China (see: capital controls). Again, after a few years, you may decide to have your consumer electronics assembled elsewhere. If Mexico had its act together, this is a huge opportunity…
Existential Disadvantage
China is a net importer of both energy and food. The U.S. is a net exporter of both. At a basic social stability level of things, a healthy import/export scheme is more important to China. Re food:
Constant demand + decreased supply = higher prices (global)
Higher prices = increasing inflation (local)
Higher prices + increasing inflation = social unrest (local)
Social unrest = civil war (local)
Crazy? How many civil wars have the Chinese had the past two centuries? 5 or 6 depending how you count them. And Chinese civil wars are remarkably bloody. In fact, Chinese Vice premier Hu Chunhua recently said that Pork Ebola (African Swine virus currently sweeping Chinese pig farms) is highly problematic “as worries grow over the impact of rising pork prices on the economy and social stability.” For China, the issue is always stability.
Cause of the Arab Spring
Question: So what was the catalyst of the Arab Spring (which ignited 2–4 civil wars, depending on how you count them)?
Did people suddenly realize that they’re oppressed? Did they suddenly read about natural law? Did their terrible economies suddenly turn worse (Syria has always had a terrible economy).
Nope. The catalyst of the Arab Spring was the failure of the winter wheat crop in the Ukraine and surrounding countries. Prices for basic foods (bread but also everything else that relies on grains, which is a lot of things), spiked throughout the Middle East and North Africa, which imports most of its grain from Europe’s bread basket (Bulgaria and east). General oppression and lots of potholes are one thing, but expensive food is entirely another. Just ask the French.
The Chinese certainly know this, which is why swine ebola is such a potentially big problem.
“This is the biggest animal disease outbreak we’ve ever had on the planet,” Dirk Pfeiffer, a veterinary epidemiologist at City University of Hong Kong and swine fever expert, said. “It makes the foot and mouth disease and [mad cow disease] outbreaks pale in comparison to the damage that is being done. And we have no way to stop it from spreading.”
China is the epicenter of this problem — both from a ground-zero of the disease perspective and an economic impact perspective. China’s food supply relies heavily on pork and the country is home to half the globe’s pork supply.
Researchers at Rabobank are estimating that this year China will suffer a 30% loss in pork production as a result of ASF. To put that into perspective, that 30% loss in production is equivalent to Europe’s entire annual pork supply, and almost 30% larger than U.S. annual pork production.
30% of 700 million pigs slaughtered annually in China = 210 million fewer pigs. That’s a lot of missing food. Global pork prices have already risen 40% this year and Beijing has officially estimated that prices in China will rise by 70% by the end of this year. The top 10% of earners in China will be able to withstand rising food prices, but rising prices are a problem below that; and pigs don’t grow as quickly as wheat, so replacing them takes a fairly long time.
I’d wager a large sum that the above formulation — higher food prices can lead to war — is exactly what’s on Beijing’s mind. Beijing responds to Occupy Wall Street with the army because, while a concentrated power structure enables rapid ascent, it also enables rapid descent. Such non-distributed power structures prove brittle when tested. And if you think people get animated about rights, history suggests that populations get far more animated about food prices. (FYI China doesn’t have a Navy but their Army has a navy and it’s called the “Army Navy.” So you have to wonder if they play themselves in football.)
The Chinese assume their existential advantage is their political system; specifically, that the U.S. has an election next year and China doesn’t, so China can wait until someone else is in office. Of course this assumes that (1) China can withstand the damage done while waiting and (2) the next president isn’t Trump and (3) and the next president changes course fairly rapidly.
That seems to be quite a gamble because, while waiting, various Chinese sourcing partners in California are introducing their clients to manufacturers in Malaysia. And China doesn’t have a service economy to replace a disappearing manufacturing economy.
Trump knows this because Lighthizer and Navarro have told him, and many of China’s best responses — surprise inspections at Apple factories to intimidate FoxConn, limiting rare earth exports — are proving more limited than believed. The rare earth threat has happened before (as recently as 2010–11), and the West responded by opening mines in Australia and the U.S. (rare earths exist outside of China but mining and refining them is environmentally messy). [Update: China is only succeeding in driving rare earth refining out of China. https://oilprice.com/Energy/Energy-General/Can-Chinas-Rare-Earth-Monopoly-Be-Broken.html]
And an executive at Hon Hai Precision Industry Co (that’s Foxconn, which assembles the iPhone), recently said:
“Twenty-five percent of our production capacity is outside of China and we can help Apple respond to its needs in the U.S. market,” said Liu, adding that investments are now being made for Apple in India.
“We have enough capacity to meet Apple’s demand.”
In other words, don’t worry about the Apple threat … which is why we’re seeing this:
And here’s a graph that shows a real existential problem. “Net errors and omissions” is what gets recorded when you export $1 worth of goods/services but only account for $.80. The unrecorded $.20 is an error or omission. Of course, it’s really capital flight — exporters (and “exporters”) declining to repatriate money. Just watch the red grow, then decline in 2017 through early 2018 as capital controls are enacted, then grow again once people figure out how to circumvent the controls. In total, that’s over $1 trillion USD that never found its way back to China.
Factories keep closing as manufacturing rotates out of China. Samsung, which has manufactured in China since 1992, closed its last Chinese factory in October 2019. Social instability is borne from unemployed young men and women. (From Dec 2019: Samsung: China smartphone factory closure leaves local community counting the cost.)
Doubt that Beijing (the CCP) only cares about political stability (that is, control)? From the editor of the Global Times (CCP-directed Chinese-English publication:
As long as it keeps political stability…
About Nathan Allen
Founder of Xio Research (A.I.), Applied Magic (A.I.), and Andover (data). A.I. strategy and development leader at IBM. Academic training is in intellectual history; his most recent book, Weapon of Choice, examines the creation of American identity and modern Western power. Don’t get too excited, Weapon of Choice isn’t about wars but rather more about the seeming ex nihilo development of individual agency … which doesn’t really seem sexy until you consider that individual agency covers everything from voting rights to the cash in your wallet to the reason mass communication even makes sense…. Lectures on historical aspects of media, privacy/law, and power structures (mostly). Previous book: Arsonist.
