Cold War 2.0: The Platform, the Players, and the Stakes

  • For decades America’s approach to China was founded on a belief in convergence. That aspiration was misplaced. China has no interest in embracing the American-led global order. Rather, Beijing is seeking to replace it.
  • That is why this is more than a trade war. At stake are the values that will determine the architecture and governance of the global economic order. While there are important differences, a number of recent developments echo events at the beginning of the Cold War in the late-1940s.
  • Since President Xi’s ascension in 2012, China has ramped up a host of policies inconsistent with free and fair trade, including limits to market access, forced technology transfer, intellectual property theft, import substitution, and industrial subsidies.
  • The good news is that the ongoing trade discussions should result in a skinny deal with some easy wins. However, many other issues, such as the “China 2025” policy of dominating key technology industries, are difficult as Beijing has zero interest in compromising fundamental tenets of its economic system.
  • Still, it is hard to exaggerate how deeply entwined the U.S. and Chinese economies have become. Although interdependence was once seen as good for security, under Presidents Xi and Trump the two countries increasingly view international interdependence as a risk.
  • This includes the highly efficient and complex supply chains that multinational companies have created in China. Some of these supply chains, which have been central to manufacturers expanding their margins over the past two decades, are being reconfigured and relocated.
  • Rising trade tensions and global policy uncertainty is contributing to slower growth and lower-for-longer interest rates. Tariffs have hurt U.S. households and have restrained corporate spending. It could get worse, for example if the U.S. decides to weaponize China’s access to capital markets and U.S. dollar funding. However, such escalation is unlikely prior to November’s election.

The recent trade negotiations between the U.S. and China produced a welcome détente, coupled with expressions of goodwill to tackle the tougher more controversial issues later. So far, the thirteen rounds of agonizing talks have largely focused on three major areas of dispute: intellectual property (IP) theft, industrial subsidies and market access. They are all fiendishly complex and none of them are likely to be fully and satisfactorily resolved before the November 2020 election. Regardless, we expect the truce to hold and trade headlines to remain mostly positive over the near term.

However, events over the last two years have made it manifestly clear that the three issues represent only the tip of the iceberg. Over the medium-term the clashes between the two countries could well become much broader than a narrowly-focused trade war. Such a development would have profound consequences for supply chains, capital markets and more broadly, the architecture and governance of the global economic order.

“In siding with the Chinese Communist Party and silencing free speech, the NBA is acting like a wholly owned subsidiary of the authoritarian regime.”
— Vice President Pence, 2019

It Should be Clear to Everyone by Now That This is Not Just a Trade War
On October 5, Daryl Morey, the general manager of the NBA’s Houston Rockets, ignited a furore in China with a seven-word tweet: “Fight for freedom. Stand with Hong Kong.” Chinese nationalists angrily asserted that Mr. Morey was challenging the country’s sovereignty over Hong Kong. Chinese broadcasters quickly announced they would not show Rockets games and retail outlets stopped selling their gear. Because China is by far the NBA’s most important international market, league executives quickly distanced themselves from the perceived offense.

As The Economist has emphasized, self-censoring to make money in China is a long-standing business practice. The most conspicuous example is Hollywood, where studios steer clear of any topics that might offend the Chinese Communist Party (CCP). But virtually all foreign businesses operating in China have long self-censored in a more subtle, pernicious way, by never speaking publicly about any issue the CCP deems off-limits (especially the three Ts—Taiwan, Tibet and Tiananmen). China’s fierce reaction to Morey’s tweet is certain to induce more self-censorship by executives in the future.

“We’re effectively losing our 1st Amendment rights because of an external power.”
— Larry Diamond, Stanford University, 2019

Are we Exporting our Values to China, or Importing Theirs?
Luckily liberal democracies have the creators of “South Park” to defend their principles against despotic leviathans. Their recent episode, “Band in China,” satirizes the movie, music and sports industries’ willingness to comply with the implicit and explicit demands of Chinese censors in order to access its enormous market. After the excruciatingly profane episode was banned in China, the show released a sarcastic apology: “Like the NBA, we welcome the Chinese censors into our homes and into our hearts. We too love money more than freedom and democracy.”

Since the fall of the Berlin Wall thirty years ago, America’s approach to China has been founded on a belief in convergence. The prevailing view was that integration into the global economy would not just make China wealthier, it would also make it more open, tolerant, democratic and market-oriented. From today’s perspective, however, that aspiration appears to have been recklessly naïve. Dreams of convergence are dead, and many Americans have come to see China as a strategic rival—a malevolent actor and duplicitous rule-breaker. How did that U-turn happen?

One key catalyst was President Xi’s ascension in 2012. During “the new era” he has elevated and entrenched the state’s leading role in the command economy. This includes his “China 2025” plan to dominate the key industries of the future, such as robotics, biotech and AI. He has also spearheaded the development and implementation of a sophisticated surveillance state to stifle dissent and tighten the authoritarian screws, squashing delusions of China morphing into a free and open society. Further, the Belt and Road Initiative has made it plain that China has no interest in embracing the American-led global order. Rather, it is seeking to radically overhaul it.

“China has used an arsenal of policies inconsistent with free and fair trade, including tariffs, quotas, currency manipulation, forced technology transfer, intellectual property theft, and industrial subsidies that are handed out like candy.”
— Vice President Pence, 2018

The Bugle-Call for a New Cold War
We date the beginning of Cold War 2.0 to Vice President Pence’s speech on October 4, 2018 in which he adopted a “bad cop” persona and warned that China was engaged in a “whole-of-government” offensive against the U.S. The VP zealously articulated the new consensus in D.C. that China has embraced a deliberate strategy to push America back and that there needs to be a strong U.S. response. Pence was particularly critical of “China 2025” and accused the CCP of obtaining “American intellectual property—the foundation of our economic leadership—by any means necessary.”

This speech marked a deep shift in America’s thinking about China, on both the right and left alike, and was a de facto declaration of cold war. Since then Democrats and Republicans have been vying to outdo each other in bashing China. Not since the late 1940s has the country’s mood swung so rapidly behind the idea that the U.S. faces a new ideological and strategic rival.

The Truman Doctrine of Containment
Perhaps the closest analogy to Pence’s Cold War 2.0 speech is a renown 5,500-word telegram sent in February of 1946 by George Kennan, who was then charge d’affaires in Moscow. His “Long Telegram” outlined the reasons why the U.S. needed to develop a containment policy and “regard the Soviet Union as a rival, not a partner” (even though it had just played a central role in defeating Nazi Germany). To restrain Moscow, Kennan shrewdly advised that “the main element of any United States policy toward the Soviet Union must be that of a long-term, patient but firm and vigilant containment of Russian expansive tendencies.”

The telegram’s impact was profound. Circulated quickly and widely, it was read by the secretaries of War and the Navy, as well as by President Truman and his advisors. It became required reading for senior members of the armed forces and was cabled to America’s embassies and missions abroad. Although the initial reaction was unfavorable, as few in the war-weary nation were looking forward to yet another protracted conflict, the sheer force and brilliance of Kennan’s argument persuaded most skeptics. Shortly thereafter, President Truman put this strategy into full force as the Cold War began. Moreover, eight subsequent presidents would go on to subscribe to variations of this seminal policy1.

Churchill’s “Iron Curtain” Speech
Just one month after the “Long Telegram” with its “containment” theme, Churchill delivered his epoch-defining “Iron Curtain” speech. Rather than a glamourous venue in D.C., New York or London, history was made in a college gymnasium at a small midwestern college in President Truman’s home state. Churchill’s address in March of 1946 elaborated on Kennan’s warning about the threat of Soviet Russia, declaring that “from Stettin in the Baltic to Trieste in the Adriatic, an iron curtain has descended across the continent.” His lecture was crucial in defining the parameters of the Cold War and outlining the rationale for the “special relationship” between Britain and the U.S., which he rightly viewed as essential to stop the spread of communism and maintain peace in Europe.

Churchill’s powerful rhetoric also helped prevent America’s retreat back into isolationism. He and Kennan understood that, with the defeat of totalitarian Nazism, the new threat to Europe and the world would be totalitarian Communism. However, this view was initially highly controversial, and precipitated a storm of denunciation. Such criticism was understandable as, after the horrors of 1939-45, few in America or Europe wished to bid adieu to the rosy glow of the immediate postwar peace. Naturally though the strongest condemnation came from the Soviet Union, with Joseph Stalin himself writing a direct response to Churchill’s monumental speech.

In an article in Pravda published just days after the “Iron Curtain” address, an indignant Stalin griped that “Churchill now stands in the position of a firebrand of war.” The General Secretary reminded readers that it was the “colossal sacrifices of the Soviet people, which secured the liberation of Europe from the Hitler yoke.” He concluded his tirade by castigating Churchill for unfairly characterizing the peaceful aspirations of the Soviet Union as “expansionist tendencies.”

While the aspirations of the Soviet leadership were anything but peaceful, as we now well know, they did sincerely fear U.S. expansionism. A few months later, in September of 1946, a telegram from Nikolai Novikov, the Russian ambassador to the U.S., stressed the danger of possible U.S. economic and military domination worldwide. This classified message was released in 1990, as an aspect of glasnost, and reveals that the Soviet Union genuinely believed the U.S. was preparing for war as part of a drive for world supremacy. This illustrates how easily misunderstandings, including potentially catastrophic ones, can occur during Cold War periods, with clear implications for today’s sometimes inflammatory rhetoric.

Regardless of the Soviet Union’s hostile response, the confluence of Kennan’s “containment” telegram and Churchill’s “Iron Curtain” speech, provided the raison d’être for Truman’s anti-Soviet policy. His Cold War programs included the Marshall Plan, which was passed in 1948, and the formation of NATO in 1949. Moreover, the Truman Doctrine remained the foundation of American foreign policy until the Berlin Wall fell in 1989, marking the end of the first Cold War.

1989 Marked the End of One Cold War and the Dawn of a Second
The wave of revolutions that occurred in 1989 led to the cascading collapse of the Soviet Union and was widely believed, at least initially, to mark the end of the totalitarian state. The West was naively euphoric in its victory, displaying more than a touch of schadenfreude. A widely cited example is an article penned that year by the political scientist Francis Fukuyama titled “The End of History?” In it he speculated that, “What we may be witnessing is not just the end of the Cold War, but the end of history as such [… That is] the universalization of Western liberal democracy as the final form of human government.” How we wish!

With the benefit of even just a little bit of hindsight, it is clear that the fall of the Berlin Wall did not mark the end of the totalitarian state. Of particular note, earlier in 1989 there was another epochal event—the Tiananmen Square tragedy—which should have alerted us to a looming challenge to the global order. A different kind of despotic state was emerging, although its true nature has only recently become fully appreciated. With this realization has come the beginning of a new Cold War, one that requires quite a different containment policy than that envisioned by Kennan, Churchill and Truman.

Plus Ça Change: Similarities Between 1946 and Now
As Yale historian Odd Arne Westad has emphasized, the similarities between China today and the Soviet Union of old are striking, starting, of course, with despotic communist rule. Another similarity is that just as the Soviet Union sought predominance in Europe, China is seeking it in East Asia, a region that is as important to the U.S. today as Europe was in 1946. Further, like Soviet leadership, the Chinese CCP views America as an arch enemy, believing the U.S. aims to undermine China’s rise through external aggression and internal subversion. The presumption in Beijing is that America endeavors to rule the world and sees the CCP as the only obstacle in its way. This sounds eerily similar to the earlier views of Stalin and Novikov.
However, there are also several important differences between the late-1940s and today. For a start, the CCP is nationalist rather than internationalist in outlook, and more willing to use market forces and trade to achieve its objectives. As Professor Westad stresses, “For all his Maoist rhetoric, Xi, both in thought and practice, is much further removed from Mao Zedong than even the reform-minded Gorbachev was from Lenin.” Moreover, China is much more intertwined with the global economy than would have been imaginable with the Soviet Union. As Kennan recognized, in economic terms the Soviets did not need to be contained, as they contained themselves by refusing to join the world economy. China, by contrast, fully understands the role trade can play, by providing access to crucial natural resources and, more importantly, advanced IP and technology. Finally, while tanks and AK-47s played a central role in the first cold war, semiconductors and digital technologies will be the weapons of choice in Cold War 2.0.

This implies a markedly different kind of rivalry than the one Kennan and Churchill saw coming in 1946. The good news is that the risk of a “hot” war is lower and the opportunities for limited cooperation are much greater. The bad news, according to Westad, is that “China’s determination to hack away at the U.S.’ position in Asia is more tenacious than anything Stalin ever attempted in Europe.” Kennan recommended deepening U.S. involvement in Europe, through the Marshall Plan and the formation of NATO. Similarly, today the U.S. could act to deepen relationships with Asian countries that are fearful of China’s rising aggression. However, recent policy decisions, including America’s withdrawal from the Trans-Pacific Partnership, provide little cause for optimism on this front.

“I now see the prospect of an Economic Iron Curtain—one that throws up new walls on each side and unmakes the global economy, as we have known it.”
— Hank Paulson, 2018

The Stakes: What Values will Determine the Architecture and Governance of the Global Economic Order
Although Cold War 2.0 is unlikely to become a “hot” war, and no shots will likely be fired, the stakes are just as important. And the stakes are values: In particular, what values will determine the architecture and governance of the global economic order. In the phrase of China scholar Elizabeth Economy, what is profoundly troubling is that “China is an illiberal state seeking leadership in a liberal world order.”

Since the nineteenth century, much of the global economic order has been rooted in the liberal democratic values of, initially, the U.K. and then the U.S. America’s values are best represented by the Bill of Rights, which guarantees civil rights and individual liberties—including freedom of speech, press, and religion. It also sets rules for the due process of law, and places clear limitations on the government’s power in judicial and other proceedings. In addition, for over two centuries now, democratic institutions and comparatively free markets have been key to the vibrancy and success of what former Defense Secretary Jim Mattis refers to as “the great big experiment that is America.”

The Rise of the Digital Dictatorship
With the rise of China and its very different type of experiment, the source of conflict is clear, as the values of the liberal world order are anathema to Beijing’s autocrats. The CCP under President Xi wields power that is unbounded and unchallenged, without the checks and balances provided by an independent judiciary, autonomous media, free and fair elections, and constitutionally guaranteed rights for individuals and society. In China, the CCP is above the law, which is best viewed as a spear, rather than a shield. And not only has state and bureaucratic power become even more centralized since 2012, but markets are increasingly taking a secondary role to the commands of the CCP, including its foundational “China 2025” strategy to dominate the technologies of the future.

In a 2018 article “Why Technology Favors Tyranny,” Yuval Noah Harari made yet another prediction about the future, arguing that advances in AI are heralding the rise of “digital dictatorships.” This certainly seems like an apt description of what is occurring in China. Beijing already exerts almost complete control over the country’s Internet and media, and is aggressively building out an intrusive surveillance system that rivals anything Orwell could have imagined.

However, freedom isn’t declining just in China. In its closely followed “Freedom in the World 2019” report, Freedom House concluded that global freedom had shrunk for 13 consecutive years. That is, starting from 2006, which roughly coincides with China’s rising global prominence and the acceleration in several digital technologies (including AI, smart phones and social media). During this period, some 116 countries experienced a net decline in freedom (including China and Russia), while only 63 experienced a net increase. Although the overall losses are still shallow compared with the gains that followed the collapse of the Berlin Wall, Freedom House emphasizes that, “The pattern is consistent and ominous. Democracy is in retreat.”

While this is not good news, China’s political system is for it to choose. And it is conspicuously evident that the two superpowers possess vastly different values, economic systems and visions for the global economic order. This is why Cold War 2.0 has become a defining reality, and not just for the next election cycle, but likely for years and decades to come.

Moreover, almost all measures of global integration (including trade, foreign direct investment and the activities of multinational corporations) are already in retreat or stagnating. In fact, these metrics have been in trouble for the good part of a decade now. In the next few sections we discuss several ways in which the global economic architecture could bifurcate if tensions between the two countries deteriorate even further.

“I see now the possibility of a great fracture with the world’s largest economies splitting the globe into two, each with its own dominant currency, trade and financial rules.”
— UN Secretary-General Antonio Guterres, 2019

The Unravelling of Global Supply Chains
Spurred on by China’s entry into the WTO in 2001, multinational companies from the U.S. and other countries began to create highly efficient and complex supply chains centered around manufacturing operations in China. In fact, it is hard to exaggerate how deeply entwined the U.S. and Chinese economies have become over the last two decades. However, this has created a number of fragilities and, under Presidents Xi and Trump, the two countries are increasingly seeing international interdependence as a risk rather than as an opportunity.

To illustrate, earlier this year the U.S. Department of Commerce blacklisted Huawei, the world’s largest telecommunications equipment producer, severely restricting its ability to do business with American firms. This was a reaction to numerous cybersecurity allegations that claimed Huawei’s equipment could enable surveillance by the Chinese government. Charges that telecom networks could be weaponized are especially sensitive with the ongoing rollout of 5G wireless networks.

These restrictions placed enormous pressure on Huawei and other companies in China. For example, the constraints could impede Huawei’s ability to purchase semiconductors designed by America or its allies. They could also limit its access to Google’s Android mobile operating system, which is integral to three-quarters of the world’s smartphones. Such chokepoints have demonstrated to Beijing just how vulnerable some of their industrial champions have become.

Weaponized Interdependence
As emphasized in a recent influential paper, “Weaponized Interdependence”, by Henry Farrell of GWU and Abraham Newman of Georgetown, U.S. policies toward ZTE and Huawei “have precipitated a major reconsideration of China’s reliance on foreign chip manufacturers and of the need for China to create its own domestic manufacturing capacities.” This could certainly result in the reconfiguration of entire networks of interlocking supply chains, which have proven to be remarkably fragile, with transformative consequences for the global economy.

Many in the Trump administration believe deep interconnections pose grave security risks and hence, advocate a “decoupling” of the two economies. As Farrell and Newman emphasize, the U.S. military now fears crucial components that are manufactured in China may have been compromised, while Beijing suspects the U.S. wants to cripple its ability to develop the advanced technology at the core of its China 2025 plan. This represents a dramatic shift from the view in previous decades, when trade and security agendas largely reinforced each other. In fact, most advisors believed that economic interdependence between the U.S. and China was good for security. If China’s economy depended on the U.S., and vice versa, neither would want to hurt the other.

Trade is the Battle, Tech is the War
That is clearly no longer the case. In an extraordinary series of tweets, President Trump recently demanded that American businesses immediately start looking to leave China, after all “We don’t need China and, frankly, would be far better off without them.” This feels like a nightmare to globalized technology firms, as they watch both the U.S. and China wield supply chains as weapons in their grand disputes. Businesses in sectors such as telecommunications equipment, consumer electronics and semiconductors, as well as logistics and transportation, fear they have become pawns on this new battlefield.

Moreover, as China realizes that the supply chain can be used to wage economic war, it is likely to redouble efforts to become technologically independent from the U.S. and its allies. For a start, we expect Beijing to pump even more money and resources into the country’s chip industry and other sectors identified in China 2025.

Additionally, will the prospect of additional sanctions lead some companies to feel they can no longer rely on Chinese suppliers and thereby, alter the global tech supply chain? While it is still early days, there is some evidence that companies are speeding up efforts to bypass China—by building factories in places like Vietnam, India or Mexico. For example, one of the world’s largest consumer electronics companies has already moved most of its smartphone production to Vietnam. Moreover, with the high-tech arms race between the two countries, it seems inevitable that export controls and investment restrictions become the new weapons of choice.

“CFIUS is the No. 1 weapon in the Trump administration’s protectionist arsenal, the ultimate regulatory bazooka.”
— Hernan Cristerna, co-head of global M&A at JPMorgan Chase, 2018

The CFIUS Bazooka
The Committee on Foreign Investment in the United States (CFIUS) is an inter-agency committee that reviews the national security implications of foreign investments in U.S. companies. Chaired by the Treasury Secretary, the heavy-hitting CFIUS includes representatives from the Defense, State, Homeland Security and Commerce departments. And lately CFIUS has been busy as a beaver investigating Chinese acquisitions of U.S. companies.

Last month CFIUS opened a review of the acquisition of a Chinese-American company, Musical.ly. It was acquired in 2017 by Chinese app developer ByteDance, and became TikTok, the hugely popular short-form video app. One might rightly wonder how the dancing and singing teens and tweens of TikTok became a threat to national security. However, the Administration is signaling concern that access to personal data could be used as a strategic weapon. Convincing a security-conscious D.C. that Beijing will not censor content (e.g., videos of Hong Kong protestors or Uighur repression) or exploit data for strategic reasons creates a high bar for the deal’s belated approval2.

Further, in recent months CFIUS forced Chinese gaming company Beijing Kunlun Tech to divest its majority interest in Grindr, a popular dating application. Similarly, CFIUS forced Chinese company iCarbonX, backed by China’s Tencent Holdings, to divest its majority ownership in PatientsLikeMe, a patient network and research platform. And last year, a $1.2 billion deal between MoneyGram, a money transfer company based in Dallas, and Ant Financial, a Chinese electronic payments company that is the highest valued FinTech company in the world and is an affiliate of Alibaba, fell apart after CFIUS refused to approve the deal.

The Digital Iron Curtain
The actions by CFIUS reflect an increasingly clear consensus in D.C.: The security threat to the U.S. from Chinese tech firms is bigger than just Huawei. If the administration views every Chinese tech company with suspicion, it could lead toward a swift technological decoupling. And unfortunately, this does appear to be where we could be heading. The State Dept, the White House and, to a lesser extent Congress, are all saying: It’s not just Huawei, all Chinese tech companies are part of China’s military-civil fusion complex and, as such, pose a national security threat.

The impact of a more aggressive CFIUS vetting regime can be seen in FDI flows from China into the U.S. (Figure 1). In 2018, the two countries were each other’s largest trading partners, yet, the level of bilateral FDI has remained relatively low. Moreover, note that Chinese FDI flows into the U.S. have plummeted during the last two years and in 2018 China accounted for only 1.4% of the total FDI stock in the U.S. It is equally worrisome that, despite years of promises to improve market access, America’s FDI flows into China are smaller now than they were in 2005 – 2008. Further, measured as a % of GDP, they have fallen by more than half over the last decade.

Reflecting a More Aggressive CFIUS, FDI Into the U.S. From China has Plummeted 87% since 2016

Will the Weaponization of Global Capital Markets be Next?
We have already experienced tariffs, export controls and investment restrictions, which raises the question of what might be the next weapon of choice. The research firm 13D has written a series of articles this year making the case that the “capital wars of the future” may prove more consequential than the ongoing trade war. This is worth considering, as America’s dominant role in global capital markets provides a number of tempting chokepoints to deploy if D.C. chooses to escalate tensions.

The U.S. dollar has been the dominant international currency for over a century now and continues chugging along without a serious challenger. This is in spite of four decades of twin deficits and dwindling international trust in U.S. policy decisions. Two decades ago, many hoped the EUR would become a counterweight, but for a host of reasons that has failed to transpire. Further, despite the growing stature of the Chinese economy, its financial markets remain woefully underdeveloped. This means, for at least the next decade or so, the USD will remain ensconced as the #1 currency, partially reflecting the lack of a credible alternative.

“US regulators have vast power not only over domestic entities but also over any financial firms that need access to dollar markets. … The U.S. currently has financial sanctions in place against 12 countries.”
— Kenneth Rogoff, Harvard, 2019

Banker to the World: The Dollar Goes to War
In terms of a template for action, a recent salient example is the U.S. pressuring the Belgium-based SWIFT payments system to shut Iran out of the international banking network. America is able to do throw its weight around this way, in spite of multiple objections, because it is a triton among minnows. To illustrate the USD’s preeminence, it was on one side of 88% of all FX trades in April 2019 (down only marginally, from 90% in 2001), dwarfing the RMB’s 4% share. Additionally, the USD represents 62% of official FX reserves (down from 70% in 2001), versus 21% for EUR and 2% for RMB.

Moreover, the U.S. also dominates global equity and debt markets, and USD financing remains crucial to the functioning of international capital markets. According to the BIS, non-US banks have $12.8 tn in USD assets (China’s share is roughly $1 tn), creating a vulnerable exposure as these assets need to be funded with USD liabilities, which frequently need to be rolled over. Controlling access to USD-funding and the SWIFT network is part of America’s “exorbitant privilege.” It also has meaningful control over the global plumbing, including many of the world’s largest financial institutions, clearing houses, and settlement and payment systems.

Is it naïve to believe that such clout will never be used as part of the strategic game being played between the U.S. and China? It is worth recalling that, well before Presidents Xi and Trump, the language of international finance began to take a more militaristic tone. The phrase “currency war” has been popular since 2010, when Brazilian leaders accused the U.S. and other countries of pursuing competitive depreciation (via their QE policies). More recently, there is much talk of the “weaponization” of the dollar. Some of this is due to Trump’s repeated “verbal intervention” to talk down the dollar (unsuccessfully) and flagrant demands that the Fed lower interest rates with the explicit objective of depreciating the greenback. Further, China is not without tools and its
official media periodically raises the threat of dumping its vast stockpile of U.S. treasuries. Unlikely maybe, but not inconceivable.

“China’s use of export and import substitution subsidies has been ubiquitous throughout the past two decades … despite explicit prohibitions in the WTO Agreement.”
— Robert Lighthizer, USTR Report on China’s WTO compliance, 2019

The State Strikes Back: Support for SOEs Is Accelerating
The previous sections analyzed a couple directions the conflict could take if tensions between the two countries deteriorated even further. A major underlying reason why the relationship remains so strained and why trade negotiations have proven so difficult is that, eighteen years after having joined the WTO, China still ranks abysmally close to the bottom on IP protection, forced technology transfer, market access, receptivity to FDI, and subsidies for domestic companies. In fact, according to the “Mercantilism Index” compiled by the Information Technology and Innovation Foundation (one of the most prestigious science and technology think tanks in the U.S.), China is ranked as the most mercantile country in the world. Bad as that is, the evidence suggests China might be getting worse rather than better on a couple dimensions.

President Xi has done much to earn the sobriquet “Deglobalizer in Chief.” In particular, he has ramped up China’s already aggressive import substitution policies, most notably with his China 2025 program3. Before Xi became President there was reason to believe that the power of the state over the Chinese economy was gradually declining. However, this changed with his ascension in 2012, as persuasively demonstrated by Nicholas Lardy in “The State Strikes Back: The End of Economic Reform in China?” and Elizabeth Economy in “The Third Revolution: Xi Jinping and the New Chinese State.”

Aside from the massive industrial subsidies associated with China 2025, the expanding role of the Chinese state can be shown in several ways. One of the most striking is the dramatic shift of bank credit away from the private sector in favor of state-owned enterprises (SOEs). Among other things, this tilt has squeezed out the more productive private sector, contributing to the ongoing slowdown in China’s growth.

Additionally, Lardy emphasizes the growth of SOE assets. At the end of 2018, the assets of SOEs (ex-finance) stood at 230% of GDP, up from 130% a decade ago (Figure 2). This growth was relatively modest through 2012, when most bank credit was flowing to private firms. However, with the ascension of President Xi, the tide has turned back in favor of state firms. Since 2012 the assets of SOEs grew at 15% annually, well over twice the pace of expansion of China’s GDP. All this suggests the path of the two economies is likely to continue diverging, which makes it unlikely that the much-touted phase one deal produces anything more than a temporary truce.

State Owned Enterprises (SOEs) enjoy preferential access to bank loans as well as to the domestic corporate bond market
Assets of State-Owned Enterprises (ex-finance) Have Soared Since 2012

Estimated Costs of the Trade War
Regardless of what type of phase one deal is announced in the next month or so, we expect the trade war to be with us for quite a bit longer. This raises the question of how costly it has been, and how much more expensive it could become. A recent NY Fed study examined the impact on U.S. households of the tariffs placed on imports from China over the last two years. The costs include both the tax burden (e.g., if a 10% tariff causes the domestic price of an imported good to increase from $100 to $110) and the deadweight loss (e.g., if the tariffs cause firms to switch their sourcing from China to a less efficient country, say Vietnam). The combined cost over the two years is estimated to be $1,245 per household (with 40% attributed to the tax burden and 60% to the deadweight loss).

This represents a very big hit to U.S. households. Further, trade-related uncertainty has significantly affected corporate investment plans. Consistent with this, the evidence is overwhelming that economic and earnings momentum rolled over hard with the start of Cold War 2.0 (Figure 3). Further, the growth of U.S. industrial production, capex and exports have all collapsed from early 2018 when trade tensions were ratcheted higher.

Economic and Earnings Momentum Rolled Over Hard with the Inception
of Cold War 2.0

Is the Expansion in Manufacturing Margins Over?
In addition to being a cyclical headwind, U.S. – China “decoupling” is also a negative for overall economic efficiency and trend growth potential, as well as for the secular trends in margins and profits. International trade accelerated from 1989, with the fall of the Berlin Wall, and was then turbo-charged at the turn of the century when China entered the WTO. A key part of this acceleration involved putting in place the complex global supply chains that exist today, a process that helped drive a dramatic increase in manufacturing margins (Figure 4). To the extent that Cold War 2.0 results in “Playing the movie backwards,” we believe margins have likely peaked, especially for sectors such as tech hardware, semiconductors, industrial capital goods and some consumer cyclicals.

Manufacturing margins were essentially flat from 1952 to 1990, but have enjoyed tremendous gains during the last 30 years, coinciding with the acceleration in trade.
S&P 500: Net profit margins (%)

Moreover, the labor cost savings from locating production abroad (largely in China) are estimated to have accounted for about one-fifth of the increase in manufacturing margins since 2000 (Figure 5). However, this factor is likely fully played out and will probably be at least partially reversed during the next couple years. With wage arbitrage largely over, and supply chains quickly being reconfigured, it is hard not to conclude that the peak in manufacturing margins is now well behind us.

S&P 500 Manufacturers: Margin expansion factors, Q1 2018 vs 2000

“China is likely to remain America’s main rival for global power and influence for the foreseeable future. But that does not mean that the two countries must maintain a dangerously adversarial relationship.”
— Larry Diamond (Stanford University) and Orville Schell (Asia Society), 2019

Constructive Engagement: Trust, but Verify
We hope that by now it is quite clear that, not only are trade wars not easy to win, but they are very costly for households, corporates and the broader economy. Another regrettable implication of the trade war is that the U.S. and China are losing their ability to interact in a manner that is anything but adversarial. While it appears the two economies are set on a path to significantly reduce their economic interdependence (“decouple”), a full chasm seems improbable and there are many areas for compromise and working together.

What can China realistically do to keep its economic relationship with the U.S. from spinning out of control? The ongoing talks are focused on reciprocation in market access, curtailing industrial subsidies, and credible assurances on IP protection. While some of these issues are difficult for China to deliver on without forfeiting its most critical economic policies (e.g., China 2025), there are several areas in which compromises are quite straightforward. For example, improving access by increasing purchases of U.S. energy and agricultural commodities. This seems like an easy win for everyone. Further, during a recent press conference, U.S. Trade Representative Robert Lighthizer stressed that China is close to agreeing to adopt normal best practices for IP, including criminal enforcement of violations with sufficiently stiff penalties. Apparently, China has softened its stance on this issue because it now produces enough sophisticated technology that safeguarding IP is in its own national interests. Greater openness and transparency would also be extremely helpful, but expectations are appropriately low in this regard.

There are also a number of things the U.S. can do. For example, it would be helpful if it dialed down the rhetoric, ceased using Twitter as a negotiating tool, and worked in tandem with other G10 countries that share their frustrations. The U.S. could also negotiate more constructively with China, by presenting narrower, more attainable objectives. The recent decision to proceed in phases, suggests this is already being done. America would also have more credibility if it became less obsessed with bilateral imbalances, a focus that few economists would support (in fact, only one does). Ricardo has demonstrated that international trade is win-win, but sometimes the Trump administration’s rhetoric suggests they view it as a zero-sum game.

Investment Implications: Cold War 2.0 and the Reversal of Globalization
The recent détente between the U.S. and China has been well received by markets and may well last through the November 2020 election. However, it has become manifestly evident that
we have only peeled the first layer of this onion, with the clashes between the two countries likely to become much broader than a garden variety trade war. Over the medium-term we expect such developments to have profound consequences for the architecture and governance of the global economic order.

This sounds alarming and some investors have expressed concern that a second Cold War would be disastrous for equity markets. While certainly disruptive, and an overall negative for economic efficiency and corporate margins, the historical experience suggests something well short of a calamity. To illustrate, during the first Cold War, U.S. real GDP growth averaged a commendable 3.6%, with the S&P 500 providing a mean total return of 11.4% (or 7.2% net of inflation). While impressive, these statistics are unlikely to be repeated given today’s demographic and productivity challenges.

Regardless, during the last two years, largely due to rising trade tensions, global economic policy uncertainty has skyrocketed to a record high. This has contributed to slower global growth, which has resulted in today’s hyper-active central banks riding fast and furious to the rescue. This, combined with demographic trends and the inherently deflationary nature of tech, helps to explain why we find ourselves entrenched in a “lower for longer” interest rate environment.

In addition, pervasive digital technologies and their associated economies of scale, suggests we are living in an asset- and capital-light world. This implies that, with less cash flow being directed to fund capex, payout ratios are likely to remain high and may even rise further from here. That is, even as bond yields have plummeted, stranding us in a world of yield starvation, we expect dividends and buybacks to remain robust. As a result, the yield available from equities can be far superior to that achievable in fixed income markets.


  1. Kennan’s arguments were later made public with his 1947 article, “The Sources of Soviet Conduct,” which was published in Foreign Affairs (pseudonymously by “X”).
  2. ByteDance has two essentially identical versions of the app, TikTok for international markets and Douyin domestically. They are operated separately and run on different servers, to comply with Chinese censorship restrictions, but they both ultimately report into HQ in Beijing.
  3. Please see our 2018 note, “Trump, Tech and Trade”