Why China Is Gaining the Upper Hand in Trump’s Trade War with Arthur Kroeber

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1:02Bloomberg Audio Studios. Podcasts, radio, news. I think we're going to be fine with China, but we have to have a fair deal. It's got to be fair.

1:21I'm Stephanie Flanders, Head of Government and Economics at Bloomberg. And this is Trumponomics, the podcast that looks at the economic world of Donald Trump, how he's already shaped the global economy and what on earth is going to happen next.

1:38Our focus this week is the big lesson from the latest rounds of the US-China trade wars. The long-term balance of power between the two economies is shifting, and it's shifting in favour of China. Things had gone relatively quiet for a few months, but in the past couple of weeks, the US-China trade war got noisy again. with a tit-for-tat over expanding US export controls and China's then imposition of more sweeping restrictions on its exports of rare earth magnets. There's been the usual talk of escalation and de-escalation from President Trump. As I record this on Friday, 17th October, he's just threatened 100 % tariffs on Chinese goods, but in the same breath admitted that would be unsustainable.

2:24Right now, the president is still set to meet with his opposite number, President Xi Jinping of China at the Asia-Pacific Economic Cooperation Summit in South Korea later this month, APEC. I bet that meeting will be on and off again many more times before you hear this and certainly before they sit down. But whatever happens around that table, we may already have seen a permanent shift in the power dynamic between them due to the simple fact that the Chinese have shown not only that they have leverage in this trade fight with the US, but they're prepared to use it. That's why I very much wanted to talk to this week's guest, Arthur Kroeber.

3:03Arthur co-founded the China-focused research service Dragonomics in Beijing in 2002. It's now called Gavacal Dragonomics and he's the research director. He's also the author of China's Economy, What Everyone Needs to Know. I'd describe him as the China expert other China experts go to for a deeper take. Arthur, thanks so much for taking the time for us. My pleasure.

3:39There's, as ever, the noise and the signal. And one reason you are so widely read on China is you're very good at telling the difference between the two. But maybe we should spend a little bit of time on the noise of the past few weeks. For those who lost track, who started it? You could go back to the beginning of time in the, you know, who went first kind of thing. I don't think that's super fruitful. But I think the sequence of events that we've seen recently is, number one, about a month ago, negotiators met in Madrid. They had what seemed to be a pretty productive meeting. They seemed to come up with a set of ideas for resolving the ownership of TikTok, which was a big issue.

4:15And the Chinese side seemed to indicate that there was kind of a wider set of discussions on, you know, investment flows more generally. And we seem to be heading towards a meeting between Trump and Xi at the APEC summit at the end of this month where they would move the ball forward. Seemed to be good. Then what happened is at the end of September on the 29th, the Bureau of Industry and Security at the U.S. Commerce Department issued a set of rules expanding its so-called entity list, which is a list of foreign companies that if you want to sell stuff to them, you have to get an export license.

4:49It's kind of a blacklist or a graylist or a darklist. And this did two things. One is it said any company that is at least 50 % owned by a named company on the entity list is automatically deemed to be on that list. So it captures a whole bunch of subsidiaries that previously could kind of fly under the radar. And you can understand why they would want to close that loophole. That seems fairly sensible. But as a practical matter with China, it expands the number of companies on the list, perhaps by as many as 10 ,000, according to some estimates. It's a lot of companies, right? Second thing it did is it said, if you're a U.S.

5:26company, you want to sell to someone, you have to verify. You have to do your own due diligence to verify that they are not at least a 50 percent subsidiary of some Chinese company. Which means, if you think about it, that requires an awful lot of forensic due diligence on ownership, which might need to go through several layers of ownership to get to the truth. Huge, huge compliance burden on the company. So this was a very consequential move. And it appears from some things that I've heard that this move, which has been discussed for some time within the Commerce Department, the Chinese brought this up at the Madrid talks and said, we hope you're not planning to do this right away because that would create a lot of problems for the trade talks and we would have to retaliate.

6:11So it happened. And so the Chinese said, okay, we're going to have to retaliate. And then they came up with something that they also had on the shelf, which was very detailed regulations on export controls for rare earths, rare earth permanent magnets, and some things in the battery supply chain. And again, if you look at those rules and imagined that they were enforced fully, they could give China the ability to really substantially restrict the production of all kinds of products around the world that depend even on very small trace amounts of rare earth source from China. So we had these two different things.

6:50And so basically what has now happened is that I think both sides have recognized that they kind of went too far in their efforts to gain leverage over the other person. And now they have to dial it back. And it seems like the signaling that we're now getting from both sides is that they kind of want to somehow resolve this issue and tee up a meeting between Xi and Trump at the end of the month in Korea that can allow for the trade talks to continue. So there was a lot of noise. But the signal in it is that both sides have pretty powerful tools that they can use against each other. And what's new is that generally this has been a one-way street.

7:29The U.S. has a lot of tools. Its counterparties don't have any. China has a really powerful tool that can cause the U.S. a lot of problems. And I think that's one of the things, certainly from talking to colleagues in China, you don't get to see Xi maybe necessary enough to talk about a spring in his step. But there is definitely this sort of feeling of strength and confidence that's come because a lot of countries have effectively given into Donald Trump's tariff demands and just decided it was easier to go along with a certain level of tariff and not necessarily try to impose their own in response.

8:02But China has shown that it can go toe to toe with the US and the US has effectively had to back down. So in a note that you put out, you said in the past few weeks that had shown us that U.S. and China had now weaponized their interdependence. So just talk us through what that means. Yeah, well, that's not a phrase that I concocted. That is a phrase that was coined by two very astute political scientists, Henry Farrell and Abe Newman, who wrote a book about this about five or six years ago, in which they were mainly talking about what the U.S. was doing in its sanctions regime through financial sanctions and controls on technology to take advantage of the fact that other countries relied heavily on certain kinds of inputs and networks controlled by the United States.

8:47The United States was weaponizing these in order to achieve certain political goals, right? Sanctions on Iran. We've seen sanctions on Russia, the trade war and the technology restrictions against China. et cetera, et cetera. And yeah, I think this is a very important, invalid concept and a good description of the way that the world has evolved over the last couple of decades. But what's now new, and I think has really been reinforced step by step this year, is that China is also able to play the weaponized interdependence game because they have this massive chokehold on the whole rare earth complex.

9:26And these elements are very important for a whole bunch of high-tech industries for defense products, notably. And they also have significant controls within the battery supply chain. So China is able, is in principle able, to make use of this to put pressure on people that it has political problems with. And we've seen this, you know, from time to time, but now it's very visible in terms of its relationship with the United States. And I think it's very powerful. This is something that people don't really talk about that much. There are a lot of commercial applications for rare earths. They're quite important.

10:00But the defense supply chain depends upon them quite a lot. And I think what is underneath the US sort of concern on this is that their defense production supply chain actually is quite vulnerable to restrictions on these elements by China. So they have to step pretty carefully. And we should say, actually, because you've reminded me, I mean, that book, Underground Empire, we've actually talked about it in the past. I It has stood the test of time in terms of thinking about the economic dynamics of this time. I recommend it to people. But people do often say, what's the big deal about rare earths or rare earth magnets?

10:37You know, the value of the imports to the U.S. and other countries is very small. But as you're pulling out, I mean, it's like it's the weakest link in some of these very important global supply chains, defense, consumer electronics, cars. Yeah, I think this is worth exploring. So there are a couple of things that people say. One is, you know, the values are very small. These are very small proportional inputs into various things, which is true. And the other thing they say is, you know, famously, rare earths are not rare. You can dig them up, you know, in lots of places around the world. So what's the big deal?

11:11And I've had people who spent a fair amount of time working on export controls as recently as a year ago who said, oh, well, you know, trying to export controls rarest is dumb because it's just a commodity. And then all you do is you create incentives for mining. And both of these arguments are flawed. So the first one is flawed because, as you say, it's not that these are a huge part of the value of the finished product. It is that they are things that you need. And if you don't have them, you cannot make the rest of the product. So it might only be 1 % or half a percent of the bill of materials, but it's the 1 % or half percent without which you can't make use of the other 99%.

11:50It's a bit like looking at the utilities value of the share of GDP. But if you don't have electricity, you can't do very much else. Exactly, exactly. Except maybe even more so than that. And then on the second point, the issue is that it's not the raw ores that are at issue here. is the refined ores and products, notably permanent magnets that are made from them. And these, both the refining and the products, require pretty sophisticated technology processes, which now basically only exist in China. The technologies for refining are, in fact, also export-controlled by China. So if you set up a mine elsewhere and you want to refine them, you have two choices.

12:33One is you can send the ores to China to get refined, which is a lot of what happens. Or you can try and get the Chinese to issue a license for the technology. Or you can try and, you know, recreate the technology on your own. It's non-trivial. And then when you look at the magnets, that has an additional manufacturing process on top of that, which is distinct from rare earth refining specifically. Also pretty technical. Also something where the Chinese have a huge cost advantage. And so there are many layers here, which means that it is, these are things that are quite important. They're quite important, not only defense industries, but to a lot of new green technologies that people want to develop.

13:11And it is very, there's a big technology component. So the export controls have real bite. And there's no quick way to extricate yourself from that vulnerability. The more we talk about this, it sounds like those debates one would have or the sort of theories of nuclear deterrence from the Cold War days. It's very flawed, the comparison between the Cold War and the situation with U.S. and China. But this does feel a bit like the sort of mutually assured destruction that people used to talk about in that time. Both sides have built up things that could blow up the other country's supply chains in one way or another, or at least make things extremely difficult for them and their companies.

13:52It's obviously a somewhat extreme example, but is that sort of a sensible way of thinking about it? Yeah, I think that's kind of the flavor of it. I wouldn't want to push it too far. I mean, the metaphor that I've used is I just borrowed a phrase from Scott Bessent, who rather notoriously said in a speech a year ago, talking about Trump's then prospective tariff strategy that, as you recall, the idea was to escalate, to deescalate. And his phrase was, the tariff gun will always be on the table, cocked and loaded, but it will be rarely fired. And now there are two guns on the table, right? There's the U.S.

14:28tariff and export control gun pointed at China, and there's the China rare earth control gun that's pointed at the U.S. They are both on the table. They are both loaded. They could be used. But in fact, I think the Chinese point on this, and I actually take them seriously on this in their public statements. They say, yeah, we could do this, but not only is it not in your interest, it's not in our interest to do this because we're a globally integrated economy. We depend on being able to trade freely. We want to be able to sell this stuff to people who are going to use it for non-defense purposes.

15:02That is actually good for us, too. So we don't really want to use this weapon, but we have to pull it out because this is the only way to prevent you from using this other weapon, which is going to be really bad for us. And I think that should be taken very seriously. But it sounds like what economists might think of as a stable equilibrium, right? I mean, that is supposed to be – that was even what the mutual issue of destruction was – you were sold it as a stable equilibrium because both sides were assured of – Yeah. Real harm if anything happened. Well, yeah. So economists call it stable equilibrium because they're economists and other people call it a balance of terror, right?

15:44Okay, but it's a balance. Right. Balance sounds better than imbalance. Right. No, it is a balance. And I think this is why the U.S.-China trade negotiations have gone on for so long is the Chinese are very clear that they want to get something out of these negotiations. It's not going to be just a capitulation. And they have the tools to force the U.S. to stay at the table and do something that they might want. So I think if you look at this from a broader standpoint, I think the net effect of this for now is probably beneficial because it is useful for the world to have some constraints on the ability of the U.S.

16:23unilaterally just to impose whatever conditions it wants on everybody. You know, just as it's useful to have those constraints in China. They've done plenty of economic bullying of their own over the years when they can get away with it. So having some kind of balance there, I think, is potentially helpful. The problem is we also have some fairly volatile leadership, particularly on the U.S. side. And so you can imagine things going wrong. And that was always the worry with the MAD during the Cold War is, yeah, it was great, but we were one step away from something really bad.

17:10going back a little bit to the sort of real world implications of the network of different export controls and potential guns that could be used at various times i know you talk to a lot of multinationals and businesses active in China, but also operating around the world. What's the implications for a multinational that's actually still got very much caught up in the US and China, both as a market and as a manufacturing base? It seems like it may be useful to have a balance of terror, but in the meantime, there's a hell of a lot of paperwork, right? I think the short answer is that at a minimum, your compliance burden goes way up, right?

17:50Because you now have to satisfy regulators in the U.S., you have to satisfy regulators in China on various things. Just the friction and the transaction costs of doing things, a lot of cross-border activities have gone up quite a lot. So that's your kind of most benign baseline scenario is that has occurred. And, you know, I think the other thing that people talk about a lot, very hard to quantify, is the uncertainty premium goes up. You're constantly kept guessing, you know, will these things be imposed? If so, when? If so, will I be, you know, victimized or are there ways to work around it? So that requires there's sort of an additional cost in terms of strategy planning, hedging planning for how you do this.

18:33I think at the moment, that's where we are. And frankly, both Trump and Xi at the leadership level have, in fact, made it pretty clear repeatedly over the course last year, that they want an agreement. They want a deal. They want to set up some kind of regime under which people can trade and invest. And the Chinese, I think, fortunately, in this case, have the leverage to make sure that deal is somewhat real rather than just a fake deal. So if we get there, that will be, I think, somewhat helpful. But even if we do get a deal, the reality is that the US and China really have this extremely adversarial relationship.

19:10You can create a deal that sort of creates a detente, if you will, to use another Cold War metaphor. But if you're thinking about the long run 5, 10, 15-year timeline investments, you have to do a lot of hedging and you have to figure out ways that you can forestall or live through situations where there might be a huge escalation in the tensions between the U.S. and China and many more decouplings. So it makes the strategic planning process a lot more difficult and more costly. But if you think of the goals that the Chinese authorities are pursuing, in many ways, they are trying, just as they try and advertise and strengthen U.S.

19:49dependence on certain things from China, China is obviously actively trying to reduce the degree of dependence it has on the U.S. And that seems to be going pretty well. I mean, that's not far off. Yeah, it is. And so if you look at, there's a bunch of work that you can do looking at sort of the OECD databases on trade and value added that shows if you just break down U.S. supply chains, supply chains for physical goods within the U.S., they are about two to three times more reliant on inputs from China as the other way around. And this is partly the result of differential industrial development, but partly the result of deliberate Chinese efforts to de-Americanize specifically.

20:32There's supply chains and they have made good progress there. Now, some areas it's really tough. So the semiconductor industry, good luck trying to de-Americanize because the U.S. position at various nodes in that is extremely, extremely strong. And despite huge investments, Chinese have made some progress there, but not a ton, frankly. So again, it's very difficult to build an alternative rare earth supply chain, probably even more difficult to build a fully autonomous semiconductor supply chain. These interdependencies, both countries would like there to be less of them. But in fact, it is very difficult to untangle them, which is why I've always been skeptical of sort of like the easy decoupling story.

21:17Oh, China and the U.S. are decoupling. It's like, yeah, you can try. And in individual sectors, you can get reasonably far. but on a macro basis, untangling the interconnections that have been built up in the global economy over the last 45 years is extremely difficult. And the other thing I would say is that as China has tried to decrease its dependency on the rest of the world from a supply side, it has increased its dependency in the rest of the world on the demand side because it's now basically an export-driven economy. They depend very heavily on markets being open to them. And this dependency has increased substantially over the last five years, has not decreased.

22:00And their own sort of supply-side obsession at home creates a deflationary, weak consumption environment, which just intensifies this dependency on international markets. And I think this is something that's not sufficiently appreciated in the world is that, yeah, on a producer basis, China is kind of self-sufficient. But they have really exposed themselves to a lot of potential economic downside if export markets close up or if just there's a global recession and people can't buy as much. And that is a real problem for them to which they have no very clear solution. I was going to ask you about that.

22:39I mean, we have, in fact, we've calculated that our economists, that China's manufactured goods trade surplus is the largest now relative to global GDP of any country since the US after World War II. And we've also shown how the amount of sort of trade diversion that's happened, just the sort of wave of exports going across Asian economies and to some extent to Europe that might otherwise have gone to the US due to these tariffs. And as you said, that itself produces a vulnerability because we see countries potentially reacting to that wave of imports. And it's funny because it's kind of the weakness on the other side of the strength, right?

23:15We tend to say China politically has an ability to withstand pain that the US doesn't have. And that means it can sort of hold its ground against Donald Trump. But to your point, ignoring quite a lot of domestic economic pain. I mean, do you see, I know you're not one of those people who is continually kind of announcing there's going to be a crisis or, you know, an end of China's growth story. But do you think they are underestimating the costs of this strategy? Yeah, that's a good question. It seems to me that the government over the last several years, they've adopted a very, very sort of a techno fetishist supply side growth model.

23:55Basically, they've said all of our problems, productivity, income, growth, whatever, they will be solved by just investing massively in the technologies of the future, which will create this productivity miracle, which will then drive future incomes and growth. It's a little bit like the people who are now going around saying AI is going to solve all known economic problems because of these productivity magic. And the Chinese view is that this is the result of sort of physical technologies, at least as much, if not more so, than AI. But it's similar kind of thinking. They haven't been doing too badly on these technologies so far.

24:29Oh, no. We think they've got a global leadership position in five of the 13 key technologies and they're catching up in all the others. No, for sure. So they've done very well on the production side. And meanwhile, nominal growth in China is less than half of what it was five years ago, right? So they used to very reliably be able to count on nominal growth of 8%, 9 % very consistently. It's now down to 4%. And these things are linked because they basically say the supply side will solve all problems. We don't need to have a demand side strategy. We don't need to support consumers if they're hammered by a pandemic.

25:05We can impose a gigantic compression of their balance sheets by crushing the properties five years in a row. and that's fine because capital will move to the correct places. And that's a very, very one-sided and incomplete view of the economy. So they are paying a price for this that is material. And I guess the question is, are they unaware of that price? Are they, do they say, well, we know that's the price, but it's fine? Or do they think, actually, you, Mr. Kroeber, you're wrong about the price. Actually, this is a short-term thing. That's a harder thing to read. And I think you can make multiple different interpretations.