China vs. US: Who Can Better Withstand a Protracted Trade War?


By Wenzhao

President Trump announced that starting September 24, a 10% tariff would be imposed on US$200 billion worth of imports from China. If China and the United States cannot reach an agreement by the end of the year, the tariff would go up to 25% on January 1, 2019. Today we will focus on the Sino-US trade war and their respective ability to withstand a protracted trade war.

First, let’s try to decipher the overt messages and the accompanying subtleties on each side.

This fall tranche of tariffs by Trump was not rolled out in batches, but $200 billion all at once, yet the rate returned from 25% down to 10%. The latter appears to be a concession to feedback from the business community, allowing them time to adjust their supply chain.

In essence, Trump is telling US companies producing in China: if you want to sell back to the US market and avoid tariffs, it is best to move production back to the US or to a third country outside China, echoing his earlier call to Apple to move production back to the US.

Regardless of country of ownership, the threat of a protracted trade war is forcing all companies producing in China, but exporting to the US, to seriously consider relocating their production capacity.

In addition, the Fed is expected to raise interest rates twice more this year, which may become the driving force for capital to return to the US. In fact, as the RMB exchange rate softens, the 10% tariff will not show up as a substantive increase in the final price of imported Chinese goods. Therefore this round of increase is more symbolic, akin to a signal from Trump to US companies to withdraw from China quickly.

At the same time, holding off the 25% tariff until next year will keep prices down during the crucial holiday shopping season, so Trump is taking consumer sentiments into consideration in his tactic.

On the Chinese side, its Ministry of Commerce announced on September 18 that it would levy tariffs of 5%-10% on $60 billion worth of American goods. My take on this retaliation is that, it is a measured response, designed to not goad Trump into taxing the remaining $267 billion of Chinese imports.

However, Xi Jinping needs to find a face-saving way to stave off or delay that additional $267 billion tranche of tariffs. Because if the entirety of China’s $500+ billion export to the US is subject to tariffs, China’s economy is sure to come in for a hard landing.
Next, let’s examine China and the United States’ ability to endure a trade war.

The most important chip in Trump’s pocket is the prosperity of the US economy. A key lever for the government to boost the economy is the tax cut. This is the main achievement in the first year of Trump’s administration. The unemployment rate in the US has fallen to a record low this year. The median household income recently reached more than $61,000, the highest in history.

The Trump tax cut stimulated the US economy, and laid a solid foundation for his ability to endure a protracted trade war.
China also instituted a round of tax cuts. How is that working out for its domestic economy, does it enable China to withstand a prolonged trade fight?

Last March, the government proposed a plan to reduce the tax and non-tax burden of RMB 1.1 trillion for Chinese companies and individuals. It was hailed by official media at the time as great news for the people. However, are we seeing any dividends six months later, in the form of increased household expenditure, employee wages, or enterprises willingness to invest?

Regardless of whether all of the promised tax cuts actually materialized, there was another series of government measures that undermined the tax cuts.

The first measure was the strengthening of social security collections. Chinese urban workers are covered by five basic insurances: pension, medical care, unemployment, maternity and work-related injuries. These used to be collected by local social security agencies, and were distinct from personal income tax collected by local tax authorities.

Last July, China’s State Council announced the “new social security policy”, which will consolidate the collection of social security and income taxes to the tax authorities starting next year. This streamlining may prove ruinous to a large number of private enterprises.

Up to now, businesses have employed a common tax dodge: when they pay social security for their employees, they typically only pay the lowest per-capita contribution instead of the actual wage-based contribution. For instance, in Beijing, the base wage is RMB 3,082/mo for pension contribution, and RMB 4,624/mo for medical insurance. Therefore, regardless of your actual salary, whether it be RMB 2,000, RMB 8,000 or RMB 10,000, your employer will compute your social security contributions based on those minimum standards.

Because social security was collected independently, the social security agencies rarely received wage information from the tax authorities to catch the cheats. Now that the collection is to be unified under one ledger, businesses will no longer be able to claim the lower contributions for social security. As a result, for a Beijing business employing someone at RMB 10,000 per month, it used to be able to get away with contributing RMB 1,163 in social security a month. Now it has no way but to pay the full load of RMB 3,210. That is an almost three-fold increase!

While it is true that businesses should not have cheated on taxes in the first place, one still cannot overlook the real impact this policy has on negating the gains from any business tax cuts.

As bad as this news is to private businesses, it gets worse.

Since businesses will not be able to hide their true payroll starting next January, they will also have to make up past shortfalls in social security contributions. According to an analyst at China’s Guotai Junan Securities, this make-up gap amounts to around RMB 2 trillion. yuan.

So there you have it. The government grants you a nominal RMB 1 trillion tax cut, but will actually recover RMB 2 trillion from the private sector. How’s that tax cut dividend working out for China’s people?

The social security reform is not the only factor that offsets the tax cut. There are other factors, such as the price increase of production materials. On September 17, the Chinese people “welcomed” the rise in fuel prices. The price of 92 octane gasoline (equivalent to regular unleaded gas in North America) rose by RMB 0.11 per liter, the 11th price increase this year. Since fuel is a key cost of the transportation industry, its increase will be passed on to other commodity prices.

Some people ask, the overall economy is weakening, how come the profits of national enterprises are still growing? Of course, monopolistic national enterprises have the pricing power over basic means of production; as long as it can increase prices, its profits will soar.

Fuyao Glass Industry Group is a private producer of auto glass in China. Its owner Cao Dewang was interviewed in 2016 after he chose to set up production in the United States. Everybody knew that China was a factory to the world, why did he move his factory to the US?

He talked about several major factors. The first was land prices. Land prices in many Chinese cities were rising too fast.

Manufacturing industries need land, so its investment cost was rising out of control. Comparatively, it only cost him $15 million to buy a factory in the United States. American government values job creation, so the local government gave him $16 million in subsidies, making his land cost essentially free.

The second factor was that China’s electricity was more expensive than in the United States. China tagged on a lot of additional costs to the basic electricity price, such as the national water project fund and the renewable energy surcharge, in addition to a myriad of local surcharges.

The third factor was the social security mentioned above, as well as various additional expenses: education surcharges, employment security funds for the disabled, etc.

Therefore, tax cuts don’t necessarily improve economic vitality, if the ultimate cost burden to the business isn’t reduced. We see the Chinese government announcing tax cuts for enterprises on the one hand, but adding other economic burdens to enterprises on the other hand, except it did not call them taxes. So the real cost to run businesses rose. Consequently, businesses could not afford hire more people to give workers wage increases.

The US has a fairly transparent social mechanism, where the impact of tax cuts shows up directly in corporate bottom lines, and drives employment. At the same time, American households’ expenditure to income ratio is relatively stable; so when a family’s income tax is reduced, it will spend that money. Trump’s tax cut is estimated to have stimulated $300 billion of personal consumption.

To summarize, we analyzed China’s ability to withstand a long-term trade war, from the stand point of enterprise cost burden and employment outlook. To wage a protracted war, one must believe that time is on his side, that the passage of time will either enhance his own advantage or wear out his opponent’s advantage.

In China’s case, the government always responds to difficulties by increasing the burden on businesses. The longer the trade war drags on, the more its economic vitality will decrease, so it does not have the economic conditions to support a protracted trade war.

Not to mention the recent buzz to re-establish public-private partnerships and state-owned private enterprises. Should the government elect to renationalize industries, it would be a sure way to destroy China’s economic vitality.

Perhaps the Chinese leadership is counting on a war of attrition, where it turns the populace into cannon fodder. Unlike the US, China has no problem turning its middle class into lower class; the people dare not say no. Whether this calculus will bear fruit for China, we might be able to see the answer as quickly as in six to twelve months.

See Wenzhao’s original Chinese commentary on Youtube

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