The China Trade Syndrome Update: Are the U.S.-China trade talks victim of a misperception game?

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K.P. O'Reilly PhD, JD

K.P. O'Reilly PhD, JD

The China Trade Syndrome Update: Are the U.S.-China trade talks victim of a misperception game?

August 13, 2019

In the span of three months, U.S.-China trade relations went from being on the verge of a settlement to the precipice of an all-out trade and currency war. It looks like Trump’s infamous quote that trade wars are easy to win will be put to a test. How did it all go so bad, so fast? It appears that the Trump administration, and President Trump, specifically, if reporting on the decision-making on his recent 10% tariffs threat is accurate, misperceived their leverage against their Chinese counterparts.

Three years into the Trump presidency, it’s readily apparent negotiating style, particularly as to trade, favors hardball tactics indicative of a zero-sum mentality. Certainly, recent economic data indicates a slowing Chinese economy, giving credence to the position that the Chinese government is vulnerable to pressure tactics. The logic of this approach seems sound so long as the Chinese most desired avoiding a trade disruption jeopardizing economic growth in the near-term.

While such an assumption might have held true earlier, at some point Chinese preferences changed. Reasons for this change in the Chinese approach include saving face given what they viewed as increasingly harsh U.S. demands and the belief that, although inflicting short-term pain, a trade war might weaken Trump’s re-election bid setting the stage for talks with a more agreeable U.S. administration. Regardless of the reasoning, the trade talks now pit two sides both ostensibly open to brinksmanship.

Using the Theory of Moves, which expresses dynamic game trees through a normal form, classic payoff matrix, we can visualize the misperception by the U.S. regarding Chinese preferences. Figure 1 shows the trade game as misperceived by the U.S. and Trump while Figure 2 shows the trade game as it is playing out. The results are diametrically opposed.

In the Misperception Trade Game (Figure 1), we see how the U.S. and Trump view themselves as stronger than China, and capable of exerting pressure through the threat of tariffs to bring China to the negotiating table. Such a view assumes the Chinese seek to avoid an all-out trade war which represents their worst outcome, which can be inflicted by the U.S. should the Chinese stand firm. The U.S. is motivated to threaten or maintain a strategy of tariffs until the Chinese side capitulates, at which time the U.S. can reciprocate with a more cooperative strategy to ultimately seek a negotiated compromise trade deal, its most favored outcome.

However, the trade talks as playing out appear more in line with the game shown in Figure 2. Problematically, in this game, the Chinese have a dominant strategy of stand firm which delivers better payoffs regardless of U.S. actions. This Chinese intransigence reflects the Xi government’s unwillingness to accept the structural reforms sought by the U.S. and their willingness to incur short term economic pain in holding out for better terms, either from Trump or a new U.S. administration in 2021. Further, they may see the U.S. as equally, if not more, sensitive to the economic hardships inflicted by a trade war.

What, if anything, can reverse this dangerous course set by the parties? Further U.S. escalation is unlikely to work as the Chinese appear ready to dig in their heels and see if they can wait out Trump. It might take honey rather than vinegar to persuade the Chinese that negotiation is the more attractive option. If a trade deal remains the goal, the challenge falls on the U.S. to both modify and, more importantly, signal to the Chinese a change in negotiating tactics (Just today, the U.S. announced the delay of some of the September 1 threatened tariffs until December). This could mean splitting apart aspects of the trade agenda, possibly negotiating matters like structural reforms separately or in progressive, incremental steps going forward. However, it is possible that China’s preferences could change should the damage of a trade war prove too much to stomach, either economically or politically.

These insights suggest investors should be prepared for prolonged uncertainty as to any sort of trade deal being accomplished. While the change in seasons might bring cooler temperatures, the trade war might start to really heat up as we head into the Fall. Meanwhile, the rhetoric and actions by the U.S. and Chinese sides can indicate the direction of any upcoming talks.

 

To download the PDF version, click here: 2019-08-13 The China Syndrome Update

 

 

 

The views and opinions expressed are those of Northwest Passage Capital Advisors LLC as of the date of this update and are subject to change based on market and other conditions. There is no guarantee that the forecasts made will come to pass. This material is not intended to be relied upon as investment advice or a recommendation, does not constitute a solicitation to buy or sell any security and should not be considered specific legal, investment or tax advice. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time. The information and opinions are derived from sources Northwest Passage Capital Advisors LLC believes to be reliable, however, Northwest Passage Capital Advisors LLC does not represent that this information is complete or accurate and it should not be relied upon as such. This information is prepared for general information only.

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2019-08-23T08:25:20+00:00 By |