Commentary: Presidents’ Agenda - The Decisions that Will Shape US-China

During the first half of November the two largest economies in the world selected their heads of state, in one case democratically extending the mandate of an incumbent leader and, in the other, transitioning power from one generation of leadership to the next in a top-down managed process. With President Obama confirmed for another four years and President-elect Xi Jinping set to run China for the next ten, these two leaders will need to determine when to compete and when to collaborate on many of the world’s most important issues. During the coming decade when China according to the estimates of most analysts is expected to overtake the US in terms of GDP, the next four years will be critical in shaping the relationships between the two countries and forming the trajectory of their respective future economic growth and development. During the past decade, China has gone from being a “strategic partner” (under President Clinton ) to being a “strategic competitor” (under President Bush ). What the US and China will be to each other will be shaped by how Presidents Obama and Xi tackle the top bilateral issues of trade and economics, foreign policy, natural resources, as well as their respective top domestic issues. It is clear that without a strong domestic base China cannot succeed in its continued socially stable rise and America cannot regain the high ground it has occupied for the better part of a century.

Before exploring the top issues facing the two countries it is useful to look at the circumstances of both leaders’ rise to power in the context of their respective political systems as well as at the nature of their roles and responsibilities, which are summarized in the table below.

A quick glance at the table above should suffice to demonstrate that the two leaders’ positions and circumstances, while sharing some similarities, are very different. The starting points from which these two men have secured their victory will affect their ability to address the domestic and international issues that will shape the big US-China decisions that need to be taken. Although total American GDP between 2009 and 2012 is expected to expand by 3.0% (the EU’s total growth over the same period is expected to be (1.0%) and Japan’s (0.1%)), the domestic impression that the American economy is not performing creates a significant pressure to address all factors that benefit the American economy including imports from China. China’s growth during the same period has slowed from 11.9% to currently 7.4% and this also will create significant pressures for the incoming government. The agenda that will occupy both men is long and complex mired in domestic, regional and international issues. The approach they take and the decisions they make on each of these can set the two nations as strategic adversaries or strategic partners. The challenge of how these potential areas of conflict are resolved will demonstrate the character of the two nations. We lay out below some of the key factors that are pertinent to the direction of each of these major factors.

The Top Bilateral Issues

1. 1. The Economic Issues

The Crux of the Issue: Although China has reduced its current account surplus significantly, from 10.6% of GDP in 2007 to 2.6% last year, the US runs the world’s largest current account deficit against China, whose strong export sector has been a key driver of its economic development. Without this and until China has created a domestic consumer society (a multi-decade challenge with its own issues), anything that undermines China’s exports undermines its prosperity and is a force for destabilisation.

The Status Quo: To date, both countries have assiduously avoided the escalations that would lead to a trade war such as tit-for-tat tariffs, and have sought to resolve their differences within the confines of the WTO, despite Chinese products from car tires to solar panels facing US tariffs from anywhere from 18% to 250%.

For the Presidents’ Agenda: Political and economic pressures in either country could easily reverse the “peaceful” status quo of today and lead to an escalation outside of the established rules of engagement. Preventing this is an essential part of continuing a global open trade environment for the world at large of which America is a major beneficiary.

The Crux of the Issue: Although the RMB has risen over 30% against the US Dollar since 2005 (including 10% since 2010), the US still believes that it is undervalued.

The Status Quo: When Governor Romney called China a “currency manipulator” during the recent presidential elections and the U.S. Senate voted to sanction China for its currency policies in 2011, China felt insulted and under-appreciated for its progress in addressing the issue, particularly given its stated commitment to the gradual liberalization of its capital account and exchange rate. Recent initiatives include doubling the trading band of the RMB against the US Dollar earlier this year, from 0.5% to 1% per day and increasing investment caps for RMB investments under the qualified foreign institutional investor scheme.

For the Presidents’ Agenda: Although China appears to be making steady progress in exchange rate liberalization, if China suffered a hard landing, it might well be tempted to devalue its currency to kick-start further export growth, even at the cost of further domestic unbalancing. For China, its currency and exchange rate are an important lever with which to manage a socially and politically stable path of growth for the country, and any pressure on its freedom to use this lever is seen as a threat to the its overall plan and rebutted accordingly. Helping China manage the transition is clearly of mutual benefit.

The Crux of the Issue: As of June 30, 2012, China held a total of $3.2 trillion in foreign exchange reserves, about 70% of which were held in U.S. dollars. Although the People’s Bank of China (PBOC) has stated that China’s exchange reserves have “exceeded our country’s rational demand” , China’s options to reduce its forex reserves generally and US debt holdings specifically are quite limited. The days when the US could comfortably say “it’s our currency and your problem ” are clearly over and the stability of the world’s primary exchange currency has become a matter of urgency for the US Treasury.

The Status Quo: China to date has sought to escape the “dollar trap” by reinvesting its dollar purchases in other reserve currencies and natural resources, but liquidity constraints limit the scale of these alternatives. Although the PBOC can today continue to absorb additional US dollars generated by Chinese export earnings in order to fund US government debt, a long-term solution would require the US presenting China with viable dollar denominated investment alternatives.

For the Presidents’ List: A more active and substantial strategy, the Sino-dollar, similar to the Petro-dollar strategy (employed by Middle Eastern oil exporting nations whereby they returned capital to the US as an investor) would represent such a longer-term solution. Clearly, despite the need for such a solution, America is not ready for the scale of Chinese investment that would represent a viable Sino-dollar strategy. Identifying a range of industries for investment is the beginning of a longer process of opening to the flow of capital.

The Crux of the Issue: In addition to intermittent trade protection, direct investments between the two countries have also been subject to increasingly frequent restrictions. While China has adopted a blanket approach to limiting foreign investment and competition in a fairly wide range of sectors, the US has taken a more ad hoc approach to restricting Chinese investment in US assets typically by invoking national security interests. The implication of closed doors is clear: Chinese companies, whose outbound investment is expected to reach up to US$800bn by 2016 , will invest elsewhere.

The Status Quo: The US regularly excludes Chinese companies from US acquisitions on national security grounds. Ralls Corp., which is owned by Chinese nationals, was the first company in 22 years to be ordered to divest an investment on the basis of national security, Ralls having purchased wind farms earlier this year near a military testing facility in Oregon. Most recently the US excluded Chinese telecom equipment manufacturers Huawei and ZTE from US contracts and acquisitions. Huawei has already established six research centers in Europe to date without a problem.

For the Presidents’ List: Such lost opportunities for the US are not incremental: combining US brands, technology and market access with Chinese capital and low cost production can create a new generation of US-Sino or Sino-US global industry champions capable of restructuring formerly uncompetitive industries. However, for this to occur, the US would need to open itself to investment from China without initial reciprocity. Britain’s commitment to free trade and the free movement of capital in the 19th century during a time of protectionism made it the richest and most powerful country in history and the US would need to follow suit in a similar manner.

In Summary, The Shape of the Economic Relationship

The macro-economic factors above will be critical for the two countries and their leaders to consider, given that under most of the “accepted wisdom” forecasts that China will overtake the US as the world’s largest economy before the end of President Xi Jinping’s reign. The graph on the right assumes a moderate recovery of US growth (to 2.5% annually) and a moderate easing of China’s growth (to 6.5% annually over the period) with reasonable inflation and Yuan-RMB currency appreciation. Clearly, the shape of both curves will be driven by each leader’s ability to push through much needed domestic economic reform. China has recognized the need for it to invest in foreign countries and to do so in scale. To succeed in this, China will need to come to grips fully with the resistance that has been growing to what nations perceive to be the Chinese government controlling their nation’s key assets. Conspiracy theory sees China managing its currency value to benefit its trade and then utilizing the reserves accumulated to buy up international assets. America appears not yet to have fully recognized that, without this investment, the value of the American homeland will decline, and we may see the end of the dollar as the reserve currency. This would be a big negative psychological blow to the US and its international standing, and may well be considered to mark the end of the primacy of the US . Finding a solution whereby China can invest in very substantial amounts across diversified sectors in the US without a “national security” alarm bell going off is becoming a strategic question for America.

1. 1. The Foreign Policy Issues

The Crux of the Issue: The most important development in US-Chinese foreign policy is the Obama Administration’s “pivot”, a shift of diplomatic and defense resources away from the Middle East and back towards the Asia-Pacific. President Obama succinctly summarized the strategy: “We will preserve our unique ability to project power and deter threats to peace … Our enduring interests in the region demand our enduring presence in the region. ”

The Status Quo: Although the US has not to date taken a direct position in the multiple sovereignty disputes in the South and East China seas disputes, its rhetoric places it on a collision course with China, which is seeking to project regional power for its own enduring interests too. For China, the uncertainty over US aims and actions is a considerable source of insecurity, which risks triggering strong reactions to perceived threats that will enhance, rather than diminish regional security. The current territorial disputes involve China and Taiwan, Vietnam, Indonesia, Malaysia, Brunei, and The Philippines in the South and China, Japan and South Korea in the East China Sea, and no roadmap for the negotiated settlement of any of these disputes has been proposed (by any party).

For the Presidents’ List: Unless China or its opponents – under US leadership – develop a comprehensive framework to settle outstanding disputes and issues, China may well find itself facing a hostile seaboard along its entire Pacific border, significantly reducing China’s security. At the extreme, it could find itself isolated by the wider international community, facing not only a strengthened US Navy 7th Fleet. Japan presents a peculiar case in point, which if current trends continue, will continue to diversify its substantial investment of capital and IP away from China. The case for Japan having a nuclear defence capability in such a case will not be difficult to find in a region where China and North Korea both have weapons (and India and Pakistan as well). The countries with disputes are increasingly asking China to stop seeing the South China Sea as Chinese but as Asian, which it is. If China can do so, it can create a mechanism for managing disputes and the South and East China Seas can become a primary conduit for the exchange of capital, goods and ideas in the region, much like the Mediterranean has been throughout much of history.

The Crux of the Issue: America’s Taiwan policy is a unique situation within the larger pivot strategy and a continued thorn in China’s side. America withheld diplomatic recognition of China in favor of Taiwan until 1972 and has continued to support Taiwan financially and militarily, even threatened to use nuclear weapons during Taiwan Straits Crisis , periodically while "reaffirm[ing] its interest in a peaceful settlement of the Taiwan question." From China’s perspective, continued US support of Taiwan remains the main obstacle to reunification with the mainland.

The Status Quo: Taiwan has in recent years become increasingly dependent on China across multiple dimensions, with more than a dozen agreements between the two countries signed on issues including tariff reduction, investments, tourism and joint police cooperation, among others, and the 2012 re-election of President Ma Ying-jeou has shown that Taiwan’s citizens are in favor of closer ties to the mainland. While doing this, Taiwan continues to buy American arms.

For the Presidents’ List: The fragile balance between China and Taiwan could be tipped quickly either way. A more aggressive policy could re-create an “Iron SeaWall” in the Taiwan Strait, while a more constructive policy would help drive a peaceful co-existence where both parties benefit from the transfer of know-how and investment.

The Crux of the Issue: Central Asia stretches from the Caspian Sea in the west to China in the east and from Afghanistan in the south to Russia in the north. As such it has historically been the crossroads for the movement of people, goods, and ideas between Europe and all the corners that touch Asia and the venue for political and military action. The region’s rich resources and borders continue to make it the intersection of interest of major and regional powers including the US and China.

The Status Quo: Central Asia today is home to America’s war on terror in Afghanistan, China’s oil and gas pipeline and deals with Turkmenistan, Kazakhstan and Uzbekistan, Russia’s low-key territorial dispute with China, and China’s most “unruly” regions, Xinjiang and Tibet. Central Asia in other words continues to be a core focus area for China’s foreign and security policy. The US, on the other hand, has pursued a hodgepodge of policies in a region that lies between two of its own focus areas, the Pacific Rim and Middle East. Currently, the US and China as well as countries like geographically important Russia and culturally-ethnically important Turkey are playing a modern, more complex version of the Great Game, in Central Asia, vying for trade, energy, and other natural resources, in addition to the security interests that drove completion between Britain and Imperial Russia in the 19th Century.

For the Presidents’ List: In the current form of the Great Game, the nations of Central Asia are participants rather than pawns, and beneficiaries of the competition over their resources and friendship. A shift in the US or China’s modus operandi could change this though to a more urgent struggle for position. From the US perspective, it may well make sense to “encircle” China by pursuing a clear Central Asia strategy to complement its Asia-Pacific strategy. From China’s perspective it may make sense to patiently build relationships, take small pieces of the board and fill the void that America leaves as it withdraws from the region such as Afghanistan.

The Crux of the Issue: Americans are the biggest consumers per capita of natural resources globally. One of the key elements of China’s foreign and economic policy is resource security, whether through foreign acquisitions of companies, sovereignty claims of resource rich territories, or the acquisition of mineral rights in third countries. China’s ability to transform its economy and maintain social stability is predicated on continuing economic growth, which in turn requires significant energy and material resources.

The Status Quo: China’s demand has already pushed up prices for key commodities globally and its acquisitions of assets in countries like the US and Australia have been subject to considerable popular backlash, driving China to pursue opportunities in countries widely perceived as pariahs by the international community, such as Sudan, Myanmar and Iran. China has had a relatively free-run at its strategy for about two decades, although resource constraints are pushing both countries into more frequent direct competition.

For the Presidents’ List: Given the demand for resources, America and China are for now natural competitors. In addition, shale gas is a potential game-changer: China has the largest single country shale gas reserves, while US-allied North America has even more. The key question for America will be whether it should share its technological advantage in exploiting shale gas or keep it and also whether it should export or stockpile the resource. Sharing and exporting will lessen competition but minimize its clout down the line when the world faces shortages. Withholding will lead to China having to pursue increasingly aggressive sourcing, potentially in South America and Canada, what America sees as its “backyard”. This “encirclement” of America has far reaching implications. As an example, China today imports 400,000 barrels of oil per day from Venezuela, all of which are at the expense of exports to the US. More importantly it has provided Venezuela with US$32bn in loans, much of it being used to purchase Chinese goods and products, including arms, affording China potential levels of influence in South America that the US for much of its history has considered as unacceptable as formulated by the Monroe Doctrine.

In Summary, The Shape of the Foreign Policy Relationship

Foreign policy choices offer each the opportunity to “encircle” the other. America’s positioning in the South China Sea and Central Asia (coupled with an India engagement policy) can create an effective encirclement of China. China’s positioning in South America and Canada can create an effective encirclement of America, and in either case both nations can put forward economic and national security interests to defend their respective moves. Effectively executing these moves will require coordination and cooperation with a wider group of partners and interested parties. The US has a long history of participating and leading in multi-national organizations, and has used these effectively to further its own policy goals, winning support where possible (e.g. NATO’s Balkan engagements) but going it alone where required (vetoing UN resolutions criticizing Israel over Palestine). China, on the other hand is a relative newcomer to multi-lateral diplomacy (learning quickly as it has demonstrated in looking after its interests on Sudan, Iran, North Korea and Syria) and this, combined with an unwillingness to take action in what could be construed as another countries “internal” affairs, has led it to take a passive foreign policy stance, vetoing multiple UN Security resolutions. America has a window of opportunity to work with China to help its participation or to see China learn how to be more proactive in defining and addressing its foreign policy goals and challenges.

1. 1. Domestic Issues

The Crux of the Issue: Both America and China are finding it difficult to regain their former economic confidence. America is struggling to redefine a form of capitalism that can align Republicans and Democrats let alone the rest of the world behind America. China is struggling to chart its own course in a world where the role model is no longer defined by America’s capital markets. This has led China to reduce its ambition to “safe” growth.

The Status Quo: Five years after the collapse of the subprime housing market, the nationalization of its auto-industry and a US$787bn stimulus package initiated in 2009, America is slowly recovering from the global financial crisis. The impact of the fall is felt in an unemployment rate of 7.9% and an economy that has very slowly recovered from the 5.3% contraction it suffered in Q1 2009 to 2.0% during the previous quarter. The recovery looks and feels more like a slow climb from a depression than the rebounds from previous recessions: America’s debt has been downgraded and the country faces a “fiscal cliff”. China too must continue to deliver prosperity to its people. The country has fallen from the heights of 12% GDP growth to under 8% now. At these growth rates, China’s economic activity does not generate sufficient wealth generation in America, Europe or Japan, who have come to rely on China to help drive their own economies. Further, at the current employment rates, China cannot rely on keeping the steady stability it has enjoyed given how raised expectations have been among its people.

For the Presidents’ List: Continued political stalemate will drive the country off the fiscal cliff, stall the fledgling recovery and perhaps throw the country into depression. This will further decrease American influence in the world and its ability to shape the global agenda, as well as exacerbating the socio-economic fault lines within the country itself. Bold bipartisan action could reinvigorate America, driving innovation, economic activity and broad based wealth creation. China’s need to reinvigorate its economy is essential to its peaceful rise. Also a lower growth China will be a far less influential force in the world, merely a trader sourcing raw materials rather than a strategic ally for growth.

The Crux of the Issue: China may be the only country in history where the minimum annual GDP growth required for assuring social stability is widely believed to be around 8%. The US election has demonstrated the divisions of ideology, economic class, and ethnicity. Although external shocks, (such as another major homeland terrorist attack which thankfully seems unlikely) can galvanize and unify the nation, America will need to find its own positive internal rationale for stepping back from its divisions to reforge US society into a more unified one.

The Status Quo: While China’s 8% growth requirement can partially be explained by the gap between nominal GDP and real income growth, the potential instability risk of lower growth in China is a function of its political system. The Chinese Communist Party during the Deng-Jiang eras implemented widespread socio-economic reforms that were not followed up with corresponding political reform during the past Hu Jintao decade. In addition, corruption, promotion based on patronage, increasingly sophisticated censorship and a higher standard of government accountability are high on President Xi Jinping’s agenda. Although the short-term priority will be economic stability and ongoing rebalancing, without longer-term political reforms, China’s huge economic gains risk being undone. On the upside, President Xi’s ten-year reign provides a sufficient runway to develop and implement a carefully managed and staged political opening. On the downside, further stagnation and repression will likely lead to internal strife and a potential risk to the system (as pointed out by Hu Jintao in a recent speech – see Perspectives below). If the new leadership sees its mandate as playing it safe rather than developing and executing an ambitious vision, China will continue to muddle through the issues rather than address them. With regards to the US, the American election cost US$6 billon. China could easily argue that America also faces the need for reform of its political system. High on the list for reform is banking and finance, healthcare, education, entitlement and immigration. A windfall profit from unlocking the riches from its shale reserves might allow the US to continue funding programs like social security and the public healthcare systems and also provide the impetus for a resurge in American industry.

For the Presidents’ List: President Xi’s ability to leave a more lasting legacy to China and the world than the outgoing leadership may largely be driven by his ability to overcome internal obstacles among the leadership team and drive change. It is not clear that the task will be any easier for a democratically elected President Obama than for a party elected President Xi

In Summary, The Impact of Domestic Issues

Both the US and China will need to manage their most pressing domestic issues, the return to prosperity for the US alongside the reform of society and political reform in China, as well as continued economic growth. Without solving its core domestic problems the US will be unable to resume a constructive leadership role in world affairs. Without political reform and continued economic development, the material gains China has made in the decades since initiating economic reform risk being undone. Successfully addressing these pressing domestic issues in China and the US will in some ways be a prerequisite for constructive multilateral engagement between the two countries. Unless both countries’ leaders can build the domestic consensus required to solve these problems it is unlikely that they will have the political capital to make the bold moves required to reshape the US-China relationship to the advantage of all.

Overall Conclusion

In reviewing the core US-China issues we have sought to illustrate the extremes of each position to provide a perspective on the potential risks and benefits of each. Given the fact that the countries need to have an integrated approach to bilateral relations and the interrelated nature of the issues themselves, it is highly unlikley that either country would actively choose to pursue an extreme position on any one of these issues. In all likelihood, both countries will continue to follow a nuanced path in the wide middle ground in dealing with one another, swinging to extreme positions tactically to achieve short term results or in response to specific events. The overall shape and direction of the US-China relationship will likley be determined by a number of factors, including

1. 1. 1. Vision and Character. Much will be determined by whether the vision and character of the leaders incline them to compromise rather than conflict. President Xi Jinping sits within a Party and Politburo that has moved toward consensual and negotiated decision making, making it unlikely that President Xi will carve out a radical personal agenda. The likely focus of the first term is the economy and modest political reform. President Obama has shown himself to be a pragmatist in his foreign policy dealings who is able to take unexpected positions. His energy will also be occupied in continuing to grow the economy while addressing reform under what is set to be difficult opposition. In both cases, vision will most likely take second place to execution focused on a safe growth path for the economy and modest progress on social and political issues.
      2. Political Action Freedom. How much freedom for political action do both leaders have? President Obama in his first term was not able to overcome stiff partisanship and establish an effective working relationship with a Republican House of Representatives. He will certainly need to do address this in his second term if he is to implement what is still an ambitious agenda. President Xi’s political freedom will be built over his first term. Barring major setbacks, President Xi should have the opportunity to exercise greater power following the next National People’s Congress in five years.
      3. Power Division and Balance. President Obama has rehabilitated the US in the eyes of international leaders away from the unilateralist superpower of the Bush era. This perceived multi-lateralism has earned him recognition and a measure of respect. Holding but not necessarily overplaying the winning military hand has also helped but this remains insufficient for the world’s leading power in the face of a China that is rapidly catching up in economic power. The overall winning hand requires the economy to be an ace. In this regard, America has a multi-decade game to play focused on carbon energy (based on shale) in the short term, a disruptive and innnovative alternative in the longer term, the transformation of its infrastructure and the expansion of its formidable and superior industry based on low cost fuel. Popular views of China overtaking America may well be failing to take into account the strength of America as a force for innovation and reinvention (see April’s Sign of the Times on China and the Freedom Advantage). For now, China and the US have realised the need to minimise distracting conflict and are willing to use international entities such as the WTO or UN to address their issues.

Finally, we focus too often on trends rather than game changers, individual events or actions that can quickly tip the scales. Many or all of the issues we have discussed can run to one of the two extremes. Events that would shift the two to a negative extreme with significant downside risk include among others (i) US military action with a direct impact on Chinese national security, e.g. intervention in Iran that chokes off one million barrels of oil exports daily, most of then to China, (ii) actions by China that escalate to conflict with a US ally e.g. Japan or Taiwan, (iii) prolonged internal unrest in China, particularly by a minority group or region, or (iv) the discovery of a next generation energy source. Events with significant bilateral upside potential on the other hand include (i) a wide-ranging opening of America to Chinese investment and reciprocal opening of China to America, (ii) a, say, US$100bn collaboration on alternative energy sources, (iii) China repositioning as the biggest provider of know-how and financial aid to emerging markets, or (iv) China settling all of its terretorial disputes, including a full reconciliation with Japan, in favour of opening wide these markets and re-positioning its brand. Both men have an important opportunity to form a vision of what a US-China looks like and set in motion a new and highly constructive pattern in the next few years.

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