Last week, in What can you do to protect yourself from increasing currency volatility?, we wrote about the rising currency/trade tension between the US and China is flaring up again. While such tensions are hardly common occurrence in the love-hate mutual co-dependency relationship between the two giants, this current one has reached a a new high point.
Last week, US politicians have agreed to vote on a bill to retaliate against perceived Chinese currency ?manipulation? with trade sanctions (see US Congress committee approves China sanctions bill). For this bill to become law, the two Houses of Congress (House of Representatives and Senate) have to approve of the bill. This coming week, the House of Representatives is going to vote for it. But it is unclear whether the Senate will support this bill before the November mid-term elections.
If this bill comes into law, and if the Obama Administration decide to slap China with draconian trade sanctions against China, then outcome will be a trade war between the world?s two largest economies. The Chinese will definitely retaliate, sparking another round of retaliation from the United States. The outcome will be mutually assured economic destruction.
Some prominent American economists (e.g. Paul Krugman) in the United States that a trade war will hurt China more than it will hurt the US. This is because they subscribe to the theory that a trade war will disrupt vast swathes of the Chinese export-oriented economy, which in turn will result in social and political instability that will threaten the legitimacy of the government. Hence, these economists are very keen and aggressive with the idea of imposing trade sanctions on China. But as we wrote in Will China fall under popular revolt?,
? this school of thought do not understand the cultural and political reality of modern China.
However, there is a subtlety that you have to understand- Yes, the immediate impact of a trade war will probably be more painful for China initially. The idea is that, as we wrote in Can China really ?de-couple? from a US recession?,
This will translate into a disproportionate contraction in the higher stages of production, which is China?s job. This in turn will result in yet another disproportionate contraction in yet another higher stage of production.
But we do not subscribe to the theory that this will result in political upheaval in China. Instead, we believe a trade war will fan the flame of nationalism in China and strengthen the position of the Chinese regime.
Regardless of who wins in a US-China trade war, countries like Australia and the rest of Asia will suffer as collateral damage. As the saying goes, when two elephants fight, the grass below will suffer.