Four Signs U.S-China Relations are Destined for Conflict

The drums to conflict between U.S-China relations have reached fever pitch.

President Trump had direct diplomatic contact and conversations with at least 18 world leaders before extending such offerings to Chinese leader Xi Jinping.

While acting as president-elect, Trump held a very provocative conversation with the Taiwanese president. It became clear that the incoming administration was not going to be acting on standing protocols that had existed for decades.

Since then, President Trump and President Xi have opened communications, but upon first impressions the indicators for a U.S-China conflict are greater than recent memory.

As Xi Jinping remarked while at the World Economic Forum in January 2017, ‘It was the best of times, it was the worst of times.’ These are the words used by the English writer Charles Dickens to describe the world after the Industrial Revolution. Today, we also live in a world of contradictions.”

It is not only contractions in rhetoric, but the actions that should be evaluated when looking at what could build into a very real conflict between the U.S and China.

Here are the four signs that U.S-China relations could reach a crisis level:

1. Advisors: Strategy for Disaster

After the U.S inauguration and the breaking of its one China policy, the U.S has seemingly reversed course.  “President Trump agreed, at the request of President Xi, to honour our ‘one China’ policy,” read a statement released by the Chinese government.

This type of quick shifting in policy can present dangerous situations. The advisors for both respective government leaders will be key to navigating norms and policy. They will also present the greatest adversarial paths to conflict and power maneuvering.

Economist and bestselling author, Jim Rickards while referencing Steve Bannon, the president’s chief strategist, reminds us that only a few months back the National Security Council member indicated that “we’re going to war in the South China Sea…no doubt.”

Rickards reports, “Admittedly, this forecast was made before Trump’s election and was a long-term forecast, not an immediate warning. Still, such comments do not go unnoticed in Beijing.”

“A conflict between the U.S. and China would be the most momentous confrontation since the end of the Cold War, in 1991, with enormous consequences for investor portfolios.”

These comments come as the Secretary of State Rex and former ExxonMobil CEO, Rex Tillerson made reflective comments. During his confirmation hearing the former CEO added that, “we’re going to have to send China a clear signal that, first, the island-building stops and second, your access to those islands also is not going to be allowed.” It should also be noted that his former oil company, ExxonMobil, maintains relations and drilling operations in the region – specifically with with Indonesia and Vietnam.

While military conflict is a more blatant possibility between the U.S and China, the economic friction might be an even greater urgent matter for advisors.

U.S trade representative Robert Lighthizer has heavily voiced his concern about the history of exports to the U.S rising faster than U.S. exports to China. This export history built up a considerable trade deficit.

In 2010, Lighthizer was a leading advocate for tariffs on China that would “force change in the system” even if it elevated “trade frictions.” While the new U.S trade representative might have been in favor of retaliatory tariffs, the Chinese side has also offered its caution to the incoming administration.

From the Chinese leadership, an American-educated political figure and arguably the top economic adviser, Liu He, has ranked as President Xi Jinping’s right hand man. He will continue to offer signals toward which way the Chinese government will direct its policy and the sentiment toward U.S-China relations.

The economic adviser has been relatively mute in public about his plans but in a study that was released over three years ago the New York Times reported that the advisor argued China “cannot shoulder excessive responsibility” for reducing its trade deficits with other economies.

The top Chinese economic figure wrote, “Populist policies adopted by the governments of developed countries are often the instigators of crisis.” What that translates to is a vocal defamation of what the new White House proposals both in rhetoric and in action.

The Chinese Ambassador to the U.S, Cui Tiankai was referenced by Chinese state media run operation, The People’s Daily, where he remarked that “the talks on formulating the Code of Conduct in the South China Sea and maritime cooperation.” Ambassador Cui said, “countries from outside the region should support such efforts to restore tranquility instead of creating new hurdles.”

While the remarks may be mild in tone, the Chinese have made clear their position that the U.S government should stay away. The Chinese Ambassador, if these issues continue to escalate, will be a vocal center for his respective government. He will also be forced to reckon with translating policy between the world’s two largest economic forces.

The influence and advisory direction on matters of economic and military action will be vital to watch in the months and years ahead.  These advisors could present clear signals of things to come between a U.S-China conflict and shape policy that impacts governments and extends all the way through to everyday investors.

2. Power Dynamics: Pivot East to West

The nature of China and Japan relations has defined the Asian region for over half a century. The two powerhouse economies for the region have also had two of the most divided diplomatic channels in the world.

As the U.S and other regional powers continue to push at China, the government has been looking to bridge the gap in once taboo relations.

Nomi Prins, a former Wall Street insider who is currently working on her latest book, Artisans of Money, was recently in Japan and China. While there she met with government and financial figures. She reports that, “geo-bullying will also push former adversaries, China and Japan closer together. The two nations are already negotiating some historic agreements.”

“We could be approaching a new era in which Sino-Japanese relations allow for diplomatic normalization and more economic partnerships, which would be mutually beneficial.”

China has also begun considerable infrastructure projects that would allow it to navigate outside of the U.S. With these considerations it has gone as far as to initialize plans for a One Belt, One Road program. This program will expand and establish greater trade between Europe and Asia.

Chinese development banks have made more than $3 billion available for projects in a number of along those routes.  The Chinese government views this infrastructure generation as a step forward for eastern relations, and a way to diversify away from the western hemisphere.

The move eastward, instead of strengthening relations between the world’s top two economic forces, has mounting considerations. The closer trade and investments are between states, the less likely they are to come into direct economic and physical conflict.

Enter the Trump administration where it has enacted an immediate exit from any further Trans-Pacific Partnership trade negotiations. The withdraw of the U.S from the TPP, a deal that included 12 Pacific Rim countries, was part of a series of Trump’s executive orders. These efforts were made in an effort to withdraw the U.S government from global trade institutions.

While the TPP had its serious flaws, it was to put forward a U.S centered trade policy that would set the standard for technology and regulatory systems in Asia.  The TPP, if imposed correctly, would have forced China to follow a new trading standard and provided challenge to its undisputed regional influence throughout Asia.

What the U.S left, the Chinese government picked up.

“China will forge ahead with the negotiation of the Regional Comprehensive Economic Partnership (RCEP) and the construction of the Free Trade Area of the Asia-Pacific (FTAAP) so as to add new impetus to regional and global economic development,” read the statement from the Chinese Foreign Ministry immediately after the U.S withdraw. The Chinese government is now creating its own TPP and seeking to build on regional trends toward partnership.

What all this signals is a further shift east by the Chinese government, and a greater divide between U.S-Chinese relations that defined trade for an era.

Further indicators of U.S-China relations edging toward separation will only create a larger potential for rivalry and opposition. The shift from western integration to an eastern pivot will heighten the stakes between U.S-China relations for decades to come.

3. South China Sea: Theatre for Proxy Skirmishes

The South China Sea has the second highest frequency in sea travel through its channels in the world. To put that into perspective, every year an estimated $5.3 trillion of trade passes navigates through those waters.

For the U.S, its trade share accounts $1.2 trillion of the total commerce that passes through the South China Sea.

According to the U.S. Energy Information Administration the South China Sea has an estimated 11 billion barrels of oil. That makes it nearly equal to Mexico’s reserves. It also holds 190 trillion cubic feet of natural gas.

That makes the watershed and sea channel a bastion for natural resources in a region where energy demands are in abundance. It also makes the region an even greater target for competition and has caused economic and military backlash.

The Chinese government has also stated that it has historical rights to over 80% of the South China Sea.

Disruptions to that trade patterns from land and sea grabs would not only negatively impact local economies along the sea routes, it would drastically impact domestic markets.

Many have speculated that under president Trump, sectors in logistics, shipping and transportation would be major areas of improvement in the economy with infrastructure stimulus. Any economic, military or trade frictions could jeopardize all of the speculative investments that have been placed into the market.

Currently, the U.S government has active operations and government access to at least five publicly disclosed military outlets.

Kyle Bass while speaking on Bloomberg remarked that in the instance that a tariff is imposed on Chinese imports by the United States government certain responses will be given directly, and sharply by the Chinese government. In this shift, Bass poses, “The question is does all of this economic wrangling really start a fire that ends up moving into a kinetic response in the South China Sea? That is something we hope does not happen.”

Bass is the founder of Hayman Capital who was spot on in predicting the U.S. subprime mortgage crisis before the devastating real estate bubble burst.

He poses that, “The big question is, where is this all going as far as trade? When I look back at armed conflicts I think they are all rooted in some sort of economic [origin].”

“This is a fire that’s been smoldering and it’s now starting to burn, and Trump is just more gasoline.”

How that fire continues to burn will be important to watch from a military, financial and trade perspective.

4. Chinese Debt: The Next Financial Crisis

The outstanding loans held by China has topped $28 trillion. That total equals nearly the entire commercial banking systems in both the U.S and Japan combined.

Beginning in September 2016, the Bank for International Settlements (one of the most influential banking organizations in the world), released for the first time data on the credit-to-GDP ratio gaps since 1961.

The information revealed that China reached an astronomical total of 30.1 in this ratio gap. Typically anything over a figure of 10 offers room for concern and the Chinese economy has tripled that.

That puts the major Asian giant at the highest ratio to date, and above all other major economies evaluated by the governing institution.

The 30.1 ratio gap is higher than the numbers seen during the Asian boom in 1997 and the subprime mortgage bubble experienced just prior to the Lehman Brothers crisis of 2008.

All of this mounts the story for a Chinese debt bubble that continues to inflate.

Former Reagan White House insider and bestselling author David Stockman noted even at the beginning of 2016 that, “The fact is, no economy can undergo the fantastic eruption of credit that has occurred in China during the last two decades without eventually coming face to face with a day of reckoning.”

Stockman did not skip a beat saying that, “Massive borrowing to pay the interest is everywhere and always a sign that the the end is near. The crack-up phase of China’s insane borrowing and building boom is surely at hand.”

While a collapse in China might be unlikely, it is clear that the Asian giant has lost its economic swagger. The Chinese economy acting with a muddled sense of direction could cause mass confusion amongst foreign exchange markets. That alone should offer concern to investors both domestically and on an international scale.

The looming Chinese debt build up has caused the government to continue a program of burning through trillions of foreign currency reserves.  With a population of well over a billion people, the prospect of a collapse and no reserves to back it up would threaten global stability and disrupt trade.

Kenneth Rogoff wrote in Project Syndicate that, “China has financial weapons, including trillions of dollars of US debt. A disruption of trade with China could lead to massive price increases in the low-cost stores – for example, Wal-Mart and Target – on which many Americans rely.”

That means that what happens in the Chinese economy will directly impact the wallets of Americans. As the global economy continues to recover from the global financial crisis, and further shock to the system could generate a conflict that no country would be capable of affording.

Jim Rickards, the author of Road to Ruin states, “While the exact path and timing of such a conflict may be unclear, it’s not too soon to start building a defensive allocation in your portfolio just in case.

“The single best asset class for the coming conflict is gold. When trade and monetary cooperation between the U.S. and China break down, gold will re-emerge as genuine world money, as it has many times before.”

During the elite power games that continue to unfold, those in the real economy could be caught between the conflict of these two world powers.

While these indicators may shift in the months ahead, U.S-China relations will be vital to understand and monitor.  Staying aware of the changes and updates in these will allow you to better position yourself for the road ahead.

Thanks for reading,

Craig Wilson, @craig_wilson7
for the Daily Reckoning