US-China trade war: the art of failure

In just three months, President Trump buried the post-1945 geopolitical order, upended the global trade regime, weakened the credibility of the US economic policy framework (Federal Reserve (Fed) independence, fiscal guardrails) and tested the limits of the executive power on immigration policies, threatening a constitutional crisis. Apart from a collapse in immigration flows (that had started in mid-2024), this policy whirlwind has delivered very little. On the geopolitical front, war still rages in Gaza and Ukraine, the Red Sea waterway is still closed, and Iran is still enriching uranium. On the domestic economic front, the fiscal deficit is still ballooning, while surveys suggest consumer and business confidence has collapsed¹. On financial markets, equities, bonds and the dollar are down in unison, in a dangerous reversal of the normal correlation regime that should prevail for the global reserve currency.

The market rout forced Trump to put on hold most of his ‘reciprocal’ tariffs. Bond vigilantes called Trump’s bluff, and won. But the 145% tariffs on China largely hold. Chairman Xi is now testing Trump’s resolve on his de facto trade embargo against China. But Trump seems to have miscalculated his own bargaining position.

In what amounts to no less than a declaration of economic war, Trump believes that he has the upper hand simply because the US is “the beautiful store that everybody wants a piece of”. “There is no greater danger than underestimating your opponent” wrote Sun Tzu in the Chinese classic The Art of War, and this is exactly what The Art of the Deal author seems to be doing.

I’ll concede that on paper, China is on the losing end of this mutual trade embargo. Its exports to the US are roughly 3.4% of its GDP (in value-added terms and taking into account plausible transshipment through third countries), versus only 1.0% for the US². But the Achilles’ heel of the US is the pricing power of Chinese exporters.

In the consumer goods sector (44% of Chinese exports to the US), China accounts for 30% of US imports, with some dominant positions in certain products such as laptops (78%), smartphones (76%), toys (66%), and footwear (58%)³. Taking into account the margin added by the distribution, marketing and retail sectors, consumer goods ‘made in China’ account for roughly 14% of total US goods consumption ex food and energy⁴. Should the 145% tariff prevail, we risk seeing a ‘sudden stop’ of such imports into the US (as suggested by the current collapse of container loading on the China-US route), and a non-linear increase in their retail prices, accompanied by shortages reminiscent of the Covid crisis.

In the intermediate goods sector, China’s central role is even more blatant. The country accounts for 40% of global output⁵, and according to Richard Baldwin from IMD Business School, China is, directly or indirectly, the first foreign supplier in all US manufacturing sectors except pharmaceuticals, accounting on average for 3.5% of total inputs (including those sourced domestically)⁶. The ratio is three times the reciprocal one for the Chinese manufacturing sector. On a more granular level, we also know that China holds a quasi-monopolistic position on certain intermediate goods, such as processed rare earth minerals (70-100%), solar panels (90%), lithium-ion batteries (76% of global capacity), active pharmaceutical ingredients (46% directly and through India)⁷. All these inputs are key for critical sectors such as defense, autos, aviation, aerospace and pharmaceuticals.

A US quasi-embargo on China would surely lead to a politically-devastating second wave of inflation and paralysis in the very sectors that Trump wants to resurrect for national security and social cohesion purposes. In China, the blow to exports would be a deflationary shock, rising unemployment, but China would still have a current account close to balance, making it possible to deploy precious fiscal space it has been saving for years. For ideological reasons, China has always been reluctant to stimulate its domestic consumption, but Trump would give it an imperious geopolitical argument to do so. On the contrary, in the US, the return of inflation would prevent the Fed from cutting rates before the end of 2025, while higher bond yields would reduce further the ability to respond with fiscal stimulus. One could also add that the tolerance to pain will be key, and a totalitarian society under constant cyber-surveillance such as China’s has a capacity to endure economic pain longer than a democratic one submitted to 2-year electoral cycles.

Besides supply chains, China has another leverage instrument at its disposal: financing chains. China has a war chest of around 3tr$ of US liquid assets (mostly Treasuries and Agencies) through holdings of its central bank, Hong Kong Monetary Authority and the big public commercial banks⁸. China could gradually swap such holdings for non-US reserve assets (Bunds, JGB, Gilts…) in order to keep a downward pressure on the USD and US bond markets. China would harvest a double benefit, with plausible deniability. First, the renminbi exchange rate would piggy-back on the dollar devaluation to regain competitiveness, without taking the risk to trigger capital outflows through a devaluation versus the USD or trigger Trump’s ire. Secondly, such move would force other G10 central banks to cut rates in order to alleviate the pressure on their currencies, thus giving more space to the People’s Bank of China to ease its own monetary policy. Conversely, a weaker dollar would fuel inflationary pressures in the US, with higher bond yields reducing Trump’s fiscal space.

It's clear the critical role played by China in the US means Xi could force Trump into an economic war of attrition, when the US President was hoping for a Blitz victory. For a man that once wrote “if you don’t deliver the goods, people will eventually catch on” things are starting to look more than a little precarious. He might soon have to admit defeat.