China will have little time to celebrate any trade deal

On Monday, President Donald Trump announced he would delay the imposition of additional import tariffs on China in accordance to a previously targeted March 1 deadline. The president’s move conformed to expectations as progress toward a negotiated settlement of the ongoing trade dispute seemed to be at hand.

During this latest round of negotiations held in Washington, D.C. the Chinese trade delegation led by Vice Premier Liu He signaled significant concessions were being made to de-escalate the tit-for-tat trade war that has unfolded over the past year.

{mosads}Progress was accelerating at such a pace that members of the China delegation stayed in Washington for an additional two days to work on the details of the trade agreement.

What has been revealed thus far indicates China’s willingness to initiate action to increase its purchases of American farm products and American energy, including liquified natural gas. Furthermore, China has agreed to support the value of its currency and take measures to avoid currency devaluation.

China has also pledged to improve access to the Chinese financial sector and reduce the barriers to entry for U.S. banks and credit card brands such as Visa and Mastercard.

Two of the most contentious issues left open for negotiation relate to changes in China’s intellectual property regime as well as a call for structural changes related to China’s state-owned industries.

News of a possible resolution to the trade conflict was greeted with open arms as financial markets in the United States and China have risen in tandem. The impact of the trade war has been felt in both nations.

While financial markets breathe a collective sigh of relief, there won’t be much celebrating in China as China’s leaders confront a set of realities that has greatly changed over the past 12 months.

As painful as the trade conflict has been, this entire episode has exposed some vulnerabilities within China’s growth model. One of the greatest vulnerabilities is the recognition that China is a flow-based economy.

Expressed in another manner, the goods that Chinese factories churn out and sold in markets like the United States results in an inflow of dollars to China as companies such as WalMart pay their China-based factories for the manufacture of goods.

As those dollars accumulate in the commercial banking system, they are purchased by China’s central bank, the People’s Bank of China (PBOC). When the PBOC purchases dollars from the banking system, it does so by issuing yuan to banks in exchange for dollars.

It is this circular flow of incoming dollars exchanged for yuan that has led to the explosive rise in credit and corresponding accumulation of debt within China’s economy. It has been estimated that China’s debt-to-GDP ratio stands above 300 percent at the present moment.

By any measure, this is a very high amount of debt relative to GDP that increases the risk of a financial unraveling should loan defaults begin to rise. So long as trade and currency flows follow past patterns, China will have the ability to manage such large amounts of debt.

The curtailment of such flows will increase loan defaults as factories struggle to maintain solvency and service existing debt. Ultimately some form of government intervention will be needed to shore up the banking system.

If the anticipated trade agreement between the United States and China comes to pass, China’s leaders will find satisfaction that a broader trade war was averted but will have little time to find comfort as the broader issues facing China’s economy will continue to persist.

The trade war only catalyzed a set of actions that exposed vulnerabilities of being too dependent on China-based supply chains leading to the relocation of factories and facilities to places such as Vietnam.

The growing view that China is a trade and geopolitical competitor will persist beyond the Trump presidency as major economies around the world take a more measured view of China’s ambitions in the years ahead.

President Xi Jinping is well aware of this change in global sentiment and has gathered Communist Party leadership at an urgent summit to remind party leaders of mounting challenges that threaten social stability.

Arthur Dong is a professor at Georgetown University’s McDonough School of Business. He specializes in legal and business engagements between China and the United States.