WEEK AHEAD

"We may find ourselves in the challenging scenario in which our dual-mandate goals are in tension. If that were to occur, we would consider how far the economy is from each goal, and the potentially different time horizons over which those respective gaps would be anticipated to close. For the time being, we are well positioned to wait for greater clarity before considering any adjustments to our policy stance."

— Chair Powell's FOMC Press Conference, May 7, 2025.

Who Blinks First in the U.S.-China Trade War?

Speculation abounds over who will blink first in the U.S.-China tariff slugfest.

Some point to President Trump's recent softening on punitive tariffs as a sign that Washington recognizes the dangers of an all-out trade war. Others argue that China's heavy reliance on exports to the U.S. makes Beijing more likely to fold under the threat of a deflationary bust.

Sure, nobody doubts the mutual self-harm from this high-stakes showdown. But this game of chicken isn't driven purely by economic realities. It's also fueled by delusion, bad math, political theater, and—critically—saving face.

While the political theater is fascinating, I'm only modestly qualified to referee the economics.

Let's zoom in on China and the risk of a deflationary bust unraveling its economy.

It's true: the U.S. is China's largest customer. China exports about $3.6 trillion globally, with $440 billion headed to the U.S. In the extreme case where China loses the U.S. market and finds no new buyers, exports could fall 12%, from $3.6 trillion to $3.16 trillion. That translates to a 2.3% hit to China's $19 trillion GDP—halving its normal 5% growth rate to around 2.7%.

It's not ideal, but not catastrophic, either. For context, COVID initially cratered China's GDP growth by 6.8%, and only a massive stimulus effort salvaged a meager 2.3% (meager by China standard) for the year.

Surprisingly, China is less dependent on the U.S. than many think. Once, America made up 22% of Chinese exports and nearly 5% of China's GDP. Today, that figure is roughly half, as China's domestic consumption rises and other countries, imitating the U.S., also outsource and import substantially from China.

Make no mistake: China remains the world's factory. Exports still account for 20% of its economy. A full transition to a consumption-led economy—like the U.S. made in the late 70s when U.S. per capita GDP hit $48,000 (in today's dollars)—is still a long way off. China's per capita GDP is only about $13,000, meaning Chinese consumers aren't yet rich enough to absorb their production fully.

But China has gotten smarter, reducing its dependence on a single customer. If all exports vanished tomorrow, no amount of domestic consumption could cover a 20% hole. But a 2.3% gap created by a spate with the U.S.? It is manageable.

As a side note, a meaningful shift in global geopolitics is underway. The U.S. is fighting the world for the first time in our collective memory. Today, China is just one of the many U.S. trade adversaries. President Trump's punitive tariffs on our global allies and his negotiation tactics have shifted world sentiment if not strategy. President Trump has mused, jokingly perhaps, posturing most certainly, on annexing Greenland and Canada and abandoning support for NATO, Taiwan, and Ukraine in pursuit of American benefits.

Under the Biden administration, the U.S. has substantially organized its allies to constrict and embargo China; however, today, the noose around President Xi's China has meaningfully loosened. The realignment of interests now puts President Trump at the center of the global trade conflict and the receiving end of the resulting world discontent. Increasingly, countries like Singapore, India, and the Gulf countries are publicly embracing a bipolar world and shifting away from U.S. hegemony. The EU, once the U.S.'s staunchest trade ally against China, is now welcoming greater Chinese imports as trade rebalance away from the U.S. Europe is gleefully forecasting price deflation, which allows it to cut rates easier to stimulate.

On another note, the forecast of a "deflationary bust" for China is entirely exaggerated. Think of it like this: when a factory loses a major client, it's stuck with excess inventory. It slashes prices, eats losses, and lays off workers. In a prolonged U.S.–China trade war, China would see falling prices and rising unemployment. For a nation of savers, deflation boosts purchasing power—but the pain of mass layoffs would likely outweigh that benefit. How much pain China can tolerate will shape Beijing's strategy.

The last deflation scare came during COVID lockdowns. China beat it back with aggressive stimulus. But a trade war could drag on longer, fueled by bruised egos and bad advice. Beijing faces the uncomfortable reality that it may need to deploy unprecedented stimulus measures.

And here's where there might be a method to President Trump's apparent "madness." Could it be real genius? In game theory terms, the crazy player—who is secretly and ultimately rational—has the advantage. Indeed, the more irrational President Trump appears to the opponent—insisting on zero trade deficits and other economic impossibilities—the more pressure is on Beijing to come to the table to bring an end to this irrational pissing match.

What about the U.S.? Could it endure decoupling?

The U.S. imports $440 billion in goods from China—15% of its total non-auto imports ($2.9 trillion). America's 2024 GDP stands at $29 trillion, but a service economy heavily depends on imported goods. America produces just $1.7 trillion in non-auto goods—only about 40% of what it consumes annually, which stands at ($1.7+$2.9) $4.6T. Chinese manufacturing accounts for nearly 10% of everything Americans buy day-to-day.

In a doomsday perfect storm decoupling, China could keep building iPhones, Nikes, HP laptops, and Samsung TVs for other markets, albeit at a 7.8% drop in volume (China's total manufacturing is $5.6 trillion, of which $440B is for America and $3.2T for other foreign countries). American retailers, however, would lose 70–90% of their sourcing for electronics, toys, and furniture.

And no, you can't simply move iPhone production to Vietnam or India—countries specialize, and the manufacturing ecosystems that support high-end production are intensely regional. Heck, even Korean giants like Samsung outsource smartphone production to China.

This creates a lopsided dependence: China has diversified its customers, while the U.S. has concentrated its reliance on Chinese manufacturing in key sectors.

Even with tariffs, the U.S. may not be able to decouple. TINA (There Is No Alternative) might be in play. Instead, American firms and consumers will absorb the cost—hidden as higher corporate income taxes and sales taxes—while Chinese manufacturers will experience only a modest volume hit.

China's assessment may be correct in the short run: the U.S. might suffer more. Thus, President Trump, as much as someone in his position could extend an olive branch, still hasn't gotten a call from President Xi.

Gone are the days when China was a low-cost, low-quality factory surviving on U.S. capital and know-how. (Actually, that's a lie for dramatic effect: China got its early capital, training, and technology transfer from Taiwan, Hong Kong, Japan, and Korea.) The role, in some ways, has even reversed.

Capital Supply: China now supplies capital to the U.S. It holds just under $1 trillion in U.S. government debt and another $400 billion in equities.

Buffer Saving: Chinese workers are no longer impoverished, needing work from America to sustain subsistence consumption. Instead, a reported $32 trillion in cash is socked away for rainy days after decades of saving 20–30% of their income. Of course, rising unemployment will be depressing; dipping into savings during tough times will trigger fear. The trade war with the U.S. will be painful. But this is far from starving due to lack of production; over-supply is financial pain and lack of supply is physical pain.

Industry Leader: Thirty years ago, when China was making t-shirts and jeans, those orders could be pulled easily in favor of Mexico or Vietnam. Today, China is often the only viable manufacturing option for many high-end electronics like smartphones and laptops. Being the only game in town—much like TSMC, the only place you can build Nvidia GPUs—meaningfully changes the bargaining power between consumers and producers.

In this game of chicken, China isn't just banking on its workers' greater ability to endure pain. The assessment correctly assumes that the magnitude of pain will be asymmetrically larger for the U.S., given the impossibility of diversifying its manufacturing ecosystem. Beijing is betting that American consumers and businesses—hooked on cheap Chinese goods—will crack first.

Ultimately, Beijing assumes that President Trump is just playing up the "art of the deal," no matter how whimsical and irrational his behavior might seem. A rational White House is simply going to have to blink first.