China v America trade war: who has the most to lose, according to game theory?

Matthew Haupt

The trade war between the Trump administration and the government of China is a strategic conflict rather than the return of ideological protectionism. So the range of possible outcomes, which are potentially significant for the global and Australian equity markets, is best understood through the lens of game theory. Game theory is the science of strategic interaction between rational decision-makers and is used to model optimal decision-making across a broad range of sectors such as economics, finance and diplomacy. Each actor faces a range of choices and the potential outcomes, positive and negative, are dependent on the choices of the game’s other players.

Beijing’s next steps are the most interesting to study as China has the most to lose. Last year, China exported $US505,470 billion of goods to the US while it only imported $US129,894 billion from it. Chinese exports to the US are primarily a source of affordable low-value-add goods, such as furniture and bedding, toys and sports equipment and parts that American companies design and have cheaply made in China to be sold back to US consumers. Generally, this means the US does not “need” Chinese imports, so the consequence of trade restrictions would be American consumers paying more for low-cost products.

By contrast, China imports food for its enormous population from the US, as well as high-value-add goods, such as aircraft, vehicles and electrical machinery, which cannot easily be replaced by another exporter. From a state of relative disadvantage, China has few options. Beijing could remain hawkish by continuing the tit-for-tat accumulation of tariffs; devalue its currency; stimulate the domestic economy; and reduce interest rates and credit standards to stimulate lending. However, these actions carry significant economic costs.

So far, the unintended consequence for the US has been the rise of the US dollar relative to the rest of the world as it’s perceived as a safe haven. With the combination of a tightening central bank and the risks of tariffs, the flight to the US dollar has seen it appreciate against world currencies. The implementation of tariffs on China has, in effect, resulted in quasi-tariffs applied to all its trading partners through the stronger dollar.

Trade alliance

Alternatively, China could increase its bargaining power by forming a significant trade alliance against the US. This would be the only option that would justify continued escalation from China as it would increase its size relatively against the US and limit the impacts of American tariffs. However, China tried and failed to enter such a relationship with the European Union in July and as no other major economies are seeking trade relationships with China, this option appears unlikely.

In the absence of a clear choice that would allow China to continue down a hawkish path, logic should see it take a third route – retreat. China’s optimal choice is to adopt a conciliatory approach that would see it benefit from lower obstructions to trade with the US. The US would be expected to stop declaring tariffs as it has nothing to gain from causing additional pain to a pacified China. In game theory terms, this outcome represents the Nash equilibrium, which sees each party act in its individual best interest in the full knowledge of what the other party will do.

If China does not back down, forcing the US to implement the full $US500 billion in tariffs, you would expect a direct impact would be a fall in global growth of 0.3-0.5 per cent, with a decline of more than 1.5 per cent in China’s and America’s gross domestic product. Given the hit to sentiment, a significant fall in global equities – in the order of 10 per cent – would be likely to follow, as well as a spike in inflation that would cause central banks to raise interest rates.

Instead, we expect to see China acknowledge US supremacy in the trade war conflict, which we would expect to translate to a relief rally in global equities and negligible negative impacts to the global economy. China’s recent decision to send a trade delegation to the White House may signal its intent to reach a Nash equilibrium sooner rather than later.

The one caveat I'd make is that Game Theory works on the assumption that both parties are rationale...

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Medium tiger

Alan CTHGPRO

Interesting analysis but I doubt China will be so willing "acknowledge US supremacy in the trade war conflict" as you predict. The Chinese government will be wary of appearing weak in the eyes of its own people in a conflict with the US. My guess is that the Chinese will be happy to stretch the game out past the November mid-term elections in the US to gage the ramifications on the Trump presidency. I believe the stand off can only be resolved by significant concessions on both sides so as neither leader will be seen to lose face in their own country. Interesting times ahead.

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William Zhang

I agree with Alan.

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Peter Koay

Not sure how you jumped to the conclusion of 'relative state of disadvantage' on China? What's the logic behind it? Just because China exports more? Why would it be a disadvantage when considering if Trump for example imposes 25% on all the $500Bln of goods that China exports to USA, which equals US$125Bln just on tariffs alone, and the entirety of the imports from USA is US$129Bln which is comparable in size to the tariffs? China is determined to rise in global influence, and provided the measures will not cause an overturn of the Communist Party, China will do whatever it takes to win this trade war. Trump needs to back down, not China, because he was the one to instigate the trade wars. Happy Nash equilibrium can remain just a theory - it won't work in this trade spat between China and USA. Not sure also about your comments on EU trade with China. USA may be perceived as 'no longer a strong ally' by EU because Trump is also waging trade wars against EU nations. https://www.cnbc.com/2018/08/30/trump-rejects-eu-offer-to-eliminate-auto-tariffs.html So, EU may eventually join hands with China, China with Russia, China with India. At the end of the day, USA will isolate itself from the rest of the world as it seeks to win trade wars at all costs.

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Jon Fogarty

After 15 years working and living in Asia, I have repeatedly seen the Chinese Govt is worried mostly about one thing only. A popular uprising of the people. Control of the population is it’s no1 priority. If the person on the street, starts to suffer or is at risk of suffering, the Govt will act. The increasing volume of the criticisms of the US actions, is evidence the threatened US tariffs are seen as a very real risk to internal stability. It’s also clear from the numbers they will lose this battle, which is why they are loudly and vocally threatening ( when weak act strong, “Sun Tzu”) , but they will unlikely fight a battle that is already lost. “Every battle is determined before it’s fought”, Sun Tzu, again.

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James Waggett

I'm surprised you haven't mentioned China's massive holding of US Treasuries & its associated ongoing flows which have effectively helped keep a lid on US interest rates. We'll all know that China isn't backing down when they start liquidating those holdings, forcing US yields higher (4% on 10 Yrs anyone ?) with the resulting recessionary impact. Then how will Trump & his supporters react ?

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