The Huawei indictment marks the end of US and China’s cycle of trust

A balloon featuring Disney's characters is seen in front of a billboard featuring a portrait of the late Chinese leader Deng Xiaoping in Shenzhen, China.

caption
A balloon featuring Disney’s characters is seen in front of a billboard featuring a portrait of the late Chinese leader Deng Xiaoping in Shenzhen, China.
source
Reuters/Paul Yeung

  • The US Justice Department’s criminal indictment of Huawei marks a new phase in the cycle of trust between the US and China.
  • It is one in which aggression is more out in the open, and that aggression will directly influence perception and policy in both countries.
  • What’s more, China is no longer opening. It’s closing. And President Xi Jinping stands to make the country more totalitarian as time goes on.

And just like that, with its indictment of the Chinese phone maker Huawei, the US entered a new, chilling phase in its cycle of trust with China. There is no knowing where the cycle will take us next, but what is for certain is that there is no going back.

Huawei stands accused of stealing trade secrets from US partner, German telecom firm T-Mobile. The company encouraged employees to lie and steal until they secured the design of a phone-inspecting robot named Tappy. When the Huawei employees were discovered, the company feigned concern, writing a falsehood-filled memo – complete with redactions – to cover its tracks. Huawei even offered its employees bonuses for stolen technology.

None of this subterfuge was particularly elegant, and it didn’t go unpunished. In 2017, T-Mobile won a civil suit against Huawei and was awarded a $500 million fine for this very behavior.

So this information is not new. Everyone knows what happened to Tappy. What’s new is the US Justice Department’s willingness to bring criminal charges against one of China’s national champions – a symbol of the success of its economic development and victory over the humiliation of a lost century.

In this way, Tappy – though hardly the pinnacle of Western robotics – has ushered in a new era in global relations.

The relationship between the US and China has worn out its phase of polite negotiation and plausible deniability. Beijing can no longer pretend it isn’t engaged in state-sanctioned technology theft, and American companies can no longer pretend to be ignorant of that theft. Now that bad actors and actions are out in the open, repercussions are carried out in the open.

None of what is happening in this new phase would have happened in the old phase: The US seeking extradition of a well-connected Chinese executive; the US State Department warning Americans not to go to China if they ever want to come home; Chinese billionaires who thought they had friends in Washington realizing those friends have turned against them; Americans billionaires with friends in Beijing being forced to admit that things have gone awry in the country both economically and politically. There is a trade war with little hope for a lasting resolution. The planet, it seems, is being split in two.

Trust and cooperation between people – posited Martin Nowak, a mathematical biologist at Harvard University – is cyclical. Decisions have consequences, and those decisions impact people’s perceptions. That perception, in turn, impacts people’s decisions. It’s a conversation.

And in an address at the Bloomberg New Economy Forum in Singapore last year Hank Paulson, former US Treasury Secretary and founder of US-China think tank The Paulson Institute, said the conversation between the US and China has turned sour.

“…at this point, after forty years, when we have had one kind of relationship but now, quite clearly, face the daunting task of transitioning to a new one – anchored in a realistic and more sustainable – strategic framework – divorce is a real risk.”

It is a risk not just because of where the US and China are in their cycle of trust, but also because of where China is in one of its own cycles – its cycle of opening to the world and closing again. Right now, it is closing.

Chinese children play near a replica of the White House seen at the World Park in Beijing, China, Wednesday, July 23, 2008.

caption
Chinese children play near a replica of the White House seen at the World Park in Beijing, China, Wednesday, July 23, 2008.
source
Reuters

A cycle of opening and closing

For the past few decades, the history of China has been rather short, at least in the West.

Here, the narrative of what China is has been crafted to encourage investment in the country, and so it begins in 1978, at the beginning of Deng Xiaoping’s “reform and opening” of the Chinese economy.

But that’s a mistake, according to Anne Stevenson-Yang, co-founder and research director of J Capital Research Ltd., a China-based investment advisory firm, who headed up the US Information Technology Office in the 1990s.

“When China embarked on its current opening phase in 1970s and mainly in the 1990s, a lot of international corporations and countries believed that China was in the process of liberalizing, and that the liberalization was open ended, and that China ultimately would become some kind of Jeffersonian democracy and a capitalist country,” she said in a recent interview with Bloomberg Radio.

“That is not at all the case. China goes through these cycles of opening and closing again. It opens when the country needs cash and that’s what happened through the 1990s and the 2000s to date… now the cost is getting higher than the benefit and so you’ll see China closing again.”

The cost Stevenson-Yang is talking about is more about control than money. To truly open its economy, China would have to take its hands off the wheel and allow the market to dictate winners and losers. It would have to allow foreign companies – or even its own private companies – to compete freely without joint ventures with Chinese state owned companies.

These are among the thorniest demands the Trump administration is making in trade talks with China. They are the demands that Commerce Secretary Wilbur Ross says the two countries are “miles and miles away” on.

To China, the demand to resolve these issues has come unexpectedly. China has been opening up its economy at a snail’s pace since it joined the World Trade Organization in 2001. For example, American companies like Visa, Mastercard and American Express have had major trouble entering China’s growing payments market. Only American Express has won regulatory approval to begin clearing transactions, and that just happened in November.

As for the US’s demand that China stop stealing technology by force or trickery – Hong Kong property tycoon Ronnie Chan, an American citizen who sits on the Council of Foreign Relations and counts Henry Kissinger among his friends, told the South China Morning Post:

“People said China has been stealing technology. Well first of all, everybody steals technology. And number two, three years ago, I had a discussion with [former CIA director] general David Petraeus and [former US secretary of state] Condoleezza Rice on this subject of stealing technology from one another. Is that something that happened in the last one year? Did it get worse? It didn’t get worse, so what changed your mind?”

To China, the US is simply not behaving rationally. To the US, China is veering off a course it never necessarily charted.

The kind of opening the Trump administration wants costs too much in the only currency China’s leaders really care about – political control. If that were not the case, the convulsions we’re seeing from China’s economy right now might not be so worrisome. But they are.

A credit cycle, with Chinese characteristics

All of China’s economic indicators are flashing red. The eerily stable labor market is even showing signs of strain. In 2018, the country’s stock market had its worst performance in a decade. The yuan is weakening against the US dollar, threatening to dip below an important psychological threshold of 7 to 1. Debt has spread from the Chinese corporate and financial sectors to households, who’ve accumulated the same level of household debt to GDP as the US after just around a decade of having credit cards.

China's labor market and wage growth are both showing signs of strain.

caption
China’s labor market and wage growth are both showing signs of strain.
source
Societe Generale

The problem isn’t all about the level of debt either, as Dr. Keyu Jin, professor of economics at the London School of Economics explained during a discussion at the World Economic Forum in Davos, Switzerland. The problem is how China’s system allocates capital – it’s that China’s state-controlled system is throwing good credit after bad.

“Today’s challenge is, how do you get credit and resources from the financial sector into the real economy, and into the productive firms, into the highly innovative private sector with latent potential. That’s China’s problem. It’s not necessarily the debt levels and slowing growth rate,” he said.

china houseshold debt

source
Autonomous Research

Last year the government shut down China’s shadow-banking system, an increasingly risky capital-allocation mechanism that provided credit to private companies and individuals. Shadow banking exploded after 2009 when the Chinese government went on an credit creation and infrastructure spending spree to avoid getting sucked into the global financial crisis.

But when the shadow-banking system was stamped out, it took around 40% of China’s new credit with it.

Since the crackdown, big state-run banks have stuck to lending to big state-run companies with implicit/explicit government guarantees, leaving private enterprise and individuals out to dry. This has even China’s most successful entrepreneurs wringing their hands, especially after an op-ed suggesting the state should just take over the private sector went viral on the country’s closely monitored internet.

The government is feverishly trying to figure out how to get capital to the right places – through tax cuts, for example – but their efforts have yet to hit the real economy, if they ever do.

china credit january 2019

source
Autonomous Research

“To the extent that a pickup is occurring in lending to SMEs [small and mid-sized enterprises] – as the authorities have been encouraging for months – we suspect it is largely taking place via shorter-term loans that can be quickly reassessed if repayment issues emerge,” Charlene Chu an analyst at Autonomous Research wrote in a recent note to clients.

This is a moment when the world could help China out of an economic mess. But it won’t.

China needs credit and the world has it. But credit comes from the Latin word for trust, and trust is in short supply right now, especially since China is unwilling to do the things (outlined above) that would cede control of the economy to the market.

impact of china slowdown on the world

source
Oxford Economics

“Foreign banks in theory could fill the gap left by maxed out mid-sized and city/rural banks,” Chu told Business Insider via email.

“But in reality, many of them say they haven’t figured out how to lend in China. That’s why their books remain so small. I also don’t know that the authorities want a truly independently operating part of the banking system – it would be a lot harder to lean on foreign banks to be aggressive with lending to whoever the state wants them to.”

A political cycle of perpetual struggle

This turn in China’s domestic credit cycle is part of why, earlier this month, Chinese President Xi Jinping told his cadres to prepare for a “worst-case situation.”

Xi also outlined all the risks China is facing in the year ahead – “political, ideological, economic, technological, social and international threats, as well as those from within the party,” according to the South China Morning Post.

So, risks from everywhere. Enemies everywhere.

This suits Xi’s political reality just fine. His understanding of socialism and politics is one of perpetual struggle. This worldview was outlined in a recent speech by John Garnault, a former journalist and Australian government official who came to have rare access to China’s Deep Red princelings – the Chinese Communist Party’s ruling class – Xi and his (almost) peers. Garnault gave the speech for the Asian Strategic and Economic Seminar Series, and it was called “Engineers of the Soul: Ideology in Xi Jinping’s China.”

Garnault argues Xi understands his party in the same way the USSR’s Joseph Stalin did – as a vehicle to engage in a perpetual struggle against enemies internal and external, where politics serve as an end unto themselves. Xi is not an opener, he is a closer.

Because of this, Garnault says, China will only become more totalitarian, not less. Xi’s anti-corruption campaign will never end, much like Stalin’s purges never did. As for the West, in this framework it exists only to serve as the Chinese Communist Party’s ideological foil.

From the speech:

“The Western conspiracy to infiltrate, subvert and overthrow the People’s Party is not contingent on what any particular Western country thinks or does. It is an equation, a mathematical identity: the CCP exists and therefore it is under attack. No amount of accommodation and reassurance can ever be enough – it can only ever be a tactic, a ruse.

Without the conspiracy of Western liberalism the CCP loses its reason for existence. There would be no need to maintain a vanguard party. Mr Xi might as well let his party peacefully evolve.”

Totalitarianism is the only way to guard against this encroachment from the West, and that is why Xi – who eliminated term limits for himself – has worked harder than any of his recent predecessors to stamp out influence in China’s physical and digital space.

Garnault does not believe that’s where this ends either:

“The challenge for us is that Xi’s project of total ideological control does not stop at China’s borders. It is packaged to travel with Chinese students, tourists, migrants and especially money. It flows through the channels of the Chinese language internet, pushes into all the world’s major media and cultural spaces and generally keeps pace with and even anticipates China’s increasingly global interests.”

So when Chinese billionaires like Ronnie Chan muse as to why the US is suddenly unfriendly, it isn’t just because of President Donald Trump and his cabinet of economist war dogs. It isn’t just because the US is suddenly angry about things that have been going on for years either.

It is because Xi is a kind of Chinese leader the world had not yet seen in this last 40-year cycle – one who naturally reorients the country toward a closed society.

BEIJING, CHINA - SEPTEMBER 30: Chinese President Xi Jinping walks to the Monument to the People's Heroes during a ceremony at Tiananmen Square, on the eve of National Day on September 30, 2018 in Beijing, China.

caption
BEIJING, CHINA – SEPTEMBER 30: Chinese President Xi Jinping walks to the Monument to the People’s Heroes during a ceremony at Tiananmen Square, on the eve of National Day on September 30, 2018 in Beijing, China.
source
Lintao Zhang/Getty Images

On Wednesday, China’s parliament fast-tracked a bill meant to protect foreign companies in the country. The body will vote on the bill in March. According to Chinese state media, it includes penalties for failure to report violations to relevant authorities.

This should be good news, but we are experiencing a trust deficit, so members of Trump’s economic team are waiting to see how China says it will enforce these measures.

This isn’t the only gesture to end the trade war China has made that has been met with skepticism. Officials also reportedly offered to buy enough US imports over the next six years to eliminate the trade deficit between the two countries.

But, as analysts at Barclay’s pointed out, sticking to that commitment would throw China’s economy off-kilter. It isn’t realistic.

Important details like that – which only amplify the trust deficit between the two countries – will only spur more talk of “decoupling” in US circles. That conversation isn’t about whether or not decoupling is valid, either.

As Paulson mentioned in his speech, it’s about whether or not decoupling will be “comprehensive” or “carefully calibrated.” Too much and the world could end up split behind an “economic iron curtain,” he said.

None of this ends with the trade war, it transitions. In this new reality, it is more important than ever to recognize China’s agency over its own destiny, independent of the West’s ambitions. It’s Xi’s understanding – not ours – of where China is in its cycle of opening and closing that could mean the difference between peace and prosperity, and confrontation and calamity.