The war in Ukraine is a focusing event in the shifting economic and political dynamics between the United States and China. Key to sketching the implications of these dynamics on the global economy are four interrelated topics: U.S.-China decoupling, the Ukraine war, major economies’ balancing acts between the U.S. and China, and implications for the short and long-term future of the international economic order. This article summarizes these developments and makes a few short and long-term predictions.

 

Decoupling

In recent years, China has publicly criticized the U.S.-led, dollar-based international economic order, calling to replace the dollar as the premier currency for settlements, invoices, and foreign exchange reserves. China has even promoted a new “multipolar” world order split between itself and the U.S.

Since 2008, the U.S. has talked about decoupling from China. Arguments cite the U.S.’s trade deficit with China and China’s intellectual property theft, currency manipulation, human rights abuses, maritime law violations in the South China Sea, and more.

Financially, however, neither country has seriously moved to decouple.

In possession of $1.05 trillion of low-return U.S. Treasury securities, China’s central bank has tried to diversify its portfolio but must continue buying these securities to create demand for the dollar, which boosts its value relative to the renminbi, making Chinese exports more competitive and preserving the value of its central bank’s dollar-denominated holdings.

Nor has the U.S. begun to decouple financially from China, whose purchases of Treasury securities paper over the U.S. trade deficit.

But whether the U.S. and China are decoupling in trade is more complicated.

The U.S. and China are economically interdependent. The U.S. is China’s largest export market, and China is the U.S.’s largest import market. China relies on the U.S. for roughly $580 billion of exports per year, total foreign direct investments of $124 billion, joint ventures in high-growth industries, and more. The U.S. relies on China for economic growth in investments, people flow, idea flows, and trade in key industries. Estimates suggest that decoupling would cost the American aviation industry up to $875 billion by 2038; the semiconductor industry up to $159 billion and 100,000 jobs; the medical services industry more than $479 billion over the next decade; and more.

But China is transitioning to a value-added, high-growth, high-tech economic model to replace its cheap manufactured goods export-led model, which is suffering from increasing labor prices. China wants to establish its companies as leaders in sectors like 5G, artificial intelligence, semiconductors, and more. They desire the rents of technological leaders and control over strategic sectors that shape the on-ramping and growth of technology.

In response, the U.S. is attempting to stymie the development of Chinese technology, in part by levying export controls against U.S. manufacturers of technologies such as semiconductors and import controls against the purchase of Chinese technology like Huawei smartphones.

 

Ukraine War

The Ukraine war has confirmed that trade does not engender political and economic liberalization. Many in the West are now worried that authoritarian states like Russia and China will form anti-Western economic blocs. Circumstantial evidence that China might be helping Russia hide money is making waves.

But China is still afraid of U.S. secondary sanctions: so far, it has refused to use a swap line with Russia’s central bank to rapidly convert its assets to cash.

China is clearly differentiating itself from the U.S.; however, calling U.S. sanctions on Russia “crazy” and intimating that China is a better place to do business. This is not a coincidence, given China’s strategy of spearheading economic growth in East Asia, where the new China-led Regional Comprehensive Economic Partnership (RCEP) is projected to add $500 billion to global trade by 2030.

China also caters to East Asian clients with its Cross-Border Interbank Payment System (CIPS), billed as a renminbi-based alternative to Western payments systems.

Despite China’s ambition to become a leader in global finance, it is running into significant hurdles. One is the renminbi’s share of global currency, which is only 1.92 percent—disproportionate to China’s share of the global economy. Capital controls imposed on the renminbi also lend it poor convertibility, which, given China’s resistance to undergo capital account liberalization, does not seem poised to change any time soon.

 

Balancing Acts

If the United Kingdom Foreign Secretary Liz Truss’s April 2022 speech on “the return of geopolitics” is any indication, EU leaders are more likely to heighten their political expectations of countries with which they do business in the future. Advocating a newly outward-looking G7 and EU, Truss takes aim at China and denounces its human rights abuses, and attempts to leverage economic ties to exact political concessions around the world, suggesting China should be countered by a bloc of newly assertive democracies led by the West.

In the wake of Russia’s invasion of Ukraine, these strict, values-based expectations of China recently saw the EU ease off trade and investment deal negotiations with China, with whom the bloc was already reluctant to deal after news of China’s human rights abuses against Uyghur Muslims.

 

Future of the International Economic Order

In the short run, the U.S. will not reduce its financial dependence on China as the latter continues to finance its current account deficit and stimulate growth in critical domestic industries. But the U.S. will begin to attempt to shift its supply chains elsewhere, including Mexico, where labor costs are in some cases cheaper than in China.

Over the next decade or two, this will become increasingly attractive to the U.S. as China faces a slowing birth rate, a diminishing workforce of cheap labor, and an aging population with few social security benefits.

It also remains to be seen whether China’s play to court developing countries will work out in the long run. Of course, China is struggling to generate the same kind of material wealth for its average citizen compared to the U.S., given domestic constraints on arable land and natural resources. So, China must compete with the U.S. for commodities from developing countries in Africa, South America, and East Asia.

But the mixed record of China’s Belt and Road Initiative has hurt its reputation and earned China few political allies. In fact, China has few allies at all and unreliable ones at that.

Also, China’s unwillingness to liberalize its capital account and relinquish capital controls prevent it from internationalizing the renminbi. This is a fundamental hurdle to the expansion of the CIPS system, which will not become a viable alternative to Western payments systems until the renminbi is easily convertible.

In the meantime, the West’s united response to Russia’s invasion of Ukraine will only result in a more hostile relationship between China and democracies allied with the West. Some even argue that it will strengthen the ascendancy of the dollar-based economic order for the foreseeable future.

Though, it remains to be seen whether a united West and allied democracies can present a coherent, united front in the evolution of the global economic order.

The transparency and openness of financial markets in Western democracies make them a more desirable place to do business. But the U.S. must establish a stronger economic presence in East Asia if it should win over developing countries with ties to China. These countries prioritize building competitive domestic industries and enriching their citizens over enforcing the values of an open, rules-based international order. India is a barometer of this dynamic, currently taking advantage of Western sanctions against Russia to purchase its weapons systems and oil at low prices.

Currently, reports indicate that the Biden administration is now developing a more “sophisticated” approach toward China. But chances that the U.S. will open itself to increased trade with developing East Asian countries seem low given the continued presence of isolationist political elements in the U.S., such as those that blocked the adoption of the Trans-Pacific Partnership in 2017. Over time, the U.S. risks hampering its ability to project leadership abroad if it does not stem sources of political dysfunction at home, including widening income inequality and prohibitive costs of higher education.

So, in the realms of trade and foreign investment, the world economy could fracture into discrete blocs in the short term. Western economic powers, including allied democracies like Japan and South Korea, might form one bloc; China, its major trading partners in East Asia, and other allied pariah states could form another. But China’s financial infrastructure will not be robust or independent enough to circumvent its reliance on Western systems. China will also wish to maintain its robust ties to the U.S. in trade and investment as long as they fuel its targeted high growth rates.

In the long run, however, things could look different. If alliances led by the West succeed in forming larger economic and security-based partnerships that win over developing powers like India and China and maintain capital controls on the renminbi, then China’s rise in global finance could be effectively countered. China’s shrinking workforce and comparatively worse ability to attract talented labor from abroad will also prove more difficult to overcome as it transitions to a value-added, high-tech economic model. And the U.S. will more cheaply decouple its supply chains from China over time.