Genuine bundles of Chinese one-hundred yuan banknotes and U.S. one-hundred dollar banknotes are arranged for a photograph at the Counterfeit Notes Response Center of KEB Hana Bank in Seoul, South Korea. (Photographer: SeongJoon Cho/Bloomberg)

Trump Needs a Plan to Win His Trade War With China

(Bloomberg Opinion) -- President Donald Trump’s trade war is less bad than it was just a short time ago. After some tense negotiations, the North American Free Trade Agreement has been replaced with a new, very similar arrangement, meaning the disruption to trade -- and to U.S. relations with Canada and Mexico -- will be contained. The agreement might even ease the damage from the president’s misguided steel and aluminum tariffs. Trump has also turned his attention away from Europe, avoiding the mistake of getting into a harmful spat with allies he should persuade to  form a trading bloc and a unified front.

Instead, Trump is increasingly focusing his trade war on the appropriate target -- China. Rather than being an ally, China is the U.S.’s main geopolitical rival. It engages in a wide range of unfair trade practices and industrial espionage that distort the efficient workings of the global economy. And Chinese import competition has been much more harmful to American workers than competition from Mexico, Europe or any other country. Even some Democrats support pushing back against China.

That doesn’t mean a trade war with China is without downsides and risks. Chinese retaliation against U.S. agriculture has already forced many farmers to accept handouts from the government in order to stay afloat. Disrupting the cozy economic symbiosis that has developed between the U.S. and China will cause painful adjustment, and will also increase the risk of military conflict. If Trump decided to call off his trade war against China right now, it would certainly be a safe course of action.

But, based on all his actions and rhetoric so far, Trump is highly unlikely to do anything of the sort. And if Trump is dead set on fighting a trade war against China, he should -- as in any sort of war -- be thinking about how to secure a victory and an exit strategy.

What would constitute a win in a trade war against China? A simple goal would be to get that country to cut tariffs on U.S. imports. Indeed, China's leaders have already offered some tariff cuts, suggesting that they’re in a mood to deal.  But although tariff cuts are good, they don’t form the bulk of China’s unfair trade practices. The government underwrites its industries in a variety of ways, from cheap loans from state-owned banks to energy subsidies to export subsidies. Costs are held down because of lax environmental regulations and low labor standards -- China crushes independent labor unions, for example. The U.S. government could demand that the Chinese reduce subsidies, do more to protect the environment, or improve worker rights.

Even then, though, the main source of Chinese protectionism doesn’t come from official policies, but from the basic way the country’s economy is structured. Most of the country’s largest companies are state-owned. With direct control of much of the economy, China can easily shut out many foreign goods if it wants, simply by telling its companies to buy domestic goods. A thicket of regulations and hostile government officials can easily keep foreign companies out of the Chinese market, while privileging home-grown champions.

Then there is intellectual property theft and industrial espionage. When China was poor, this probably was a good thing for the world economy -- it allowed China to catch up technologically, which helped it pull hundreds of millions of people out of poverty, while not hurting developed countries too much. But now that China is increasingly close to the technological frontier in many industries, its rampant IP theft is increasingly parasitic. Why should companies spend billions to invent cutting-edge technologies when those technologies will simply be stolen, copied and produced by state-backed Chinese companies at a fraction of the cost?

Unfortunately, cutting down these more nebulous abuses is extremely hard. There’s no way to measure the amount of state interference that China is using to shut out foreign companies. And IP theft, by definition, happens in secret and is thus difficult to detect or to prove. China’s entire economy is centered around pervasive state intervention and skullduggery -- even if it made some moves to change that model, the U.S. couldn’t verify that changes had really been made.

Instead, the U.S.’s best bet is to concentrate on a key Chinese government intervention that can be measured easily -- currency manipulation. Though China no longer pegs its currency to the U.S. dollar, it still closely manages the yuan’s value and maintains an extensive system of capital controls. In recent years, China usually hasn’t had to intervene in order to keep its currency cheap, since the yuan has fallen:

Trump Needs a Plan to Win His Trade War With China

But the threat of intervention is still there, which undoubtedly keeps a lid on the currency’s value.  Meanwhile, measures like the Economist’s Big Mac Index show that the yuan is undervalued against the dollar by about 44 percent. This effectively provides a subsidy to all Chinese exporters, and a tax on U.S. goods sold in China, thus distorting the global economy and the patterns of world trade.

As his main goal in the trade war, Trump should push for a large upward valuation in the yuan, followed by a much freer float of that currency against the dollar. This would be similar to the 1985 Plaza Accord, in which Japan and some European countries raised the value of their currencies versus the dollar. After the accord, the U.S. trade deficit with Western Europe narrowed substantially, and though the deficit with Japan persisted, American exports to that country did grow substantially:

Trump Needs a Plan to Win His Trade War With China

So a stronger, more flexible yuan should be the victory condition in Trump’s trade war with China. Ultimately, that will be good for the world economy, removing one of the biggest, most persistent distortions in global trade. And it will help China make the transition from parasitic upstart to responsible pillar of the world economy. It would be a happy, productive resolution to a potentially dangerous and increasingly bitter trade war.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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