The emperor’s surprising beneficence

Who’s zooming who?

For the last couple of months, I’ve been troubled by China’s surprise retreat in the trade war with Donald Trump. Not that the “temporary truce” was seen as such by the consensus commentariat who described it instead as President Trump “blinking” in the face of Chinese superiority or as a US “climbdown.”¹1 But it’s hard to view the agreed outcome as anything other than a Chinese capitulation given the final tariff disparity: the US keeps a 30% general tariff – in addition to the 25% Section 301 tariffs on selected items still in place from President Trump’s first term – and a 50% tariff on all steel and aluminium content, autos and parts; while China retains a 10% general tariff in addition to its remaining retaliatory tariffs from the US Section 301 tariffs.²2

It’s not the wrongness of the consensus that bothers me – that’s a normal day at the office – but rather the question of why China, the country with the superior hand, appears to have backed down, even if only temporarily.

Despite an arsenal of economic weapons…

Over three-decades, China has carefully cultivated formidable weapons of economic warfare. Most threatening are its near monopoly positions in the refinement of rare earths and critical minerals like antimony, cobalt, Gallium, Germanium, graphite, lithium, and nickel. These commodities are essential to the production of batteries, windmills, solar panels, electric motors, and permanent magnets used in an array of high-tech manufacturers. China also maintains supply dominance in specialty chemicals indispensable to refrigerants, aerospace coatings and semiconductors; and in active pharmaceutical ingredients and antibiotics crucial to modern medicine. Were China to shut off US access to these vital inputs, US manufacturing – including of backlogged advanced weapons systems – would come to an abrupt halt and the US healthcare system would face acute, life-threatening shortages.

…China capitulated

While China did impose restrictions on exports of rare earths, several critical minerals and permanent magnets as an early step in its rapid escalation ladder following President Trump’s “Liberation Day,” it did not use the full scope of its economic weapons, and little more than a month later, as part of the temporary truce, promised to speed necessary approvals for exports to the US of restricted items. China continues to emphasize that expedited export approvals – which were being slow walked despite the agreement – are only temporary.³3 Furthermore, the US also agreed to rescind its retaliatory restrictions on semiconductor-design software, aircraft engines and ethane (a plastics and chemicals feedstock). But President Trump publicly declared that US waivers were contingent on fulfilment of Chinese export approvals.⁴4

Just given its overwhelming “escalation dominance” in trade economics, China’s willingness to unwind its export restrictions without full US capitulation is perplexing. But for a country that invested its national prestige in rapid-fire, tit-for-tat escalation of both rhetoric and actions following Liberation Day, the Chinese climbdown to accept starkly unequal tariffs while lifting its boot from the American economic jugular represents a shocking loss of face. What explains that?

Why?

For the world’s second largest economy and population, China can be surprisingly opaque. I can postulate a number of theories to explain China’s standdown, but most don’t seem to hold up to scrutiny.

Xi Jinping really is Winnie the Pooh

Maybe I simply misread the intent of China’s leadership. Maybe China is not an expansionist power that has waged three decades of economic warfare against the US while building a parallel international architecture to supplant its post-War liberal order. Instead, the People’s Republic of China seeks de-escalation and return to business as usual under the US-led rules-based order after ego and the heat of the moment led to an unwanted escalation. This explanation seems unlikely given that Chinese officials from President Xi down – most recently at the BRICS Summit – continue to call for replacement of the US-centric international order, that China has undertaken one of the most aggressive military expansions in world history, and that it aggressively bullies its neighbors from the South China Sea and to the Galwan Valley of India.

Ploy to delay…

Alternatively, China could be biding time, to delay Western industrialization, to await a more favorable time to deploy its economic arsenal, or to prepare for something bigger.

Western reindustrialization…

It seems unlikely that the truce is just a means to delay Western reindustrialization by releasing only enough critical materials to undermine incentives for rebuilding. Allowing still-high US tariffs to continue to be applied to Chinese exports amid the threat of withheld supply would seem to provide plenty of incentive for the US to rebuild capacity.

For a more opportune time…

Similarly, when might China have a more opportune time to wield the industrial advantage it has built over 30 years? American allies’ anger at the US arguably was at its apex following Liberation Day; US weapons stockpiles have been dangerously depleted by the Ukraine and Middle Eastern wars;⁵5 the negative effects US tariffs have on China’s international standing as they divert more of China’s excess capacity towards third countries increases with time (i.e. the “tariff funnel”); and every passing day is one closer to the US and other countries finding solutions to or building capacity to address to their vulnerabilities to China’s monopolization of critical industries.

Preparing for “Unrestricted Warfare”…

More worryingly, the truce may be a feint until China is ready for “Unrestricted Warfare,” i.e. not just economic but potentially kinetic warfare in a move to seize Taiwan. In this view, China’s climbdown on trade talks was a tactical retreat to better set up its strategic preparation for a final showdown over Taiwan. Imports of Western software for chip design, jet engines and ethane may not be critical to near-term economic functioning but could be part of a broader stockpiling effort to prepare for a potential interruption of trade in the Western Pacific when China embargos or seizes Taiwan. China’s ongoing stockpiling of primary commodities reinforces this thesis.⁶6

I can’t dismiss that keeping its eyes on the larger prize is the motivation for China’s willingness to accept a humiliating even if temporary truce. But there are two sound reasons to question that as the cause. First, China has made impressive progress towards its goal of effective self-sufficiency under the “Made in China 2025” campaign. Despite extensive American export controls China’s national champion, Huawei, recently introduced a new microprocessor to rival the top NVIDIA chips and a state-backed startup, DeepSeek, launched an LLM that challenges the top US AI firms at a fraction of the price. The share of primary commodities in total Chinese imports has doubled from 15% in 2000 to over 30% recently, illustrating the country’s shift towards manufacturing self-sufficiency. It seems unlikely that US retaliatory controls on software, engines and plastic feedstocks are critical to China at this stage.

Second and more importantly, it would be strange for China’s leadership to be undisciplined enough to engage in a short-sighted escalation like that in April only to reassert discipline a month later. Even the EU did not impose – only pass and threaten – retaliatory tariffs before engaging in negotiation with the US after Liberation Day. Not only would China’s unnecessary escalation and subsequent capitulation represent an embarrassing loss of face, particularly for President Xi, given his frequent invocation of “eat bitterness” as a path to overcome Western dominance, but it would be uncharacteristically rash.⁷7

Or, China is a lot more fragile than I thought

There is one more explanation that, despite the lack of direct supporting evidence, is more difficult to dismiss: China is far more fragile socially, politically or economically – or all of the above – than I thought.

Unlike many others, I see most Chinese economic policy as driven by national security interests. Under that view the economic inefficiency of its extensive industrial policies is a feature, not a bug, designed to rapidly scale China’s industrial base for warfare while undermining those of its strategic competitors and to accelerate China’s technological advancement. This is extraordinarily costly in terms of Chinese economic welfare – literally trillions of dollars likely have been lost to intentional investment in over capacity – but it has propelled China from an underdeveloped, technology-importing also-ran to the world’s largest manufacturer, a major innovator and peer competitor to the United States in less than a quarter century.

Is half a year’s growth a hardship?

Seen in that light, even complete cessation of exports to the US – which was certainly possible with 145% tariffs – would cost China just over 2 percentage points of GDP, or about half a year’s (officially reported) growth. A small price to pay after three decades of eating far larger economic losses. By comparison, full application of China’s economic weapons likely would have brought the US economy to a screeching halt within months. President Xi often remarks that the Chinese people are far more willing to eat bitterness than Americans, a view seemingly validated by the US inability to address its livelihood and national-security threatening budget deficit even in a booming economy with full employment.⁸8 Yet, it was China that ultimately retreated.

“However improbable…”

As Sherlocke Holmes said, “When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”⁹9 While I cannot fully eliminate the “long-game” strategic incentive, its implication that Chinese policy in April represented hasty egotism that yielded quickly to face-losing capitulation shortly thereafter seems less plausible than China facing an internal crisis that a full-blown trade war might make acute.

Potential sources of crisis: Economic…

If an internal crisis is the cause of China’s standdown, then the question turns to the nature of the crisis. There are three possibilities.

The most obvious (and least dangerous) is a debt crisis created by decades of industrial policy. Because capital controls create a closed system with a single credit guarantor, the Communist Party (CCP), China’s economy is resilient to most forms of acute debt crisis like bank runs or capital flight. But losses ultimately accrue somewhere and China’s lethargic (and likely overreported) growth for the last decade is consistent with amortization of those losses through a Japan-style “lost decade.” But subsidization of industry has continued unabated, accruing further losses and building stresses within the system.

In the last two years, Chinese authorities have announced with much fanfare policies to support growth that do little to change the underlying problem: national-security-based industrial subsidies for industrial and technological development. But in the last week cracks have begun to appear in Beijing’s commitment to that policy: multiple official and semi-official bodies have decried the price wars their subsidies created.¹⁰10 The timing, following at least temporary capitulation in the US trade war, suggests that the two might be related and that the economic stresses within China’s system are becoming acute.

Political…

But there also are recent rumors of political turmoil. Unsourced reports suggest that Party elders are preparing to strip President Xi of titles and perhaps CCP leadership at the annual Party retreat in Beidaihe later this month or early in August.¹¹11 Similar rumors circulated ahead of the 2023 Beidaihe conclave, yet proved unfounded,¹²12 while other recent reports suggest that Xi’s control of the party and campaign of purges is proceeding unchecked by opposing CCP factions.¹³13 Further, President Xi’s consolidation of power at the 20^th National Congress seemed total: not only was he reappointed to an unprecedented third consecutive term as president but he purged all other CCP factions from the two top decision-making bodies, the People’s Standing Committee and the Politburo.¹⁴14

Or both combining in the provinces

While President’s Xi’s grip on the Party at the national level may be iron, Beijing’s practice of forcing systemic losses down to provincial governments combined with intensifying economic pressures may be creating local factions that threaten power and could be the source of a possible crisis. As I have often noted, the bloodiest human conflicts of each of the last three centuries were Chinese civil wars started when a regional elite challenged the emperor in Beijing, usually over economic spoils.

Four high-impact, uncertain implications

This is what ultimately troubles me about China’s trade capitulation: a process of elimination leads me to four high-impact outcomes with unknowable probabilities (Uncertainty): (1) imminent war over Taiwan; (2) an economic crisis (that could precipitate political turmoil as well); (3) a leadership shuffle in Beijing that might presage a sharp change in China’s policies; or (4) a protracted leadership struggle or even civil war in the world’s second largest economy with the world’s largest military.

What might I be missing? How do you explain China’s surprising, even if temporary, capitulation on trade? Let me know in the comments.