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The Complex Reality Behind the US-China Decoupling

Summary

While the pandemic reveals the dangers of overreliance on a single nation’s production facilities, Washington is calling on American MNCs to shift supply chains away from China. However, the economic relationship between the world’s top two economic powers is complex and a rushed decoupling could sink the global economy to unprecedented depths. Instead, both nations should carefully consider how to effectively diversify the risk of economic overdependence while continuing to maintain healthy trade relations.

While the COVID-19 pandemic cripples economies around the globe, it has also revealed the threat of overreliance on a single nation to global supply chains. The US Trade Representative Robert Lighthizer, among others, has referenced these dangers in his advocacy for an expedited US-China decoupling. Relations between the top two global economies reached chilling lows during the Trade War and have continued to rapidly deteriorate throughout the pandemic. Citing the operational instabilities that China’s shutdown levied on MNCs during Q1 2020 and its subsequent impact on the US’ ability to source critical emergency response medical supplies, Lighthizer has called on manufacturers to shift their supply chains away from China and consider severing key economic partnerships that, in many cases, have spanned decades.

While a full decoupling may be viable in the long-term, it would be near-impossible to accomplish in the short- to medium-term. The US and Chinese economies are strikingly codependent on each other, with the US providing specialized high precision manufacturing to China and China offering key assembly infrastructure, advanced supply chains, and low-cost manufacturing in return. Without fundamental changes to each nation’s economic structure, neither country would be effective in quickly replacing the specialized solutions of its rivaling nation. A premature decoupling would therefore introduce structural volatility into both nations’ economies and further destabilize domestic and global markets.

Economic Interconnectivity

US-China Trade Totals

Sources: FRED, The China Guys


Since re-establishing trade relations in 1979, the US and China have consistently enjoyed a rapidly expanding trade relationship. Beginning at a paltry US$4 billion in 1979, the two economic rivals had ramped up trade to over US$600 billion in imports and exports in 2017. Until February 2019 at the height of the Trade War, China had been the US’ largest trading partner. Currently, China is still in the top three and, in 2018, 21.2% of all US imports came from China while 7.2% of all US exports went to China.

In recent years, China’s technological infrastructure has been supported by a rising number of qualified engineers, new innovative production technologies, and outside investment that have coalesced to drive the country’s economic production shift towards higher value goods. Despite still exporting large quantities of household goods, toys, and plastics, Chinese exports to the US have largely transitioned from low-value labor-intensive products to more capital intensive goods – in particular, those that require advanced machinery and higher amounts of capital to produce. These goods generally cover electronics, machinery, telecommunications, and other industries.

The primary capital-intensive products exported from China to the US include smartphones, computers, and semiconductors, with more than 25% of computers and 50% of smartphones imported to the US annually arriving from China. In 2018, China shipped US$70 billion of smartphones and US$45 billion of computers to the US, nearly a quarter of its total US$479.9 billion US-bound exports that year. Additionally, even if a smartphone was not fully manufactured in China, it is likely that at least one portion of its supply chain journey was completed there as most smartphones require rare earth materials, of which China dominates the market with a 90% market share. Aside from smartphones, the US also sources rare earth materials from China for other consumer electronics and military technologies, including lithium batteries, night-vision goggles, and GPS equipment.

By contrast, China is one of the US’ largest export markets for products that require high-precision manufacturing. While capital intensive goods require higher initial investment and more advanced equipment, high-precision manufacturing requires specialized tools and a highly skilled labor force. High-precision manufacturing products accounted for US$120 billion in 2018 US exports to China, with aircraft at 15% (US$18 billion), machinery at 11.7% (US$14 billion), electric machinery at 10.8% (US$13 billion), optical and medical instruments at 8.2% (US$9.8 billion), and vehicles at 7.8% (US$9.4 billion) of the segment’s total exports.

The Issues Driving the Decoupling Movement

US officials remain unsettled by the economic codependence between China and the US. Given the recent global pandemic and increasingly divergent national interests, many officials are advocating for a swift decoupling due to a persisting trade imbalance between the two nations as well as the implications of Chinese supply chain dependence on US industry resilience.

Trade Imbalance

Chinese Trade Surplus with the US, 2004-18

Sources: Statista, The China Guys


In 2019, Chinese exports to the US reached US$452.2 billion while US exports to China lagged at US$106.6 billion. The resulting US trade deficit with China has reached US$345.6 billion – a 6.8% increase (US$22.3 billion) from the previous year and a 38.24% increase (US$95.6 billion) over the past five years.

Both nations have a different narrative to explain the trade deficit’s origin. While President Trump contends that China’s ‘unfair advantage’ is driven by forced technology transfer through business ownership limits as well as currency manipulation, Beijing stands behind its ‘fair trade practices’ and attributes the gap to disparate consumer demand.

China’s ascension to the role of the world’s manufacturer can be reduced to its competitively priced manufacturing capabilities. China’s low manufacturing costs precipitate from two primary factors: lower wages due to an overall lower cost of living as well as a strategically managed RMB valuation enabled by the country’s unique managed-float currency regime. As a result, China has historically been effective at winning bids for foreign manufacturing contracts and ultimately become the key manufacturing hub for corporates around the globe.

US China GDP Per Capita Growth

Sources: The World Bank, The China Guys


Compared to many developed nations, China’s lower cost of living facilitates lower wages – which in turn significantly reduces the overall cost of production. In 2018, China’s GDP per capita of US$9,770 was starkly lower than the US’ at US$62,794. Likewise, the average annual salary of a Chinese employee in 2018 was approximately US$11,537 compared to the US average of US$63,179. As a result, China has been able to consistently produce goods at a lower cost and, as the US hosts a consumer-based economy, Americans purchase a disproportionately larger amount of goods from China than they sell.

China has strong control over the value of its currency through its ‘managed float’ regime. Historically, China has leveraged its tight control over the RMB to keep its value artificially low and boost the competitiveness of domestic exports, as a cheaper RMB would mean cheaper imports for Americans.

On August 5th, 2019, The US Treasury Department officially labeled China as a currency manipulator after the PBOC allowed the yuan to break through seven yuan per dollar for the first time in a decade. While the real exchange rate is difficult to estimate and numerous parties hold different contentions, currency controls can have a profound effect on trade. Studies have shown that a 1% decrease in the effective exchange rate would cause an increase in China’s current account surplus equivalent to 0.3%-0.45% of GDP.

The US-China trade war further extended the trade deficit. After President Trump initiated the trade war in 2018, China stopped importing soybeans from the US until an interim deal was struck, resulting in a US$9.1 billion or 75% year-over-year drop in soybean industry exports. Subsequent tariffs were placed on Chinese steel exports to pressure the Chinese government into cracking down harder on intellectual property theft by Chinese companies, which further widened the deficit. While both countries eventually relaxed certain trade restrictions following the Phase One trade deal, soybean and other product imports have still not returned to previous levels – indicating that the trade war may have a mid- to long-term effect on the US-China trade balance.

Some longer term effects may include higher production costs, increased public debt, and reduced US-bound foreign investment inflows. Tariffs on various US imports could drive American companies to source products from countries that charge higher premiums compared to Chinese competitors, which could lead to a significant increase in production costs. Furthermore, Chinese trade has historically helped finance US debt, so reduced trade could ostensibly transfer the debt burden to other stakeholders – particularly US households. Finally, rising tariffs would likely reduce Chinese investment in the US economy, leading to reduced capital flows into the country. As a result, the trade restrictions levied through the trade war, if continued, would be likely to culminate in a rising cost of living for many Americans.

Supply-Chain Vulnerabilities

The recent shortage in essential medical supplies has called into question the risk of overreliance on China for global supply chains. China’s cheap manufacturing attracts many global medical supplies producers; poignantly, according to 2018 data, China supplies 48% of US PPE and 43% of global PPE. However, with the outbreak closing most of the factories around the country, critical supply lines to the outside world were severed. Of the factories that remained open, many either sold their products to the highest bidder or to local residents. As a result, many hospitals in the US quickly ran out of key supplies and were grossly unprepared to combat the outbreak.

While PPE happens to be the most in-demand product at the moment, medical supplies only comprise a small portion of all essential products that are sourced from China. US officials are increasingly concerned about American reliance on Chinese supply chains and its implications for other sectors of the economy – namely semiconductors, 5G telecommunications gear, and critical minerals for weapons and batteries. Because many of these products have military purposes, their production and application have national security implications, which has consequently driven governmental concerns regarding the country of production. Starting June 9th, 2020, the US will tighten export restrictions on certain technologies being sent to China and expand upon the license requirements on components that have “military end use.” This has the potential to throttle trade relating to innovative technologies and components moving in and out of China, as more companies will have to ensure that they are meeting security requirements in order to continue operations.

The pandemic has opened the eyes of many that now call for MNCs to diversify supply chains away from China. The current overexposure to Chinese supply chains presents the threat of losing access to essential and nonessential products to companies and consumers alike, should another international crisis occur or political interests diverge. However, while diversification of supply chains could safeguard against future disruptions to production, the reality of a drastic economic shift of this magnitude is near-impossible over the short- to mid-term as few countries currently have the manufacturing infrastructure to absorb Chinese production demand – and the markets that do also pose their own unique operational challenges.

What does the economic partnership mean to China?

The US plays host to a number of companies that produce complex products like vehicles and machines. The assembly infrastructure and proprietary technology required to produce these high-precision products are kept locally for reasons spanning economic exclusivity to national security regulation. As a result, should China desire these products, it must purchase them directly from American companies.

China is heavily reliant on American high-precision manufacturing for its aircraft and vehicle industries. Boeing, for example, is one of the only companies capable of supplying large-scale aircraft and flight equipment orders to China, with jetliners as the largest US-manufactured export to China. With both countries coming to an agreement with the Phase One trade deal, it is likely that companies like Boeing will continue to have opportunities to supply the Chinese market over the short- to mid-term. 

However, realizing the dependence it has on US manufacturing in a key industry, China has made a push over recent years to develop its domestic aircraft manufacturing capabilities. Its domestic airline manufacturer, Comac, currently only offers two models of jets – only one of which is in service. The plane, ARJ21, has been plagued with a host of problems and deemed inferior to its competitors from the US, Canada, and Brazil. Furthermore, these jets are only certified to fly in China and other particular regions in Asia, Africa, and South America that recognize the Chinese certification. If Comac hopes to expand its presence in other international markets, the company must first reach a threshold of quality that would enable it to obtain an international certification from organizations like the FAA.

In addition to the high-precision manufacturing infrastructure that the US offers, China also benefits from access to a large consumer market and significant US investment. In 2018, China’s US$479.7 billion of exports to the US contributed approximately 3.5% of its annual GDP. In addition, American institutions also invested US$116.52 billion into Chinese companies and infrastructure during the same period, injecting liquidity into Chinese industries to drive growth and innovation. By decoupling, an annual US$600 billion in value could vanish from China’s balance sheet.

What does the economic partnership mean to the US?

While Chinese manufacturing may have its roots in low-cost, low-skilled labor production, it has since evolved into a globally competitive ecosystem with highly-skilled workers proficient in the manufacturing of advanced technological components, well-established supply chains, and advanced manufacturing robotics.

China currently has an abundance of engineers and other technologically-proficient workers that surpass that of many other leading countries. Many MNCs maintain close partnerships with Chinese manufacturers to access a large pool of skilled vocational workers, with leaders like Apple CEO Tim Cook crediting the Chinese education system for its emphasis on specialized vocational talent before many other countries. China sends a large number of its student population to study internationally and graduates more engineers than many developed nations. With a significant proportion of these students returning to the Mainland after graduation, many matriculate into China’s burgeoning technology industry and further develop the country’s formidable technology manufacturing capabilities.

Engineering and Computer Science Undergraduate Degrees

Sources: Asiatimes.com, The China Guys


Partly due to its educational curriculum that emphasizes STEM degrees, China also boasts one of the largest robotics industries in the world. 2017 sales of industrial robots in China accounted for 35.6% of total global sales that year. Chinese companies have been extremely active in integrating robotics into various aspects of the economy for years due to the government’s “Made in China 2025” strategy. By introducing robotics technology into the logistics, automotive, and other manufacturing industries, China hopes to boost its competitiveness in advanced manufacturing to decrease reliance on outside countries through domestic production.While AI-based robotics manufacturing requires significant investment over the short- to mid-term, it has the potential to offer extreme savings in production costs over the long-term. Foxconn, one of Apple’s largest suppliers, is just one of such examples when it made news after replacing over 60,000 assembly line workers with robots in 2016.

The Path Forward

With the global community still reeling from the economic impact of the coronavirus, it is understandable that some are calling for a US-China decoupling. Significant supply chain disruptions have aroused heightened concern among the international community and led to movements demanding increased self-reliance for manufacturing in the domestic economy. However, the economic relationship between the world’s top two economic powers is complex and a rushed decoupling could sink the global economy to unprecedented depths. Instead, both nations should carefully consider how to effectively diversify the risk of economic overdependence while continuing to maintain healthy trade relations.

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