China v America trade war: who has the most to lose, according to game theory?

The trade war between the Trump administration and the government of China is a strategic conflict rather than the return of ideological protectionism. So the range of possible outcomes, which are potentially significant for the global and Australian equity markets, is best understood through the lens of game theory. Game theory is the science of strategic interaction between rational decision-makers and is used to model optimal decision-making across a broad range of sectors such as economics, finance and diplomacy. Each actor faces a range of choices and the potential outcomes, positive and negative, are dependent on the choices of the game’s other players.

Beijing’s next steps are the most interesting to study as China has the most to lose. Last year, China exported $US505,470 billion of goods to the US while it only imported $US129,894 billion from it. Chinese exports to the US are primarily a source of affordable low-value-add goods, such as furniture and bedding, toys and sports equipment and parts that American companies design and have cheaply made in China to be sold back to US consumers. Generally, this means the US does not “need” Chinese imports, so the consequence of trade restrictions would be American consumers paying more for low-cost products.

By contrast, China imports food for its enormous population from the US, as well as high-value-add goods, such as aircraft, vehicles and electrical machinery, which cannot easily be replaced by another exporter. From a state of relative disadvantage, China has few options. Beijing could remain hawkish by continuing the tit-for-tat accumulation of tariffs; devalue its currency; stimulate the domestic economy; and reduce interest rates and credit standards to stimulate lending. However, these actions carry significant economic costs.

So far, the unintended consequence for the US has been the rise of the US dollar relative to the rest of the world as it’s perceived as a safe haven. With the combination of a tightening central bank and the risks of tariffs, the flight to the US dollar has seen it appreciate against world currencies. The implementation of tariffs on China has, in effect, resulted in quasi-tariffs applied to all its trading partners through the stronger dollar.

Trade alliance

Alternatively, China could increase its bargaining power by forming a significant trade alliance against the US. This would be the only option that would justify continued escalation from China as it would increase its size relatively against the US and limit the impacts of American tariffs. However, China tried and failed to enter such a relationship with the European Union in July and as no other major economies are seeking trade relationships with China, this option appears unlikely.

In the absence of a clear choice that would allow China to continue down a hawkish path, logic should see it take a third route – retreat. China’s optimal choice is to adopt a conciliatory approach that would see it benefit from lower obstructions to trade with the US. The US would be expected to stop declaring tariffs as it has nothing to gain from causing additional pain to a pacified China. In game theory terms, this outcome represents the Nash equilibrium, which sees each party act in its individual best interest in the full knowledge of what the other party will do.

If China does not back down, forcing the US to implement the full $US500 billion in tariffs, you would expect a direct impact would be a fall in global growth of 0.3-0.5 per cent, with a decline of more than 1.5 per cent in China’s and America’s gross domestic product. Given the hit to sentiment, a significant fall in global equities – in the order of 10 per cent – would be likely to follow, as well as a spike in inflation that would cause central banks to raise interest rates.

Instead, we expect to see China acknowledge US supremacy in the trade war conflict, which we would expect to translate to a relief rally in global equities and negligible negative impacts to the global economy. China’s recent decision to send a trade delegation to the White House may signal its intent to reach a Nash equilibrium sooner rather than later.

The one caveat I'd make is that Game Theory works on the assumption that both parties are rationale...

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