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US-China: The cool war

EURASIA LIVE
4 September 2019
US President Donald Trump and Chinese President Xi Jinping meet at the G20 Summit in Osaka. REUTERS. US President Donald Trump and Chinese President Xi Jinping. REUTERS.
I'm going to present a new view of the international system and US-China relations—and explain the implications for markets.

Setting the table

What is the current structure of international relations? No topic has generated more heated, erudite debate since the end of the Cold War in 1991. I will argue that today's global structure is one of “emerging bipolarity.” The US and China are superpowers, the rest lag far behind.

I use the word emerging because it's a close-ish call whether China is already a superpower or well on the way to becoming one. I'll go with the latter formulation mainly because China lags in the military sphere. Still, we are entering the second bipolar world since 1945. Though both are bipolar, the new system has quite different characteristics than the Cold War. It will be more economically focused and less confrontational—I call it the new cool war.

The onset of bipolarity is very important. Bipolar systems are more stable than multipolar ones. So the next several decades will probably be somewhat more peaceful than many observers expect ... though only somewhat as the new system will have dangerous chasms.

In more than 30 years as a practitioner of political science, I have found realism (Kenneth Waltz) to be the single most useful theory in explaining the highest level of state behavior and international outcomes. Realism holds that the distribution of capabilities in the system determines its structure. I focus here on the two most important capabilities, military and economic power. The system exerts important pressures on state behavior, such as the impetus to balance against the other superpower. I also recognize that structural attributes alone are insufficient to explain many geopolitical outcomes. Therefore, I include nation-state intentions and possession of nuclear weapons as state-level attributes that are also key in explaining outcomes.

The literature on emerging bipolarity is strong but thin. Yan Xuetong, Oystein Tunsjo, Stephen Brooks, and William Wohlforth—among others—have made important contributions. This essay draws and builds on their work; I especially focus on teasing out market implications of the new bipolarity.
 
"The new [bipolar geopolitical] system has quite different characteristics than the Cold War. It will be more economically focused and less confrontational. I call it the new cool war."

Why the world now has an emerging bipolar structure

The first step in my argument is showing that we are entering a bipolar system. To do so, one must first show that the gap between the senior superpower (the US) and the junior one (China) is not too large and becoming smaller. But second, and often neglected, one must also demonstrate that the gap between the junior superpower and “the rest” is large and growing.

In the military sphere, the US remains the clear leader. Nominal defense spending in 2018, according to SIPRI, was $649 billion, compared to roughly $250 billion for China (38.5% of US spending). US spending has increased under President Donald Trump and accounted for 36% of total global defense spending in 2018, compared to 14% for China. The two countries are not close to coequals on military matters. Still, a key fact supporting emergent defense bipolarity is that the gap has rapidly closed; Chinese defense spending grew by 83% in nominal terms between 2009 and 2018, while US spending declined by 17%.

Then, the second criteria for bipolarity—the gap between China and the rest. It's vast. India is the third-ranking major industrialized country when comparing defense spending. It clocks in at $66.5 billion in expenditures for 2018, 3.7% of global spending, and a 29% increase since 2009. That's very far below China.

Regarding economic capability, emerging bipolarity is evident. US nominal GDP was $20.4 trillion in 2018 (IMF), while China's was 65% of that figure. But the gap has closed since 2010, when China was at 40% of the US number. In purchasing power parity (PPP) terms, China stands at over $25 trillion, while the US lags at 81% of that figure. Again, to illustrate China's economic rise, its PPP came in at about 20% below the US in 2010.

And then the gap between numbers two and three. Again, it's very large. Japan and India vie for third place. Japan comes in at 37% of China on nominal GDP and 20% on PPP in 2018. India stands at 22% and 41% respectively. Lastly, on R&D, the US and China (OECD numbers) come in very close for 2017 at $483 billion and $444 billion respectively. Japan was a distant third at $155 billion.

Yes, China could suffer a hard landing. But as a base case, I'd argue that China's politics are stable, its economic governance capacity is quite skilled, and its relative economic trajectory is unlikely to suffer drastic change. The IMF predicts a growth rate of 5.5% for China in 2024 (and 1.5% for the US). Demographics and debt are problems. China probably will endure somewhat slower growth, but that won't affect its superpower status.

So there it is—I've laid out the facts, and the emerging/existing distribution of capabilities clearly shows that emerging bipolarity is upon us.

Broad implications of my “realism plus”

Geopolitics is on a more peaceful trajectory than many believe because of the nature of balancing under bipolarity. In bipolar systems, the superpowers primarily use internal balancing to offset each other's capabilities. This includes arms buildups and bolstering economic strength. External balancing such as alliances is of secondary importance because of the superpowers' outsized capabilities. This yields stability because internal balancing in more predictable, reliable, and transparent than use of alliances. History is replete with examples of destabilizing alliance defections.

Then the “plus” parts, drivers I include that are not structural. Leadership intentions are central to explaining and predicting both foreign policies and outcomes in geopolitics. Realism gives us the all-important uber-macro take, but analysts must also use intentions to put enough meat on the bones. In addition, possession of nuclear weapons profoundly changes the behavior of states that possess them, prompting those states to proceed with much more caution.

"The next several decades will probably be somewhat more peaceful than many observers expect ... though only somewhat as the new system will have dangerous chasms."

Ok, so what?

The new cool war has key implications for geopolitics and markets. I discuss them here, in order of importance for investors.

Balancing

The cool war will be different from the Cold War in very significant ways. Most important, balancing between the US and China will be more modest than the harsh, global interaction that marked the US-Soviet confrontation. Several factors will limit this balancing. First, on the structural level, the US will remain dominant in its military capabilities—deterring strong balancing from China in this area. Second, China's intentions are very different from those of Soviet elites. China seeks a slow and careful rise. It hews to a different ideology, but this won't be an ideological struggle like the Cold War—no overt attempt to spread the revolution this time. Third, China is focused on Asia. While it has global economic reach, its geopolitical interests are largely in Northeast and Southeast Asia. We'll see less US-Soviet style, zero-sum, geopolitical balancing. Lastly, the US will be enduring some degree of retrenchment, regardless of who is president. Political culture and a likely slower US economy will dictate that. More modest balancing means there will be a very low chance of superpower war (more on that later), few if any proxy wars, and less preoccupation with alliances compared to the Cold War.

Competition over advanced technology

The greatest antagonism and strongest US-China balancing will occur in the economic realm. This is in distinction to the arms racing that marked the Cold War. The above statistics show that China is already close to the US in the economic sphere. That means China can and will attempt to balance US capabilities on butter more than guns.

Therefore, the battle over advanced technology and trade is the main theater of the cool war. Competition over robotics, AI, quantum computing, and 5G is the new, primary form of structural balancing between the two superpowers. That's a critical point. Understanding it makes clear that this battle will be long-term and confrontational—the same forces are driving the advance technology battle in the cool war that drove ICBM competition in the Cold War.

The dynamic is evident in both US and Chinese economic policy, where both sides want superior capabilities in the international marketplace and defense spheres. Both sides see advanced technology as the key, and that's where the strongest balancing hits. The clearest single example is Trump's 2017 National Security Strategy (NSS). The document states that it is the mission of the US government to maintain competitive advantage over other nations, by helping prioritize innovation generally and emerging technologies such as AI and computing specifically. The NSS also says the US government must protect the national security innovation base against competitors, and it explicitly names China. Beijing is pursuing the same policies, subsidizing innovation and keeping foreign firms out of its defense procurement.

This balancing dynamic raises the very real possibility that advanced tech firms around the world will have to choose between US-aligned and China-aligned markets. The US may take steps to prevent sensitive algorithms or source codes that are vital to US infrastructure or that have dual use applications from being sold or transferred to China. Economic bifurcation will likely plague some sectors. It's a real risk that corporate strategic planners must face. At the same time, the US and China will fiercely compete to supply large third-country markets with advanced technology, much of which will have military application. The current battle over the fate of Huawei and 5G is probably a preview of the future, in that Washington or Beijing for national security or economic reasons will seek to restrict the other's activity in certain sectors. In short, countries and their firms will often have to choose between the US and China for sales and purchases in the innovation sector.

The escalating trade war also reflects balancing behavior, as the sides jockey for advantage. This interaction represents an interesting mix of structural and foreign policy drivers. For Steven Mnuchin, Larry Kudlow and other Trump advisers, the trade/tariff war is a discrete foreign policy designed to level the playing field by stopping certain Chinese policies. But for others, such as Peter Navarro and John Bolton, it's an effort to contain or balance China – and that's structural. Trump has a foot in both camps but is tacking toward the hardliners. Balancing behavior is therefore also driving the trade war, which bodes ill for a resolution.

Spheres of influence

In my view, spheres of influence will always be a structural part of the geopolitical landscape. With concentration of capabilities comes influence and spheres. The key question for investors is what the new spheres will look like and how they will affect business.

Asia will be the most fluid arena in coming decades, as China will flex its muscles there. Northeast Asia will remain closely tied to the US, through treaties and military deployments. US commitments to Japan and South Korea are unlikely to weaken markedly, especially because they are now located on the front porch of the other superpower. Meanwhile, Tokyo's and Seoul's historic suspicion of and enmity toward China is unlikely to abate significantly for a long time.

But the ASEAN region could well become a relative Chinese sphere of influence. ASEAN states have geographic proximity and large and rapidly growing economic ties with China. Beijing has focused on infrastructure and technology sector investment; tech regulation in the region has accordingly taken a Chinese-like tack on data localization and other issues. Meanwhile, from the US perspective, Southeast Asia is not a priority area for the political establishment. Under conditions of retrenchment, the US probably won't be a reliable strategic partner for ASEAN countries.

Cambodia, Laos, and Myanmar are already in China's orbit. Prime Minister Mahathir Mohamad's election in Malaysia led to a recalibration of that nation's tilt toward China, but the long-term trend will continue. Indonesia and Singapore will try harder to remain non-aligned, but both will come under great economic pressure from Beijing. The Philippines' trajectory depends on whether President Rodrigo Duterte completes his term through 2022, who succeeds him, and how much of his pivot toward China becomes institutionalized. Moreover, the South China Sea issue is headed toward game over in terms of territorial disputes and Chinese expansion, with Beijing winning.

In my view, Vietnam will probably be the most independent ASEAN country. Antipathy toward China and strong economic links to Russia, South Korea, Japan, the US, and the EU give Hanoi more leverage.

Southeast Asia's likely drift toward China has important implications for investors. Many large corporations are decamping from China and relocating to ASEAN nations—including Malaysia and Thailand. Investors should beware that China will have increasing sway over the investment climate in those countries. Risk will also go up in Vietnam, the preferred choice for relocation. If Hanoi becomes the only outlier from China's sphere, that status will further antagonize Beijing. If, on the other hand, Hanoi relents more than I'd bet, it's in the same quandary as its neighbors. There will continue to be significant opportunities in the ASEAN region for non-Chinese firms, including those from Japan, the EU, and elsewhere. But corporate risk management will have to focus closely on China's agenda and influence over the investment climate.

Other regions will experience more fluidity compared to the Cold War, at least outside the advanced tech sectors. Nation state and private sector alignments in Africa and Latin America will show allegiances to the US, increasing influence for China, and continuing robust activity for the EU, Japan, and others. Europe will also be more fluid, with its trajectory in part dependent on the fate of NATO. Southern and Central and Eastern Europe, for economic reasons, will likely see the biggest uptick in Chinese influence. The Middle East, on the other hand, will remain tied to the US for longer. Iran aside, China's ascent has been slower there.

In the new bipolar system, there will be major players that are not deeply embedded in a sphere of influence. Russia, India, and Brazil are good examples. Yet they fall so far below the superpowers regarding distribution of capabilities that their “floater” status won't have major impact on the system or outcomes. Finally, the EU28 in the aggregate lies between the US and China on both nominal GDP and defense spending. But the EU lacks (and is unlikely to acquire) an army. On the economy, the EU as an entity is both under stress and far too unlike a nation state to compare it in a distribution of capabilities ranking.

War

The chance of any military conflict between the superpowers will be low in the new bipolar system. Possession of nuclear weapons and an assured second-strike capability drastically reduces risk. More modest balancing behavior compared to the Cold War further lowers risk. Again, China's intention and overarching vision is a slow and careful rise—one that focuses mainly on economic growth. Military conflict with the US or one of its allies would likely shut many markets to Beijing.

The system will carry some risk of conflict however. As Tunsjo argues, the main flashpoints will be in maritime East Asia—Taiwan, the East China Sea, and the South China Sea. One side might conclude that a maritime conflict between superpowers carries less chance of escalation than a land conflict, for example in the Fulda Gap during the Cold War. That miscalculation would be quite dangerous. Taiwan stands out as the major potential flashpoint. Reunification is a “must have” for Beijing, and a Taiwanese move toward independence could result in a miscalculation.

Meanwhile, the chance of smaller wars around the world is likely to increase. The US and China will be focused on each other and on their respective economies. Conflict prevention, “global cop” capacity will be low in the new system. Accordingly, conflict between Iran and Saudi Arabia could erupt, and Russia will have a freer hand in Eurasia.

Public goods

Multilateral behavior and the provision of global public goods will likely decline, but not by much. US intentions will not focus as much on alliances or multilateral institutions as in the past. Populism will keep many Western nations looking inward. Meanwhile, China's long-standing emphasis on national sovereignty limits its appetite for the kind of activist role that the US has played in the global system. However, China has been stepping up in the provision of public goods, from contributing to UN peacekeeping to founding new development institutions such as the Asian Infrastructure Investment Bank. Beijing is increasingly interested in rulemaking and maintaining a stable trading environment, though on its own terms. If or when there's another global financial crisis, expect mutual interests to lead to common efforts. Climate change (if there's a new US president in 2021) and terrorism are other arenas where the US and China will cooperate.

The world is entering a new bipolar structure, with major implications for geopolitics and markets.

Read about US-China in our Top Risks for 2019 report, and look at Cliff Kupchan and Paul Triolo's op-ed A third party solution to the US-China tech war? in The Straits Times.
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Eurasia Group Chairman Cliff Kupchan.
Cliff Kupchan is Eurasia Group's chairman as well as director of research and leader of the firm's global macro coverage. He has held high-level positions in the US government and has been a leading expert on international relations for more than two decades. Cliff co-authors Eurasia Group's annual Top Risks publication.
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