The great de-coupling

Since the end of World War Two, the global geopolitical landscape has gone through several significant changes. The world divided into two ideological camps led by the US and the Soviet Union during the Cold War that started in the late 1940s. The two superpowers engaged in a global competition for influence and power, involving proxy wars, espionage and arms races.

The collapse of the Soviet Union in 1991 marked the end of the Cold War and the US’s emergence as the sole superpower. Around the same time, China’s integration into the world economy began in earnest, a process that accelerated after the country’s accession to the World Trade Organization (WTO) in 2001.

Since the late 1970s, China had implicitly cooperated with the US on most economic and political matters despite occasional tensions. This good relationship, especially on the economic front, was dubbed “Chinamerica” by some observers and provided a peaceful and supportive external environment for China to pursue its development. This was the backdrop to China’s emergence as a major global power, both in economic and, increasingly, military terms.

Chinese investments in US Treasuries have been falling

However, in recent years, the US-China relationship has become increasingly tense, with the US accusing China of unfair trade practices, intellectual property theft, cyber espionage and other misdeeds. The two countries have also clashed over issues such as Taiwan, the South China Sea and human rights. After over four decades of relatively cordial relations, the growing rivalry between the two countries has sparked a process of  ‘de-coupling’, especially since the presidency of Donald Trump (2017–2021). The reshuffling of relations in the rest of the world (such as the recent peace deal between Saudi Arabia and Iran, brokered by Beijing) is also re-shaping the global geopolitical landscape.

In our view, several factors have contributed to the rise in US-China tensions.

First, China’s rapid rise as a major power has led the US to consider it a real and increasing threat to the world order that has been led by the US since World War Two. According to the latest National Security Strategy, prepared by the Biden administration in October 2022, “the People’s Republic of China harbours the intention and, increasingly, the capacity to reshape the international order in favour of one that tilts the global playing field to its benefit.”

The US’s perception of China is not totally unfounded. Since Xi Jinping became the head of the Chinese Communist Party (CCP) in 2012 and president of China the following year, there have been significant changes in Beijing’s foreign policies. The long-held strategy by Deng Xiaoping (China’s leader throughout the 1980s) of “keeping a low profile and concentrating on self-improvement” has been replaced by a much more assertive stance in the name of “new major power diplomacy”. In our view, this change is part of a much broader policy shift as Xi pushes for “the great rejuvenation of the Chinese nation.”

The deep political divisions within the US have probably exacerbated the tensions between the two major powers. The need to be tough on China has apparently become one of the few major issues on which Democrats and Republicans can agree. Criticism of China seems to be a safe way to score political points in the US.

China’s maintenance of close ties with Russia since the latter’s invasion of Ukraine in February 2022 has added to US-China tensions. While the West has strongly condemned Russia’s military actions and stands behind Ukraine, China’s reluctance to openly criticise Russia has led to US threats of punishment.

It looks like other recent developments may also accelerate de-coupling between the US and China. For example, the US has significantly stepped up its efforts to contain China’s capabilities in advanced technologies in recent years, especially in high-end semi-conductors. Trade blacklists have expanded greatly in coverage and scope, posing significant challenges for China’s tech sector.

One could argue that de-coupling began in earnest in 2018, when President Trump started a trade war by imposing high tariffs and/or quotas on a range of Chinese imports. Despite the surge in demand for mostly Chinese-manufactured tech products during the covid pandemic, the US’s average monthly imports from China in 2019-2022 were 7.9% below the average in 2017–2018. By contrast, the US’s average imports from Canada rose by 12.0% in 2019–2022 and by 15.7% from Mexico. In response to the US restrictions, China is trying to reduce its reliance on US technologies. For example, in May 2022 the Chinese authorities ordered all central government agencies and state-owned enterprises to replace foreign-branded personal computers with domestic alternatives within two years. Many Chinese businesses are also seeking to reduce their use of US technologies for fear of future sanctions. Achieving technological self-reliance has become a national priority for China, with the CCP’s latest five-year plan (2022–2027) promising big increases in research & development.

As a further possible sign of decoupling, the Chinese government has been reducing its holdings of US Treasuries over the past decade. After reaching a peak of USD1.3 trn in 2013, Chinese holdings of US Treasuries dropped to USD849 bn in February 2023. We expect China to continue reducing its exposure to US government bonds going forward to mitigate the risk of potential reserve losses should tensions rise further. The freezing of Russian foreign reserves by the West could stimulate China to accelerate these efforts. In addition, China has made some notable progress recently in its efforts to internationalise the renminbi. For example, Brazil and China agreed in March 2023 to settle bilateral trade (worth USD150 bn in 2022) in their respective currencies instead of the US dollar.

Geopolitical risks involving China could rise in the decade ahead. As Xi has secured a third term as the head of the CCP and military until 2027 (and possibly beyond), he may be tempted to push for the ‘re-unification’ of mainland China and Taiwan during his tenure. The geopolitical stakes involved are extremely high: any move to take over Taiwan is certain to provoke a backlash from the US and its allies in the region such as Japan and Australia. Even without military intervention by the US, economic sanctions similar to, if not more severe than, those that have been applied to Russia since 2022 would be almost inevitable. Such a development would have dire consequences both for China and the world economy. For the time being, such an escalation is not our base-case scenario for the coming decade, given our belief that the Chinese leadership is well aware of the severe consequences of any attempt to capture Taiwan.

But such a scenario cannot be ruled out, and its probability has risen compared with five years ago. The risk of miscalculation has increased too. Since the August 2022 visit of Nancy Pelosi, the then US Speaker of the House of Representatives, there have been other, high-profile visits by western politicians to Taiwan. These visits are seen as provocations by Beijing. It has responded by increasing the frequency and size of military drills around the island. While we don’t see these drills as precursors to real action, the sabre rattling and apparent absence of communication between the US and Chinese militaries have raised the probability of accidents.