China's road block?

China plans to open an investigation into US subsidies for car makers, possibly within a week, according to news reports quoting the American Automotive Policy Council on October 29. The move follows the United States' imposition on October 28 of a temporary tariff of 9.8 per cent on Chinese steel pipes, pending the results of an anti-dumping investigation due in January 2010. Trade tensions have been evident since the early days of US President Barack Obama's administration, but the global economic crisis and the precarious recovery have led to protectionist threats from both sides that have escalated since Obama's decision in September to slap 35 per cent tariffs on imported Chinese tires.

Neither China nor the United States wants to torpedo the other's economic recovery – the two economies are mutually dependent to a great extent. But as the relationship gets testier, the odds improve for both sides to fail to perceive correctly the other's actions and overreact, thereby increasing the danger that trade spats could take on a life of their own.

Of course, the Chinese decision to target US auto makers makes sense as a retaliatory move. Automobile manufacturing is an obvious area where the United States can be accused of favouring its own industries. US car companies have been piling up inefficiencies for decades in accordance with US labour policies that benefited unionization and led to high labour costs, gradually eviscerating profits. Political influence has enabled them to benefit from a wide range of policies throughout the years, despite their decreasing ability to compete fair and square on the global playing field. By the time the financial crisis struck in 2008, the major domestic car companies were teetering on the brink of ruin.

Viewing indigenous manufacturing as a strategic asset despite its current uneconomical state, and fearing the political and economic ramifications of liquidation, the Obama administration chose to rescue General Motors (GM) and Chrysler with approximately $US60 billion in public funds (Ford did not take bailout money.) The administration has taken other actions to support domestic car makers, such as subsidized returns of used cars (the "Cash for Clunkers" program) in July and August to spur new cars sales.

But China has yet to begin its formal investigation of US. car makers, – today's leak is merely a threat. Next will come obligatory consultations with the United States to see if the two sides can patch things up on their own. Only after these consultations will Beijing be able to file its complaints with the World Trade Organization (WTO) – and a ruling will take years. At present, China is only threatening to investigate US car exports (numbering about 30,000) and not US cars made in China, where the majority (over one million) are manufactured through joint-ventures to avoid shipping costs. In other words, Beijing is sending a warning signal that it is not without leverage in the emerging trade battle.

But Beijing is aware of Washington's clout. As China's single greatest export destination (only the European Union as a block is bigger), the United States has a large arsenal to choose from should a trade battle emerge. The United States ran up a $US268 billion trade deficit with China in 2008 (about 33 per cent of its total trade deficit). Much of this is for non-essential goods that could be eliminated should the administration decide to build up its trade barriers.

As Beijing knows, Washington has a powerful weapon in Section 421, a domestic law that allows the United States to slap tariffs on Chinese goods that China itself agreed to as a precondition for joining the WTO in 2001. This was the rule that the United States invoked when it levied tariffs as high as 35 per cent on Chinese-made tires in mid-September, a move that unleashed a wave of complaints and claims over everything from chickens and steel pipes to intellectual property and quality control issues.

On steel pipes in particular, the United States has continued to act aggressively, increasing the heat on China yet again on October 28 when it declared that customs would demand a 9.8 per cent deposit on Chinese steel pipes until the final ruling (tentatively due in January 2010) on whether these products deserve a full anti-dumping tariff. The deposit will be returned in full if the United States rules that China has not been dumping. But if it rules against China, the deposit will be kept, higher tariffs will be imposed as early as March 2010, and the Chinese will be expected to pay the difference as well as the tariffs going forward.

Thus, being highly dependent on exports to the US consumer market, China does not want to provoke the full wrath of a giant that could, if it really wanted to, dramatically curtail or stop buying Chinese goods, which would send its export sector and its economy (along with social stability) into a nose-dive.

Nevertheless, the Chinese have two advantages in raising the potential of an auto investigation. First, China's rapid economic growth (hitting 8.9 per cent in the third quarter) and its booming domestic market for automobiles (GM estimates total 2009 car sales in China will reach up to 12 million units, up from 9.1 million in 2008). In 2007, the value of US car exports to China totalled $957 million and grew 38 per cent while US. exports of parts fell to $893 million in 2008, down from over $1 billion in 2007. This growth of car exports allows the Chinese to leverage their developing consumer strength against the car exporters. While the fundamentals of Beijing's hunger for cars are not necessarily as vibrant as they appear – being driven largely by fiscal stimulus policies amid the global slowdown – they are real enough to command attention from manufacturers, especially at a time of low demand elsewhere.

Second, the Chinese know the importance of auto makers to the US economy and their precarious economic state at present (after a disastrous 2008, GM's sales have fallen by 36 per cent, Chrysler's by about 40 per cent and Ford's by 22 per cent so far in 2009). This American vulnerability maximizes the efficacy of the Chinese threat – a serious Chinese import barrier on US cars could dash Washington's bailout and take out one of the last markets the car companies have. Moreover, a Chinese case at the WTO could trigger other members (such as the EU) to complain of US car subsidies.

In other words, the Chinese threat will put pressure on the car makers, which in turn are capable of putting political pressure on the US government to pull back from its protectionist measures against China. This is Beijing's strategy – not to attack the most sensitive part of the US manufacturing base with full force but to deter the United States from pressing further against China with its own import barriers.

With Obama headed to China for a November 15-18 visit, his first to the country since he took office, both China and the United States are reconnoitring the battleground, with each flashing a formidable array of trade threats and counter-threats. Neither side wants to hinder the other's economic recovery, but with China's rapid growth and simultaneous vulnerability to the United States – and Obama's domestic weaknesses – the risks of misperceptions and miscalculations are rising.

Stratfor provides intelligence services for individuals, global corporations, and divisions of the US and foreign governments around the world.