South Korea: Beyond the US-China trade and hegemonic war

While the US-China trade war has affected the US and Chinese economies, it has also taken a toll on Asian economies that have tight production links to China. Korean exports, for example, fell 11% in July from the year before, its 8th consecutive month of decline. Meanwhile, job losses in the manufacturing sector are expected to continue. While GDP growth rebounded in the second quarter (+1.1% yoy), this was on the back of strong government spending.

The rivalry between the US and China has triggered references to the conflict between Athens and the Spartans in 5th century BC. Professor Graham Allison, a political scientist in the US, calls it the “Thucydides Trap” – when a rising power causes fear in an established power, it eventually escalates into war¹.

The Thucydides Trap² basically draws its argument from the text of the ancient Greek historian Thucydides – “It was the rise of Athens and the fear that this inspired in Sparta that made war inevitable”.

In 5th century BC, a fierce rivalry existed between two leading states, Sparta and Athens. Sparta, the dominant state, fearing the rise of Athens, organised the Peloponnesus League, a confederation of Greek city states and went to war, ultimately defeating the Delian League, an alliance organised by Athens.

According to Professor Allison, among the 16 examples of hegemonic competition between the great powers after the 15th century, only 4 did not result in war. See Fig. 1. These included the hegemonic competition between the US and Soviet Union from the 1940s which involved an arms race (Strategic Defense Initiative) started by the US in 1983 to defend itself from the Soviet Union’s intercontinental ballistic missiles. The Soviet Union, which had started to experience declining economic growth from a slow-down in agricultural productivity, eventually collapsed from the continuous arms race.

Fig. 1. Examples of hegemonic competition³

While prior wars focused on military might, the core of hegemonic competition has largely shifted to economic influence after World War II. However, history tells us that the outcome can be surprising, and the continued ascendancy of any economy is not guaranteed.

After the Chinese civil war in 1949, the US and Japan united against communist power and ideology. USD60 billion worth of military supply orders from the US to fight the Korean (1950) and Vietnam (1965) wars caused the US to suffer a massive trade deficit with Japan. Japan’s GDP rose to become two-thirds of the US (See Fig. 2). Its manufacturing industry boomed as exports soared on the back of a competitive exchange rate as well as significant technology transfers from the US

Fig. 2. Trend of Global GDP Distribution⁴

This hegemonic competition did not end in a war as the Japanese economy subsequently lost steam after the Plaza accord. In 1985, Japan signed the Plaza accord which sought to correct the over-valuation of the US dollar by asking the main current account surplus countries (Japan and Germany) to boost domestic demand and appreciate their currencies. Accordingly, the yen appreciated sharply - up 46% against the US dollar and 30% in real effective terms by the end of 1986. As a result, Japan’s export and GDP growth essentially halted in the first half of 1986. Pressured to respond, policymakers introduced a sizeable stimulus which led to an unprecedented boom in asset prices, and ultimately a collapse - what is now known as Japan’s Lost Decades⁵.

China’s GDP is currently two-thirds of the US’ (Fig. 2.) and forecasts suggest that China will become the world’s largest economy by 2050⁶. China is currently the world’s largest producer of aluminium⁷ and steel⁸. Many of its tech companies are market leaders and it is becoming a world leader in developing 5G technology. With its “Made in China 2025” blueprint, China aims to transform the country into a hi-tech powerhouse that dominates advanced industries such as robotics, advanced information technology, aviation and new energy vehicles.

The US views these ambitions as a threat to its technological leadership. Among other things, the US wants China to respect intellectual property rights, provide safe guards against unfair competition from its state-owned enterprises and provide a more level playing field.

At the same, hegemonic power goes beyond trade and potentially extends to the exchange rate – whoever owns the global reserve currency becomes the hegemonic power, and finance (capital markets). On the exchange rate front, China wants to share the global reserve currency spotlight, but this would require allowing market forces to play a greater role in determining the renminbi’s value and opening up the capital account further. Meanwhile, China has chosen to open up its capital markets at its own pace, to avoid destabilising capital outflows and excessive volatility in its financial markets.

Changes in global order affect other economies. Due to China’s rapid progress and Korea’s delays in innovation, Korea lost about 50% to 60% of global market share in light industries over the last 20 years. Previously known as one of the four Asian tigers, South Korea experienced exceptionally higher growth rates in excess of 7% per annum from the early 1960s to 1990s. Its growth outlook has since been clouded by ageing demographics, a low birth rate and more recently the decline of its manufacturing sector on the back of the US-China trade tensions as well as export restrictions imposed by Japan. In addition, if China achieves its goal of self-sufficiency in core components as laid out in its “Made in China 2025” blueprint, this could further hurt Korea’s hi-tech export sector.

With the world economy becoming ever more intertwined, emerging powers will have to share the world stage. The resolution of global issues will require the participation of more players, China included. It will be necessary to achieve mutual understanding and adopt a set of universal values – this will not be easy, as we have seen.

At the same time, the unpredictable path of events suggests that wild cards cannot be ruled out. Some form of the trade resolution ahead of the US presidential election will lift animal spirits as well as business and consumer sentiment. For Korea, successful negotiations between the US and North Korea, can lead to greater inter-Korea economic co-operation, giving the Korean economy a new boost. In view of the faltering economy, the Korean government has unveiled its most expansionary budget since the 2008 global financial crisis. Fiscal spending will rise 9.3% yoy in 2020, as the government looks to support economic growth through innovation and investment.

The Thucydides trap helps us understand the magnitude of the challenge ahead for the US-China relationship and the urgency for a solution. Although the current realities appear dark, the eventual outcome need not be negative. While it will take time, a resolution will lift Korea’s growth potential and increase the attractiveness of its financial markets to foreign investors. For now, within the Korean fixed income market, we are neutral on credit given increasingly stretched valuations. The Bank of Korea is likely to cut rates again in the fourth quarter and we will be looking for opportunities to tactically trade duration.