The short-term conclusion of a trade agreement between China and the United States is unlikely. For Chinese President Xi Jinping, such an agreement would nevertheless be welcome. It would allow him to reform the Chinese economic model, cleverly leaving the White House to play the bogeyman.

In a series of scathing tweets, President Donald Trump torpedoed trade negotiations between China and the United States. By attacking Huawei, he only added fuel to the fire. As a result, the probability of reaching a deal in the next few months has dropped to 30%. We estimate there is a 20% probability of a full-blown trade war and a 50% probability of talks occurring throughout the year without any concrete results.

Both presidents are impatiently awaiting the conclusion of a deal. Trump urgently needs to prove his reputation as a deal maker. In addition, this deal is necessary to keep the stock market at the level to which Trump says he has raised it. One can deduce that a strong correction would certainly encourage him to be more flexible.

President Xi should also breathe a sigh of relief because the economic impact of this trade war is beginning to be felt, on the heels of a slowdown in growth that China is facing due to a necessary transformation of its economy.

In 2013, Xi’s predecessor, Wen Jiabao, had described the Chinese economy as “chaotic, unstable, and untenable.”

Bursting Speculative Bubbles

Since then, Xi has taken back the reins with an iron fist and further centralized the economy. However, Wen’s last two descriptions of China’s economy are still accurate. China must face three major challenges: bursting the speculative debt bubble, organizing the shadow banking system and reducing state participation in public companies.

China’s total debt – from the public, financial and nonfinancial sectors – has doubled since 2008, reaching almost 300% of the gross domestic product. A large part of this debt was financed by a huge shadow banking system. This involved an unregulated, and therefore impossible-to-control, credit system that operated in parallel with commercial banks. The Chinese authorities have turned a blind eye to these practices because they enabled financing of market players, such as local authorities, real estate agents and small and medium-sized private companies, that had trouble obtaining credit via official means.

This tolerance policy ended two years ago, which explains why nonfinancial sector debt decreased by 5% to 7% of the GDP, compared to its peak in 2016.

Slightly over half of this debt is held by government-owned companies. These represent another headache for Chinese leaders. They played a crucial role in maintaining the stability of the Chinese economic model. They receive a substantial amount of subsidies and create huge overcapacity, which explains their structural losses.

During his inauguration, Xi promised to confront this problem head-on, but he has made many enemies trying to fight corruption and regain control over the Chinese army. The great purging of these state enterprises has thus been postponed indefinitely.

Voluntary Black Sheep

Reducing government subsidies and the participation of the state in public enterprise are among America’s requirements for a trade deal. Xi thus has an excuse to tackle these issues, despite the wishes of his Chinese opponents. A complete elimination of state-owned companies is doubtlessly unrealistic. An evolution toward the Singapore model, in which public companies are obliged by a supervising authority to be as effective as private companies, offers the promising potential of increasing productivity in China and putting the country back on a faster track toward growth.

Many other American demands would equally benefit long-term growth in China. In an attempt to evolve from “made in China” to “created in China,” and from Chinese products to Chinese brands, China has every interest in better protecting intellectual property.

This strategy is perfectly aligned with the “Made in China 2025” program, which is meant to propel the country into a position of absolute leadership in 10 promising sectors, primarily within high-tech. This is the only way for the country to achieve status as a developed nation and avoid the “middle-income trap” of countries like South Africa and Brazil.

China would also succeed more quickly at increasing the quality of its products if it opened the door to foreign goods and services. Lower tariffs and the removal of many nontariff barriers (e.g., licensing and legal barriers) would reduce the prices of imported products and increase the buying power of Chinese consumers. The Chinese president would thus transform a threat into an economic opportunity, leaving the White House to play the role of the bogeyman responsible for controversial reforms.