Hong Hao: War and Peace

2019-05-21 IMI

This article appeared in the author’s WeChat public account (ID: Honghaochinastrategy) on May 14, 2019. Hong Hao, Senior Research Fellow of IMI, Managing Director and Head of Research, BOCOM International. “If everyone fought for their own convictions, there would be no war.” ― Leo Tolstoy, War and Peace Let us assume that the trade talks are a repeated and sequential game with finite rounds, ignoring political influences and ideological differences. Each party in this game is to maximize self-economic interest, given the actions of its opponent. This is not a cooperating game, as establishing long-term binding contact appears difficult. To win in this game, it pays to establish credibility by making a “strategic move”. Such a move is one that “influences the other person’s choice in a manner favorable to one’s self, by affecting the other person’s expectations of how one’s self will behave. One constrains the partner’s choice by constraining one’s own behavior” (Thomas Schelling, The Strategy of Conflict, 1960). It is counter-intuitive to achieve one’s objective by limiting one’s option. But it is the right way to play such a game. And it is exactly what Trump did last Sunday. He has created a fait accompli that has left China with little choice. Applying the Stackelberg model for sequential games, it appears on paper China’s rational strategy is to work with the US to reach a deal (Figure 1). Essentially, this is a textbook maximin strategy to maximize minimum gains in order to avoid catastrophic losses, given the US’s hands. If so, it seems that in theory Trump’s negotiation brinkmanship that demonstrates a credible threat can indeed help accomplish a deal. Figure 1: After the US unilaterally raised tariff towards the final rounds of trade talks, China’s rational choice is to work with the US to reach a deal.

Source: BOCOM Int'l That sounds plausible on paper. But such analysis has a number of restrictive assumptions: each player is rational being one of them. But it is easy to lose one’s head in a stressful situation. The analysis is also short-term focus and entirely utilitarian, ignoring longer-term impacts such as relocation of industrial supply chain, loss of foreign confidence and potential capital flight. Further, in such a game, the winning strategy for both sides is really to play “tit-for-tat” – you scratch my back and I scratch yours. Before the hiccup, both sides did show goodwill in delaying tariffs and compromising during talks to reach an agreement. But now tension starts to escalate. The constraints outside textbooks are showing in unpalatable technical patterns of risk asset prices. For instance, soybean futures has broken its support level last seen during the worsening trade talks in 2018; the Hang Seng’s long-term support has turned into significant near-term resistance; the RMB is plunging towards its lows (Figure 2-4) – just to name a few. This is a high-stake game that has the potential to change the trajectory of economic cycle, and reshape the world order. In our 2019 outlook report published last November, we set satisfactory trade talks as our base case, and a breakdown of talks as a risk scenario. While we continue to hope for the best, with theoretical support, the market is saying we should also prepare for the worst. Figure 2: US soybean futures has broken its support level seen during the trade frictions in 2018

Source: Bloomberg, BOCOM Int'l Figure 3: the Hang Seng’s long-term support has turned into near-term resistance.

Source: Bloomberg, BOCOM Int'l Figure 4: The RMB is plunging towards its lowest of ~7 last seen in late 2016.

Source: Bloomberg, BOCOM Int'l

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Hong Hao: War and Peace

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