The great U.S.-China "decoupling" dilemma

The U.S. and China may be on course for a “phase one” deal to prevent further trade war escalation — but a hardening between the world's two biggest economies could last far beyond the tariffs and truces of the Trump era.

Why it matters: Kevin Rudd, the former Australian prime minister and current president of the Asia Society Policy Institute, fears talk of “decoupling” — in which the U.S. and China disentangle their economies and erect new barriers — will become a “self-fulfilling prophecy,” with drastic consequences.

"A fully 'decoupled world' would be a deeply destabilizing place, undermining the global economic growth assumptions of the last 40 years, heralding the return of an iron curtain between East and West and the beginning of a new conventional and nuclear arms race with all its attendant strategic instability and risk."

Where things stand: In a speech delivered at the University of California San Diego and shared with Axios, Rudd notes that there are already some signs of decoupling, even if a complete severing of economic ties is unlikely.

• Technology: China has made eliminating its reliance on U.S. tech a top national priority, the U.S. is attempting to block Huawei's global 5G rollout, and each country is racing to defeat the other in artificial intelligence.
• "Human talent": Rudd fears we are "entering a new McCarthyism" in which Chinese students, experts and others are blocked from visiting the U.S. (and vice versa), while even Chinese Americans could face "a veil of suspicion."
• Currencies: China is deeply concerned about its dependence on the dollar and "senses a serious opportunity" to reduce it via digital currencies, Rudd writes.
• Investment: Chinese investment in the U.S. is declining, and many believe "the investment door to the United States is now closing."
• In other areas, like capital markets, decoupling seems a more remote possibility.

The U.S. view: Rudd writes that while the U.S. has developed an "attitude" toward China — fueled by anger, frustration and a sense of betrayal — it lacks a clear strategy.

• Still, officials like Vice President Pence who are otherwise quite hawkish have insisted the U.S. does not wish to decouple what is arguably the world's most important bilateral relationship.

The Chinese view: Facing slowing economic growth, Rudd says, Chinese President Xi Jinping is willing to offer some concessions in the short-term to limit the trade war damage. But he's also "rapidly diversifying Chinese export markets" and focusing more on domestic consumption.

"[W]hereas the Trump administration may indeed be genuine when it says it doesn’t want to embark on economic decoupling with China, it may well be Xi Jinping’s administration that initiates and accelerates the process in the name of national self-reliance."

What to watch: "After an 18 month-long trade war, it appears that both sides have stopped, stared into the abyss, concluded that its a very long way down there and a lot people on both sides could get seriously hurt — and without any real lasting benefit to anybody," Rudd writes.

• "Resolving or reducing the scope of the trade war is one thing," he continues. "But that will not of itself mean the end of the technology war, the 'talent' war, the declining flows of foreign direct investment or the new, emerging uncertainties on currency."