The US’ recent restrictions on Chinese exports and direct investment in China are likely to cause substantial collateral damage to the Chinese economy, raising the risk of conflict. But if China and the US can agree on the concept of a special economic zone (SEZ), such as Hainan Island, the collateral damage and geopolitical risk may be mitigated substantially.

Jake Sullivan, US President Joe Biden’s National Security Adviser, has likened the US economic restrictions on China to a “small yard with a high fence.”

While the administration aims to undermine the Chinese military’s capacity to fight US forces in the South China Sea, American policymakers still hope for bilateral cooperation on global issues such as climate change, fentanyl control, biodiversity, and nuclear non-proliferation. This is the message sent to China by both Treasury Secretary Janet Yellen, who recently concluded her visit there, and Secretary of State Antony Blinken, who visited the country last month.

The US and its allies’ trade restrictions against China focus on exports of high-end semiconductors and the materials and equipment needed to produce them. These include advanced insulants and lubricants, ultra-pure water, and 20-plus types of chip-making machines whose production is dominated by a small number of US, Japanese, and European firms.

The problem is that the same materials and equipment are also used to produce less advanced chips. China currently produces roughly 20% of the world’s semiconductors, mostly the low-end and mid-range varieties integral to electric vehicles (EVs), medical devices, consumer electronics, and industrial components.

The Western export and investment restrictions will undermine many of these Chinese industries, negatively affecting not only their global competitiveness but also domestic employment, income, and tax revenues. These effects make the Chinese very sceptical of Sullivan’s “small yard” and less willing to cooperate on other global issues.

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The full impact of these measures may not be evident for several years, because Chinese companies maintain an inventory of the products on the export restriction list. But unless China’s domestic industrial policies manage to overcome many of the shortages, the quality gap between chips produced there and elsewhere will likely widen.

The “peak China” hypothesis, used in the US to justify a tough stance on China, claims that Chinese economic growth may have already reached its apex, and that the best time for China to endure or prevail in a conflict with the US would be now or in the near future.

Given that China’s growth rate is unlikely to fall below that of the US any time soon, the “peak China” hypothesis does not seem to align with the economic fundamentals. But the Biden administration’s export and investment restrictions could potentially create a self-fulfilling “peak China” scenario. In particular, the US and Western technological restrictions are erecting roadblocks to China’s advances across semiconductor manufacturing and a host of other industries that use semiconductor chips.

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The longer China waits, the more the technological gap between the two countries will widen. Consequently, if China feels compelled to risk a military conflict with the US, it will have little incentive to wait. In other words, the US trade restrictions may end up accelerating the war they hope to prevent.

Identifying ways to minimize the collateral damage of American restrictions would benefit all parties involved. One approach could involve China and the US negotiating an agreement that exempts certain SEZs from some restrictions. Such an agreement would enable China to relocate the production of low-end and mid-range semiconductors to designated zones in Hainan, for example (which is larger than all of the Hawaiian islands).

For the SEZ to minimize collateral damage, China could issue a special visa for international inspectors, pre-certified by both China and the US, who could make frequent and unannounced visits to production sites in Hainan to ensure that restricted products are used only to produce non-highend chips for EVs and other civilian products, including those exported to the global market. To alleviate Chinese security concerns, the inspectors would need a separate, regular visa to visit other parts of the country.

The newly established SEZ would provide the US with additional reassurance that the restricted products would not be diverted for other purposes. It also would minimize the negative effect of the US-imposed restrictions on the Chinese economy, enabling China to maintain its commercial competitiveness in non-defence industries such as EVs.

Such an arrangement would enable US companies to maintain their presence in mainland China, rather than withdraw from one of their largest markets altogether and suffer a catastrophic decline in sales. With much of the Chinese civilian economy better insulated from geopolitics, China might be more inclined to cooperate with the US on climate change, fentanyl, and other issues. Most important, fostering cooperation would help prevent an artificial “peak China” scenario and thus mitigate the risk of a war in the South China Sea.

This solution would also benefit the rest of the world, because a SEZ would preserve the efficiency gains associated with China’s role as a global production site. Companies from Europe and elsewhere could continue to sell to China through Hainan, thereby supporting domestic employment and tax revenues and protecting global economic stability and prosperity. — © Project Syndicate

Shang-Jin Wei, a former chief economist at the Asian Development Bank, is Professor of Finance and Economics at Columbia Business School and Columbia University’s School of International and Public Affairs

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