U.S.-China Relations Are Up in the Air

"U.S.-China relations, as complex as they have been, used to be largely governed by a simple law -- the law of common interests. These days, another well-known principle, is driving events: Murphy's Law, or whenever something can go wrong, it will.

The diplomatic furor about alleged spy balloons over the U.S. and its allies from China is only the latest example of this phenomenon. That should deeply worry investors and the public -- particularly with regards to Taiwan -- and has had a significant negative impact on markets.

What is remarkable about the latest diplomatic row is how obvious it is that the Biden administration and Beijing want to put a floor under the relationship. The catfight erupted days before Secretary of State Antony Blinken's visit to Beijing, a meeting that was in the works for weeks.

Mr. Blinken's visit was meant, among other things, to help lower the temperature after the high-stakes brinkmanship over Taiwan. It would have come on the heels of a positive turnaround in Beijing's posture toward business, foreign and domestic, since December.

Reporting from both The Wall Street Journal and the Washington Post indicates the balloon's passage over the continental U.S. may well have been a mistake. Top Chinese officials were caught off guard when Washington informed Beijing of the sighting. The balloon appears to have originally been bound for Guam, a U.S. territory. And China's initial response was highly conciliatory by recent standards.

None of that mattered.

By last week, Washington and Beijing reverted to full outrage mode, Mr. Blinken's visit was indefinitely postponed, the balloon was shot down over the ocean and Chinese stocks followed suit.

To be sure, the incident is far from the only factor weighing on markets. But Chinese shares, particularly U.S.-traded ones, have been sagging. The MSCI China -- which had been handily outperforming the S&P 500 and the Nasdaq Composite in early 2023 -- has lost nearly 10% in the past 15 trading days according to FactSet, compared with a 2% gain for the S&P 500.

The MSCI China and Hong Kong's benchmark Hang Seng Index also lagged behind the MSCI Emerging Markets Asia Index, which is only off 5%. Meanwhile China's onshore CSI 300 Index -- dominated by domestically focused, state-owned firms like Chinese banks -- is down 2% in dollar terms. It is hard not to read all this as the impact of the flyover.

Needless to say, nobody likes foreign objects of dubious intent floating over their territory. But the fact that the cautious rapprochement under way was so easily derailed by, quite literally, hot air illustrates a very worrying deeper trend.

Hawks in both capitals, and especially the U.S. Congress, have gained so much clout that a small problem can easily escalate, even when leaders in Beijing and Washington are actively trying to calm the waters.

Consider, for example, what would happen in the event of a midair collision near Taiwan or over the South China Sea -- as nearly occurred less than two months ago. As long as this dynamic persists, it will put any "relief rallies" related to warming relations -- particularly in U.S.-listed Chinese shares -- at risk of sudden and more-or-less entirely unpredictable reversals.

With a U.S. presidential election just over 18 months off and being "soft on China" becoming even more of a political liability, new confidence-building steps and robust mechanisms for handling emergencies will be essential. Otherwise, buckle your seat belts. Mr. Murphy is in the driver's seat." [1]

1. U.S.-China Relations Are Up in the Air
Taplin, Nathaniel.  Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 17 Feb 2023: B.12.