Along with a seemingly endless amount of news about the US-China trade war, it has become obvious that we are living amid one of the biggest misdirections of all time. With a technique borrowed from magicians, the US seeks to direct the world’s attention toward “unfair” trade practices, so its true intentions go unnoticed. President Donald Trump himself has claimed that the main goal behind these tariffs is to stop Chinese economic growth:

“China’s 2nd Quarter growth is the slowest it has been in more than 27 years. The United States Tariffs are having a major effect on companies wanting to leave China for non-tariffed countries. Thousands of companies are leaving. This is why China wants to make a deal…”

The problem is that in this race for global supremacy, it is not only the parties that are directly involved that suffer but also the rest of the developed and emerging markets.

On the one hand, greater protectionism would lead to a loss of prosperity due to worse allocation of productive resources in the US economy, which would be even more the case in China, considering it was the United States’ largest supplier of goods imports in 2018. For emerging countries that were not directly affected by the measures of the trade war, there would be gains in terms of exports and prosperity, especially in sectors where these countries are competitors. The rest of the emerging markets would see a reduction in trade balances in the vast majority of sectors.

According to research provided by MDPI, if the trade war were to lead to a reduction in US imports of Chinese products on which it imposed tariffs, improving the trade balance and domestic production, Chinese retaliation would reduce the import of all US products. As a result, both countries and the world as a whole would lose the biggest driver of economic growth, due to the significant reduction in allocative efficiency, especially in the US, and the loss of terms of trade in the Chinese case.

And that is exactly what we are observing right now – the World Trade Organization, for example, has recently decreased its global trade-growth forecast for 2019 to 1.2%, less than half of its projection of 2.6% earlier in April.

In the case of the US, we have the following image for September:

Does it mean that if China and the US finally reach an agreement, the economic performance of the Asia-Pacific region will return to normal?

Let’s start from stating a quite obvious, but still very important, fact – China is the main driver of economic growth in the Asia-Pacific region, meaning that almost all of the neighboring countries’ economic performances depend on China’s development.

According to research by the Economic and Social Commission for Asia and the Pacific, China’s economic transition toward an innovative, inclusive and sustainable growth path presents many opportunities for the Asia-Pacific region, primarily through expanding trade and investment in areas of rising value added. China’s rebalancing from external to domestic demand implies that China, while remaining a hub for regional production networks, is increasingly an important source of final demand. Realizing the export opportunities will depend on the ability of trade partners to expand their access to Chinese consumers and adapt to their tastes, as well as on China’s further market liberalization, especially in services.

Now, if we look at China’s situation before the trade war, it will become clear that the Asian country has a more important problem to worry about – an over-leveraged economy. It looks like the world simply forgot that China’s banks are over-leveraged, are under-capitalized and struggle to lend, whereas Chinese corporations are also dealing with debt problems. In order to prevent the Great Chinese Recession, the central government began injecting massive sums of money in the economy. As a result, debt levels have skyrocketed.

Back in 2018 China recorded government debt equivalent to 50.50% of the country’s gross domestic product.

This means that a trade agreement, if it happens, may improve investors’ sentiment, and will probably even trigger economic growth – but the effect will be temporarily. The real problems are in China’s financial structure, and eventually the debt bubble will burst.

By the way, according to the Institute of International Finance (IIF), “Data suggest that China’s total debt surpassed 300% [of GDP] in Q3 2018: robust foreign demand for Chinese bonds and the authorities’ efforts to support domestic activity have all contributed to this sharp debt buildup.”

On the other hand, we shouldn’t forget that China is famous for hiding data. This, the true iceberg of the debt and the damage it will produce, is yet to be discovered. Last year, Bloomberg published an article with this header: China may have $5.8 trillion in hidden debt with ‘titanic’ risks.”

Finally yet importantly, keep in mind that two months after officials seized troubled Mongolia-based Baoshang Bank because of the serious credit risks it posed, government-controlled financial institutions had to take stakes in Bank of Jinzhou, which holds a roughly US$100 billion balance sheet. According to analysis by ZeroHedge, there is a third Chinese bank, Heng Feng, that for many months received an implicit state bailout. In this context, it seems even more alarming that China’s small banks are struggling to obtain funds to lend three months after the first bank failure in 20 years.

Since mid-2015, the Shanghai Stock Exchange Composite Index (SHCOMP) has lost more than 7%, while the S&P 500 (SPX) gained over 46% and FTSE 100 (UKX) improved 17%. If the Chinese debt bubble bursts, we will definitely see one of the biggest market downfalls.