The recent U.S. calls for China to stop flooding the global markets with excess steel and tensions over the South China Sea have strained relations between the two countries. “Excess capacity has a distorting and damaging effect on global markets,” U.S. treasury secretary Jack Lew said on June 6 in Beijing, as part of a delegation that secretary of state John Kerry led to China.

A common ground seemed immediately out of reach for the two countries, as they engaged in the eighth round of the U.S.-China Strategic and Economic Dialogue. That position is distinctly different from the cooperative spirit they demonstrated with their joint agreement on combating climate change in November 2014. No respite is immediately visible in terms of resolving the disputes on how China tackles its overcapacity or over the South China Sea, according to experts at Wharton and New York University.

The disputes actually seem to make sense for select interest groups in both countries, the experts said. In the U.S., China is a useful scapegoat in the presidential election season’s rhetoric. Similarly, for China, increased military spending to boost its presence in the South China Sea is a useful diversion from its economic downturn, overcapacity and unemployment.

According to Wharton management professor Minyuan Zhao, the U.S.-China agreement on combating climate change could have created a new phase in the relationship between the two countries. However, soon after that agreement, China’s economy began to go downhill, and it had “lot of burning concerns” that needed to be urgently addressed, she said. “[That called for] fire-fighting first and economy-building later.”

At the same time, both the U.S. and China have accused each other of maintaining a provocative military presence in the South China Sea, said Ann Lee, adjunct professor of economics and finance at New York University. The ostensible reason is to guard economic interests in the area, in addition to an assertion of territorial rights. About $5 trillion worth of trade passes through that maritime route annually, as a recent Knowledge at Wharton article noted. Trade relations between China and other regions in the country have also been thriving. “If there is more commercial cooperation, it takes away [the U.S. military’s] raison d’être [in the region],” she added.

Zhao and Lee discussed the disputes and the outlook for resolution on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

In order to resolve the economic disputes, both countries need to appreciate the interdependent nature of the global economy, said Zhao. “If you destroy the market, we are going to all sink in the same boat,” she said. “If the rest of the world is not doing well, you are not going to sell your goods – that is a convincing argument.”

“The common ground is in having rules for the market, some regularity [and] some expectations that investors can look forward to.” –Minyuan Zhao

If governments choose to address overcapacity by subsidizing firms, those firms would use those resources to add new capacity, Zhao said. As a result, firms in both countries would suffer as they would fail to find “any decent price” for their products. This is a war of attrition that does not help anyone, she noted.

Reap Now, Pay Later

Zhao said that China is well aware of the implications of its economic policies; In fact, China is the country that will bear the most consequences. However, the outcome of China’s economic policies coming back to haunt it seem “remote” and “secondary,” compared with the pain it now faces with unemployment as overcapacity forces the closure of factories, she noted. This is not unlike the quantitative easing policies implemented by the Fed in the middle of the 2008 financial crisis, even though many other countries (China included) blamed the Fed for hurting the long-term stability of the global financial system.

Foxconn in China, which manufactures many Apple products, recently let go of some 60,000 employees at its Kunshan factory as it switches to robotics and moves some operations to India, she said. “As many as 600 major companies in Kunshan have similar plans,” a report in the South China Morning Post said, citing a government survey.

According to Zhao, during the 2008 financial crisis, the country tried “to keep [its] economy alive” by investing heavily in adding industrial capacity, she explained.

Zhao said governments take those short-term approaches because they need to get quick fixes to their immediate crises more than looking at longer-term goals. They also take such actions to avoid “legitimacy issues,” because regimes lose credibility during downturns and trigger social unrest, she added.

Territorial Disputes

The South China Sea is strategically important and resource-rich, said Zhao. The issues surrounding China’s territorial rights in the South China Sea go back a long time in history, and the maritime boundaries are also unclear, she added. She recalled growing up in China against the backdrop of radio broadcasts “all the time about invasions from neighboring countries into our territory.”

Tracing the historical origins of the South China Sea disputes, Lee said China feels its rights there are non-negotiable, because that has been its territory for hundreds of years. In fact, after World War II, the Allies including the U.S. and the Soviet Union had agreed that those islands would be turned over to China as a returned favor for helping the Allies beat Japan in the war, she recalled. Japanese forces had occupied those islands during the war.

After World War II, those equations changed. A civil war in China that ended in 1950 saw communists winning over nationalists. “The U.S. was very much anti-communism at the time and … so decided to only recognize Taiwan because the nationalist party fled to Taiwan,” said Lee. Taiwanese claims over the islands exactly mirrored those of China, she added.

U.S. Double Speak?

The U.S. has protested that China was building military installations on some of those islands. “Frankly, China is reacting to the fact that other countries like Vietnam and the Philippines had already built military installations on a number of other islands there, and the U.S. said nothing about it,” she noted. “They were calling the U.S. on that sort of hypocrisy. When the U.S. couldn’t back down on the fact that China was right about this, it blamed China for building bigger military installations on those islands than what the other countries built.”

Further, the U.S. is guilty of double standards in applying the United Nations convention on the Law of Seas to the South China Sea dispute, according to Lee. She said the U.S. failed to speak up against Japan when it illegally arrested Taiwanese fisherman for fishing in waters far outside its maritime boundaries.

“The U.S. position on the South China Sea has been ratcheted as more of a political issue as opposed to an issue concerning international law.” –Ann Lee

In view of those inconsistencies, “the U.S. position on the South China Sea has been ratcheted as more of a political issue as opposed to an issue concerning international law,” said Lee.

Threats of Economic Activity

Lee noted that until three years ago when the tensions escalated in the South China Sea, China and its neighbors had thriving economic activity and cooperation. China had made peace with Taiwan and the two had strong economic ties, she said. “Japan, South Korea and China also got along so well prior to 2013 that they even talked about building an Asian currency, much like the euro,” she added. Others in the region like the South East Asian countries were also interlinked with China’s supply chain network, she said.

All that economic activity provided the setting for the U.S. to assert its military strength in the region, according to Lee. “There was so much activity, peace and cooperation going on,” said Lee. “This was frankly a threat to the U.S. military. They needed a reason to be there.”

At the same time, the U.S. presence in the South China Sea gave China the justification to build up its own military strengths, said Zhao. “It basically gave each other the reason to spend more [on their military strengths].”

With the economic downturn and overcapacity in China, nationalist emotions could be easily taken advantage of, Zhao added. “They had a reason to build up their presence in the islands with excess capacity back home. There was a need to divert attention from economics to other things like national pride.”

Outlook for Resolution

According to Zhao, both the U.S. and China have to show each other that if they continue on the present path, both will suffer. “The common ground is in having rules for the market, some regularity [and] some expectations that investors can look forward to,” she said.

As for unwinding its excess industrial capacity, Lee said China is constrained because many of its factories are with state-owned enterprises. “Developed countries know how difficult it is to go against entrenched industries.”

The U.S. and China could settle their issues over the South China Sea, especially with China looking to attract investments from U.S. companies in a variety of energy projects, Lee noted. “There are many ways to negotiate and take down tensions,” she said. “It’s just that you have various entrenched interests that want conflict and war there.”