China Strategic Reset: Failing To Prepare Or Preparing To Fail?

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Summary

President Trump has accepted China's challenge to enter a new technology race.

The failure of attempts to stop capital flight provides an incentive for China to do a trade deal underpinned by an agreement on exchange rates with America.

China's response to President Trump's rhetorical threats leaves significant room for discussion and compromise on trade.

China has abandoned its growth target to anticipate either a successful trade deal with America or a failure which compounds the weak global macro fundamentals in 2017.

The abandoning of the growth target signals that Chinese policy makers have reached the limits of their abilities to boost economic growth.

The last report discussed the rising tension between China and President Trump in relation to his rhetorical questioning of the One China principle. This was given specific context by the incident of President Trump's phone dialogue with the Taiwanese leader. The report also noted China's stimulus of its indigenous technology industries as a matter of national security and economic policy. The issue of Taiwan should also be put into the context of this Chinese technology initiative since Taiwan is acknowledged as a key player in the global technology sector. Clearly, there was more than just grandstanding involved in President Trump's phone conversations with the Taiwanese leader, given that China eyes this nation's technology centre covetously. If Taiwan does not return to the fold in the near future, China will have a greater incentive to develop its technology industries in isolation. President Trump has identified a Chinese strategic weakness which he intends to exploit with great vigor in his quest for a bilateral trade deal which is favourable to America.

(Source: Seeking Alpha)

The previous report discussed the feedback mechanism into President Trump's policies, from China's strategic signal to develop its own technology industries in order to close the military and commercial application gap with America.

(Source: Bloomberg)

President Trump responded with alacrity, signaling his intentions and capabilities to accept the Chinese challenge by holding a summit with "Big Technology" leaders. His latest comments about the costs of various defence programs also hint that the efficiencies associated with the technology sector will soon be applied to defence company business models and their products. Taking the President's isolationist rhetoric at face value, the probability of a streamlining of forces to project power in a way that does not lead to massive engagements of American boots on the ground in the future also points to smarter munitions and ordnance platforms. The resulting microeconomic landscape, resulting from the President's overriding global macro agenda, may resemble not only a rise in high tech defence startups, but also mergers of defence and technology companies. The clash of cultures will be amusing to watch.

(Source: Bloomberg)

Further, Chinese strategic weakness in the global media is being exploited in order to nudge China towards a grand trade bargain with America. A recent report in this series observed that China is now exporting inflation rather than deflation from its industrial overcapacity. This observation was then supplemented in the previous report with the view that Chinese capital outflows follow the inflation in order to seek opportunity for pecuniary gain. The latest nuanced nudge of China towards a grand trade bargain came with revelations of its latest export of antibiotic tainted agricultural and aquacultural produce. A new trade barrier has thus been effectively concealed within the larger emotive barrier of food health and safety.

Any reciprocal trade restriction on Chinese agriculture will prove to be a massive benefit to farmers in America and also the EU. Populist enthusiasm from the farmers will be assuaged by their new pricing power. Farmers and fisheries in developed nations now have the power to boost both output and prices, as cheaper Chinese imports are effectively barred for health and safety reasons. China still exports inflation even when its exports are banned!

Apparently, Chinese aquacultural exports are also fungible with those from Asia in general. This implies that restrictions will be placed upon all Asian agricultural produce as a template for agricultural trade agreements with America throughout the region to replace the agricultural component in President Trump's hated TPP. In consequence, food prices will also start to rise in Asia's trade partners, so that the great inflation germinating in the global economy gets fundamentally baked in.

(Source: Bloomberg)

The pressure on China's economy from capital flight continues. In the latest clampdown on outward flows, restrictions have been placed on private capital flight using life insurance policies as the medium of economic transfer to enable the flows. PBoC Governor Zhou Xiaochuan tried to portray the outflows and curb measures as a temporary phenomenon, but this view is not accepted by the majority of observers at this time. The authorities are agonizing over the wall of foreign currency deposits at the local banks, and what may happen if these leave the Chinese banking system. In addition to restricting conversion amounts, ostracism by naming and shaming those who covert their yuan are being used by the banks in combination with pecuniary incentives not to convert. It is clearly no longer in China's interest to see the yuan weaken further, especially if the potential boost to Chinese exports is nullified by offsetting trade restrictions if and when trade wars break out.

(Source: Bloomberg)

Attempts to fight capital flight by raising interest rates have however backfired and have counterproductively driven a bond market sell-off that has triggered further capital flight. Chinese policy makers may have concluded that an external agent is required to stem the panic. This external agent is America and more precisely President Trump, thus illustrating the need for China to accommodate his rhetoric whilst remaining a rational actor itself.

Since President Trump threatens to brand China a currency manipulator, in his quest to bring jobs back home, an aligned interest in a stronger yuan has developed between the two nations. This aligned interest forms the basis for cooperation between the two countries going forward. A managed foreign exchange deal to enable a bilateral trade deal therefore looks set to be struck informally at least so that China can continue to pretend to be moving swiftly towards an open capital account.

(Source: Seeking Alpha)

In a previous report in this series, the divergence of China and its trade partners was observed. This coincided with the Chinese export of deflation and its migration up the manufacturing value-added chain through foreign acquisitions.

(Source: Seeking Alpha)

A swift transition phase after the election of President Trump was then observed, in which President Xi accelerated his anti-corruption drive and tightened his control of policy. A common theme of the build-up in financial risk in the Chinese banking system was still evident during this phase.

(Source: Seeking Alpha)

As noted in a more recent report, this divergence between China and its trade partners has been effectively ended by populism and national security worries in China's trade partners.

China has now become an exporter of inflation and capital, which are its contributions to the global rebalancing that has been talked about for some time. This rebalancing needs to be managed since it is disruptive in equal and opposite ways for China and its trade partners. If mismanaged, it could bring recession in China and dangerous inflation in its trade partners, the combination of which is bad for the global economy. Rationality and flexibility are needed by all involved rather than inflammatory rhetoric. The latest signals are that China is responding to this changing economic and political climate by becoming more flexible and responsive to its trade partners.

(Source: Seeking Alpha)

As noted in the last report, thus far China's response to President Trump's invective had shown great maturity and rationality despite its recent seizure of a probing American submarine drone in an act classified as piracy by the Pentagon. President Trump is determined to get his campaign promise of a 350-ship Navy, so this latest stand-off is an opportunity to build bipartisan consensus on achieving this target in order to break the budget constraints that currently threaten it. China has therefore done the President a favor by seizing the drone, and its moderate response to his rhetoric is unlikely to undo the strategic victory for the President that this smaller tactical success in seizing the drone has delivered to China.

Continuing with its intentions to remain a rational actor, China adopted the negotiating tactic of outlining its red lines and flexibilities through lower ranking officials in order to create the conditions for constructive dialogue at the higher level. This contrasts with the current brinkmanship being shown at the higher level by President Trump, which leaves little room for maneuver if adopted by his opposite ranking counterpart President Xi. Deputy Finance Minister Zhu Guangyao recently deployed these Chinese tactics. Addressing the problem of brinkmanship, Mr Zhu opined that this "zero sum" mentality should be abandoned by both countries since their reciprocal actions would harm each other. Responding with alacrity to a private signal from the First Family, Mr Zhu then noted President Trump's granddaughter's poem recital in Chinese at a family gathering as a signal of mutual trust and understanding at the higher strategic level.

Mr Zhu then proceeded to outline China's red lines, and thus by default everything else that is open to discussion and negotiation. According to him, these red lines are "territorial integrity, sovereignty and safety of political systems". Territorial integrity is clearly the One China principle. The issue of sovereignty was reiterated separately in a speech through the diplomatic channel of the Chinese Ambassador to the USA. Sovereignty and safety of political systems is clearly President Xi's effective control group of party policy. Evidently, China has great flexibility on all other economic and trade issues that are not demarcated by the red lines, so that there is great scope for discussion and negotiation.

The media rhetoric was then given some teeth when GM (NYSE:GM) was hit with a relatively small $29 million fine for price-fixing of some of its models. This relatively tiny punitive action still showed that China is no-pushover and is very capable of playing by the rules to defend its competitive position. The signal from the relatively small size of the action was therefore symbolic rather than systematic. By dint of his silence, President Xi ostensibly remains above the squabbling in the media and the tactical positioning of the lower officials, and is thus able to negotiate a deal with President Trump one-on-one if required to do so. President Xi also has the option to descend into the bitter rhetorical struggle should a deal not be possible.

China has reciprocated with alacrity to President Trump's strong hints that behind the rhetoric he wants a trade deal that he can sell as a victory to the American people. Chinese media combats President Trump's media China bashing, but Chinese officials remain aloof from this squabble and ready to negotiate. Since President Trump has stated that America is no longer in the foreign regime change business, there is therefore a strong probability that an agreement can be reached that is acceptable to both parties. China gets the One China principle maintained and President Trump gets his trade deal. It would appear to be win-win. This win-win view was upheld by Chief of Staff Priebus, who kept the deal alive when he qualified the President's threat by saying that the One China policy was not being questioned right now. Clearly, it may come onto the negotiating table in the future if negotiations are not yielding President Trump's desired outcomes.

To try and level the negotiating playing field with ebullient President Trump, President Xi recently took up an economic posture which takes the pressure off him. Under President Xi's aegis, economic growth expectations and targets have now been ratcheted down, from the arbitrary 6.5% GDP figure which has been unofficially adopted until now. The abandoning of the growth target takes pressure off Chinese policy makers to rely on monetary and fiscal stimuli which are creating unsustainable debt levels and driving capital flight. By lowering the growth target, any breakdown in negotiations with President Trump and potential ensuing trade war have already been accommodated by President Xi. In addition, the upcoming volatility in the eurozone's 2017 election year, Brexit and FOMC rate hikes have also been factored into China's economic forecasting. All the bases have thus been covered by China.

President Xi's positioning is therefore tactical and prudent in light of the global macro environment. His only weakness is that it is now clear that Chinese policy makers are no longer omnipotent even if the President remains omniscient. He may be able to see into the future, but he is powerless to deliver economic growth in ad infinitum. Tactical positioning to blame external global effects for China's currently declining growth trajectory may succeed in the short term; however, in the long term, it shows that new policies and thinking are required. Thus far, there has been little evidence of any new policies other than those that concentrate power in the leadership of the President. A concentration of power which correlates with falling economic activity is ultimately a recipe for disaster unless this chain can be broken. "Fail to prepare, prepare to fail", as a famous footballing strategist once observed.

President Trump has been the main driver of Alpha since the election and is most likely to continue to do so in the New Year. Despite China's signals that it is ready to deal, the 140 character foreign policy from the President is still aimed at driving a hard bargain. Further weakness in Chinese capital markets and capital flight are therefore likely to occur until President Trump signals that he is ready to start negotiating face to face rather than through Twitter.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.