Trump Vs. China, Round One

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Summary

Since China is considerably more dependent upon the US market, at first sight, it looks like the US is in a strong position versus China to deal with trade frictions.

However, there is an obvious way China can hit back on any US-imposed import tariffs, stop defending its currency and let it float.

In the end, protectionism is likely to make everybody worse off.

China finds itself in a precarious balancing act. On the one hand, it has to keep growth going, which has already almost halved from 4-5 years ago when the economy was still growing at 10%+.

Yet the country needs growth, for political stability, for financial stability (as there are really substantial debt levels in China, most notably in the corporate sector).

On the other hand, it knows it cannot rely on the old investment and export led model. After several decades of rapid wage and currency increases, exports have lost competitiveness and at least some industries are moving to cheaper countries.

No country in history has been able to keep up investing almost half of its GDP for as long as China has, and this too is running into rapidly diminishing returns, from The Telegraph:

The efficiency of credit has collapsed. Fitch estimates that each new yuan of credit generates just 0.3 yuan of economic growth, down from 0.8 before the Lehman crisis. At the same time, the growth rate of nominal GDP has halved from around 15pc to nearer 7pc, making it much harder for the country to work off the debt load - the so-called denominator effect. A pattern has become entrenched where credit is rising much faster than the underlying nominal base of the economy, and is achieving ever less in the process.

At times when growth seems to decelerate too much, there is another round of pump priming (expansionary fiscal and/or monetary policy). While the effectiveness of that is diminishing, the side effects are increasing; take for instance, from Business Insider:

House prices in leading Chinese cities are exploding, according to figures from property consultancy and estate agency Knight Frank. Eight out of the top 10 cities for fastest growing prices globally in the third quarter of the year were in China, according to Knight Frank, and 10 Chinese cities recorded annual price growth above 20%. Prices in the Chinese city of Nanjing, the hottest property market globally, were on average 42.9% higher in the third quarter of the year than they were a year earlier.

Construction is especially beneficial for those industries that suffer from overcapacity and high debt levels, so any new construction boom will be a boon to these industries and delay and/or ease their restructuring needs.

But in comes Trump, and he has promised to be tough on China during the campaign, threatening to slam 45% tariffs on Chinese imports and designating them as a currency manipulator.

While we'll have to wait to see what he actually does when he is President, there are a few ominous signs, like the nomination of Peter Navarro, of a yet to be created White House National Trade Council. Navarro is a well-known hardliner on Chinese trade issues:

Dr. Navarro authored a trilogy of books that articulate his view of the "inextricably intertwined" relationship between the China trade and the possibility of nuclear war. In those books he argues that China is "the greatest single threat facing the United States" and that "every 'Walmart dollar' we Americans spend on artificially cheap Chinese imports" increases that threat.

There are also plans circulating for a more protectionist stance, not just towards China, but in general; here is Business Insider:

On Thursday, CNN reported that President-elect Donald Trump's administration is considering imposing a 5% tariff on all imports into the United States. While the decision is not final, sources told CNN the tariff could be implemented through an executive order in the early days of the Trump presidency. The move is not surprising given that Trump made free trade one of the central topics of his campaign after criticizing China, Mexico, and Japan. He suggested putting a 45% tariff on Chinese imports, said he would declare China a currency manipulator on his first day in office, proposed taxing imports from Mexico, argued in favor of " ripping up" trade deals, and called the Trans-Pacific Partnership, or TPP, " a rape of our country." After the election, Trump has said in victory rallies that for trade "you have to look at it almost as a war," asking "who the hell cares if there's a trade war?" "If tariffs are more punitive and lead to a public trade spat with China, markets will get nervous, especially if a sharp, retaliatory, [Chinese yuan] depreciation looks like a realistic response," Ajay Rajadhyaksha, head of macro research at Barclays, said.

The tariff could even be 10%, and we've given our thoughts about that here already, so we're not going to repeat ourselves. Needless to say, we think it's a bad idea. The question is, what will happen next?

We don't think the Chinese are going to take this lying down, and as it happens, circumstances have conspired to provide the Chinese with a rather effective response. Before we get to that, most people assume China will retaliate by imposing tariffs or other restrictions on US imports, embarking us in a trade war (from Fortune):

Mark Zandi of Moody's Analytics and former John McCain advisor, for one, predicted that if Trump went through with threats to institute 45% and 35% tariffs on goods from China and Mexico, respectively, it could help trigger a trade war and a recession longer than the one we experienced in 2008 and 2009. But like any economic forecast, Zandi's and other economists foreboding outlooks make a number of assumptions. How will our trade partners will retaliate, if at all, to the threat or initiation of protectionist tariffs or other measures on them, or others? Who knows?

Now, that is entirely possible, although we don't think the effects would be quite as dramatic as Zandi has it. For that to happen, it really has to completely escalate. But it will be disruptive, and it will knock growth lower.

The yuan

The fact is China is a currency manipulator. In the last two years, they have spent $1 trillion, a quarter of their foreign currency reserves, in order to prop up the yuan. Despite still significant trade surpluses, the capital outflows are such that the PBoC has to spend tens of billions of dollars a month in defense of the yuan each month.

It's a fair bet that they can't defend the currency if capital keeps on flowing out of the country at this speed for that much longer, despite a strengthening of capital controls.

The irony is, the strengthening dollar, on the back of Fed tightening and the reflationary policies under Trump, doesn't help either. Having to defend their currency is automatically tightening domestic monetary conditions as well.

Should the Trump administration slam tariffs on Chinese imports (or imports in general), the Chinese could simply respond by less forex interventions, letting the currency slide faster. They could even stop intervening altogether, which would probably cause a substantial depreciation of the yuan.

This would produce another irony, the Chinese would stop to be a currency manipulator and let the yuan settle according to (more or less) free market forces, just as the Trump administration would want to, but the effect would be the opposite of what they want.

The downside for China is that this will fuel inflation in China, which is already making a comeback.

Note especially the rapid rise in the producer price index (PPI), which has been negative for years, but just in the last two months, has shot up to 3.3%. Will higher inflation be a problem for China?

Well, apart from recouping lost competitiveness (both through rising wages and the US tariffs), it also helps reducing the real burden of real debt. Since China has quite a lot of debt, there are some benefits to higher inflation.

On the other hand, it can get out of hand and lead to social unrest, which is exactly what the authorities want to prevent.

Another thing one should note is that the yuan might be slipping against the US dollar, it is still rising more against other currencies. In fact, on a real trade-weighted basis, the yuan is still appreciating, not depreciating (red line):

All the more reason why the Chinese might be willing to give up their defense of the yuan.

US reaction

One might realize that the US has used tariffs, or the threat of tariffs successfully in the past to achieve concessions from trade partners. For instance, the threat of tariffs was material to achieving the Plaza Accord of 1985, which produced an end to the surging dollar by forcing Japan and to a lesser extent (West) Germany onto more expansionary paths.

But whether they can pull of something like this again we very much doubt. It's hard enough for China to support its currency at the moment, even without the pressure.

And in January, Chinese citizens get a new yearly allotment of $50,000, which they can move out of the country which is likely to provide fresh impetus to capital flight.

The US could simply escalate, and there are those that argue that China has much more to lose, here is Chris Matthews in Fortune:

The United States is the destination of 18% of all Chinese exports, while China accounts for just 7% of American exports. The United States is much wealthier than China, too, meaning that it has more resources to suffer through any slowdown that may result from a trade war.

What's more, it has been the explicit goal of China's leadership to reduce its trade deficit. That hasn't happened because of the political power of China's large exporting firms. But Trump's threats of large tariffs may actually be, perhaps privately, welcomed by some reformers in China.

China's trade surplus isn't that big anymore, and escalation is likely to make everybody lose. We think the yuan is heading towards being a floating currency anyway, which is likely to involve a one-off substantial depreciation. US pressure is only likely to hasten that process.

Another issue is that Trump's abandonment of the trans pacific partnership, the (largely) Asian trade deal excluding China has left the field wide open for China to fill the void.

Conclusion

While we don't subscribe to the more dramatic renditions of the effect of a possible trade war between the US and China, we do think it will be disruptive and the US will have little to gain from it. It isn't going to bring back the lost manufacturing jobs, it's only going to produce more upheaval.

China is already exerting great effort and resources in keeping the yuan from falling faster and it would not be an enormity for them to simply let go. Sooner or later, that is likely to happen anyway, US trade pressure is only going to speed that up.

The US retreat in the pacific has left an opening for China to deepen its integration with Asian and Pacific economies; this could produce a world-leading trade block and reduce American influence.

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.