One of the differences between the economist and the non, or perhaps between the one well versed and the one superficially, is that the economist grasps that the economy is a complete system. Perhaps the most important question that the amateur fails to ask is the "Yes, but then?" one. It's not that tough to work out the initial reaction to a change. But how that the influences the rest of the machine is actually the important part and all too often the thing that isn't done.
Take the imposition of tariffs on exports for example. More specifically, US tariffs being applied to Chinese exports to that country. This is what is known as a change in the terms of trade. Our economic effect is exactly the same as if the cost of shipping something to the US had become more expensive. Maersk decided not to work between China and the US say. Shipping costs to the US rise, those to everywhere else stay the same.
Standard theory tells us that such a change in the terms of trade will be balanced by a change in the exchange rate. The latter will balance out the effect of the first. We can say the same thing the other way around. The costs of those tariffs will fall upon the exchange rate itself.
We've seen this when talking about the reaction of Sterling to Brexit:
If the United Kingdom leaves without a negotiated deal then the country will revert to World Trade Organisation (WTO) terms. This will mean it faces the same tariff barriers as any random country out there. Rather worse in fact, as many have already negotiated partial exemptions in trade deals, exemptions that will not be available to British exports.
The way that markets -- this is the larger idea here, economic markets, not merely financial ones -- is that if a country faces a deterioration in its terms of trade then the currency will fall. It's rather a self-balancing act, as so many markets are. British exports will now face tariff barriers of some x or y percent, barriers they did not face before. The currency will then fall to balance this. The net price of exports -- on average, always upon average -- to those foreign buyers behind those tariff walls won't change.
OK, so we would expect the yuan to fall against the dollar as a result of those US tariffs. This makes Chinese exports to the rest of the world more attractive, their transport/tariff costs haven't risen, the Chinese economy will rebalance itself at that new and lower exchange rate. The fall in the yuan will be of the blended change in terms of trade. So, a 25% US tariff won't mean a 25% fall. It's the extra added cost to China's overall trade which determines the fall in the currency.
This is how it is supposed to work and in the absence of other factors is how it would. But as IHS Markit points out this isn't quite how it is:
Adding to the downside risks for China’s export sector, the US government announced on 13 May that another tranche of US tariff measures against China are under preparation, with a 25% tariff planned to be imposed on a further USD 300 billion of Chinese products that are exported to the US. This next tranche of US tariffs would be another significant negative shock to China’s export sector.
It is not a realistic strategy for China to try to mitigate a 25% tariff by allowing further sharp declines in the yuan. A key priority for the Chinese government since 2015 has been to stabilize the exchange rate and prevent large capital outflows, in order to protect its foreign exchange reserves. Furthermore, if the US assesses that there has been significant currency manipulation, countermeasures could be applied by ratcheting up the tariff rates on Chinese imports to even higher rates.
It is economically a perfect solution to allow a further decline in the yuan. It's even what should happen. But those political measures won't allow it. It's actually all a little bit silly. A decline in the yuan would lessen capital flight in itself. But the Chinese government can't even do that to deal with that other problem. For those obvious political reasons. A decline in the yuan would be seen by some in the US as a sign that China was a currency manipulator. And they might even, if the decline was significant enough to deal with this problem from the Chinese point of view, be able to push through that political declaration of being a manipulator.
It is the politics here, not the economics, which constrains. For fear of being declared a currency manipulator China can't allow to happen that decline in the yuan which is the solution both to the US tariffs and fears of capital flight.
China will thus be stuck with an exchange rate too high for its terms of trade. This is obviously a negative for China stocks based upon exporting. As investors we'd also note that it's good for those who produce the imports China desires. As an investment position therefore the US tariffs upon China's exports leave us thinking light on Chinese exporters, heavy on those who produce China's imports. But it's not the costs of the tariffs themselves, it's the political inability to allow the exchange rate to adapt to them.
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.