As I've stressed in prior articles, interpreting the Chinese reaction function is key to navigating the current macro environment. While the Trump administration has been largely consistent in its approach toward trade negotiations, China's approach toward the trade war with the US has evolved over the past year and a half.
At first, China tried to avoid a trade war. Then China attempted to push for a trade deal with the US. Since early May, however, it appears that the Chinese strategy has taken yet another turn. China now appears to have taken a long view, focusing on the preservation of its economic resilience while accepting the increased US tariffs as a fact of life, for now at least.
There are two reasons for China's latest shift. First, the frictions between the two countries have extended far beyond trade, which means that China no longer has as much to gain in any potential trade deal. Second, the fallout from the increased tariffs has proven more manageable than expected.
As its recent white paper points out, China will be holding firm, opting to play the long game, instead of engaging in a tariff tit-for-tat with the US. But with both sides looking far from a resolution anytime soon, further escalation is likely and the CNY may come under further depreciation pressure into year-end. The September meeting will be key but I would not get my hopes up for a prolonged de-escalation - I'd hold off on any USD/CNY bets until then.
The Evolving Chinese Trade War Strategy
If one were to pay close attention, it is perhaps striking how differently China has reacted to the more recent US tariff implementations compared to the prior ones. I believe the shift reflects a marked shift in strategy by the Chinese. To understand the shift, it is helpful to remind ourselves how the trade war has developed over time. I believe trade developments so far can be broadly split into three key phases:
Phase One: The first of those phases ran from early 2018 until September 2018. During this phase, China attempted to deter the US from introducing tariffs. Each time the US introduced new tariffs, China responded promptly with tariffs of its own on US goods.
Source: BBC News
In this phase, it was generally felt that the trade war would not become a reality provided China could prove to the US that it had just as much to lose in a trade war scenario. But by March 2018, it had become clear that there was no quick resolution to the trade war. At this point, the value of the Chinese RMB began to fall sharply, depreciating 8.5% against the US Dollar by September 2018.
Phase Two: The next phase began with a telephone call between President Trump and President Xi in early November 2018. Between November 2018 and April 2019, China had stepped up its efforts to achieve a trade agreement with the US to prevent further trade escalation. China appeared to be genuinely trying to achieve to such a deal, holding six rounds of trade talks, purchasing US agricultural products, suspending certain tariffs on US products, passing the Foreign Investment Law and revising regulations on technology transfers. Over phase two, the RMB regained one-third of the losses it had made in the first phase by April 2019.
Phase Three: The game has, however, changed since May 2019, when trade talks between the two countries broke down. Shortly after, China published a white paper detailing its position on trade talks. In the June white paper, a set of principles for a trade deal to be struck was laid out. China's formal position on trade deals had not previously been spelled out, so the publication of this white paper was significant. It is perhaps telling that by August, the RMB had lost even more value, depreciating to record lows against the USD.
Why has China changed its strategy?
Firstly, China no longer views the trade war as the major issue where the relationship with the US is concerned. The problems between the two countries now extend beyond just trade to intellectual property, national security, and even Chinese sovereignty. Any hope China had that a solution to the trade war would improve its relationship with the US now appears to be dead.
The second reason - China may have decided that the fallout from the trade war is manageable. China may have viewed Japan's 1980s experience as a useful case study - the consensus view is now that Japan's economic growth miracle was not ended by the US-Japan trade war, but rather by policy miscues that culminated in a balance sheet recession. Source: I'm an Economist Blog
What is China's Current Strategy?
China no longer appears to be looking for an early resolution to the trade war. Instead, it looks like China has accepted the trade war as a fact of life. Indeed, the recent white paper out of China focuses on preserving its economic resilience regardless of the external environment. From the white paper:
"China remains committed to its own cause no matter how the external environment changes. The fundamental solution to economic and trade tensions is to grow stronger through reform and opening up. With the enormous demand from the domestic market, deeper supply-side structural reform will comprehensively enhance the competitiveness of Chinese products and companies. We still have sufficient room for fiscal and monetary policy maneuvers. China can maintain sound momentum for sustainable and healthy economic development, and its economic prospects are bright."
It is clear, however, that China is willing to continue trade talks with the US. The country has not canceled any trade talks yet despite the slew of new tariffs the US has imposed against it. China still seems to believe that having trade talks is better than not having trade talks. China does want a trade deal; it is just that it doesn't want one at any cost.
But there are broader issues at play and it is not likely that a resolution to the tariff issue would solve the broader problems facing the US and China at the moment. Certain trade issues, for instance, the Huawei ban, may not be dealt with in a trade deal. Therefore, China will not want to offer too much to secure a trade deal, given that doing so would bring limited benefits. It will likely hold firm to the principles outlined in the white paper.
China will continue to react to retaliatory tariffs, but they will continue to be smaller than the corresponding US tariffs.
The goal, it seems, will be to prevent further US tariffs rather than to cause economic harm to the US. China is also unlikely to consider non-trade action such as imposing restrictions on US business interests in China. It should be noted, for instance, that Costco (NASDAQ:COST) has just started trading in China and Tesla (NASDAQ:TSLA) will be opening a factory in Shanghai shortly.
China will also explore trade opportunities with other countries. Not only will this benefit the Chinese economy, but it will also mean that in a trade war, the cost to the US will be increased. Over time, it is likely that China will reduce its reliance on US suppliers.
In short, China will continue to have trade talks with the US when opportunities arise despite the new tariffs. It will not deliberately cut off economic ties. However, it will not be willing to meet every single US demand in order to reach a deal. If the US introduces new tariffs, China will react, but will not look to escalate the trade war.
With China holding firm, and further tariff escalation on the horizon, we could see the Chinese yuan come under further pressure into year-end. The upcoming US-China meeting in September will be the key event to watch in this regard - however, with the situation currently on edge, I would be hesitant to put on a long (or short) USD/CNY trade anytime soon.
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.