USA China trade wars - who wins?

Robert Swift and the global equity team take a quick look at the USA China Trade War while also presenting the opinion of an associate of theirs, Stewart Paterson.

In light of the aggressive and well publicised trade disputes between the USA and China, we thought it worthwhile providing commentary from an associate of ours with expert insight. Stewart Paterson worked for many years in India, Hong Kong, and then Singapore as a macro-economic strategist and hedge fund manager. He is currently writing a book on China’s admission to the WTO and the unintended and unrealised consequences of this admission. (“China, Trade and Power: why the west’s economic engagement has failed”) Essentially he thinks that President Trump is [sort of] correct when he asserts that “a trade war is easily winnable’. He debunks the fears of some in the USA who believe China has the better hand. He also believes as do we, that any pressure on China to effectively liberalise is a good thing.

Our long term perspective is that China (and much of mercantilist Asia) will have to think harder about the dangers of running economic policies which deliberately impair their domestic demand for foreign imports, and concomitantly rely on the effective subsidy of their export driven industries, by which to amass large current account surpluses and foreign exchange reserves which then have to be sterilised to avoid currency appreciation. This has been their playbook for many years exacerbated by the experience of 1997 during the Asian crisis, when the IMF response to the Asian crisis which actually occurred in the corporate sector, was to punish ALL citizens and government with austerity. This still rankles in Asia especially as the response to the GFC in the West in 2008 was met with a wall of very easy money and not much at all in the way of bank write downs and general austerity i.e. the exact opposite of what was prescribed for Asia 10 years earlier by the same institution! Accumulating vast foreign exchange reserves from mercantilism of course reduces the likelihood of the IMF ever being needed again. Think of it from their perspective as a long term plan for independence from a western biased organisation – the IMF. If you can amass enough reserves then you have a rainy day fund sufficiently large to never need the IMF again.

The dangers of doing this for too long are now clear. At some point the Western consumer buying all this stuff made in Asia or owned by Asian companies, will be ‘tapped out” with too much debt (fast approaching?); may also take the view that their wages, if they have a job, are being held down by ‘unfair’ competition from Asia, and consequently elect governments determined to remove these trade imbalances via retaliatory measures. It is quite well understood that these measures might hurt both sides, but from the Western consumers’ perspective it is at least BOTH sides this time. You might as well take one of theirs down for one of yours?  “Make America Great Again” spoke directly to this emotion.

Consequently and for a multi year period, the likelihood is for Asia to have to deploy its vast fiscal reserves on encouraging ‘consumption’ at home in all its forms. As Premier Li Keqiang stated recently, “China will better utilise its fiscal and financial policies to support the expansion of domestic demand, structural adjustment and boost the development of the real economy”. We shall see, but he is saying the right things.

This increase in domestic demand includes ‘stuff you might want to own e.g. ‘luxury’ goods’, services, and heaven help them, mortgages and university and school tuition fees. With this multi year trend it is likely there will be investable opportunities. “Go Trump” we say because it is a much needed change and will benefit all participants in the global economy! As part of the necessary global rebalancing act, Asia has to spend more and the sooner we start, the better. 

In anticipation of this continuing pressure for change and the investment opportunities it will create, we have launched an Asian smaller companies strategy.

​This is what Stewart wrote:-

CNBC have just published an article under the title "4 powerful weapons china has in its arsenal to win the trade war". They are according to the article: 1) sell / stop buying US treasuries. 2) Devalue the Yuan. 3) Obstruct the operations of US companies operating in China. 4) Isolate the US by signing trade deals with other countries. If this is indeed the arsenal that China has its disposal I personally think the US administration can live with the consequences and at the risk of hubris - declare victory. Here is why.

1. Stop buying / sell US treasuries. The USA is an autonomous monetary entity. The US Government, through the Federal reserve can print as many dollars as they like. Sure, it may cause some inflation short term and that is the key constraint. If the Chinese sell the USD1Tr of treasuries they own, they still will hold Dollars in cash, they then have to move the dollars into another currency. The result will be to drive the Dollar down and whichever other currency they choose up. This may prove incompatible with either weapon 2 (devalue the Yuan) or 4 (striking trade deals with other countries), who may not wish to see their currencies rise vis a vis the Dollar. More importantly, the idea that this will lead to higher US rates is not a slam -dunk. The Fed could well step in to buy the debt to stop long rates rising or simply cut rates if need be. The idea that a USD1Tr capital outflow is going to derail the US economy is frankly laughable - for every seller of a dollar there is a buyer the only question is the price. Furthermore, if the Chinese do bail out of US Dollars altogether, they will highlight the fragility of their own financial system and particularly their currency. The USD1Tr of Fx reserves held in Treasuries is only about 5 months of imports. Total FX reserves are about 15 months of imports but importantly for confidence in the Yuan, only about 15% of RMB M2. Since most global trade continues to be denominated in US Dollars, bailing out of dollars is hardly prudent and could well lead to a loss of confidence in the Yuan. If they do drive interest rates up short term as they leave the Treasury market, they will drive down the value of their own assets as they leave.  
2. Devalue the Yuan. This would be an act that would help unite the rest of the world against communist  China. The reality is the Chinese have accrued these foreign exchange reserves and Treasury holdings by keeping the exchange rate undervalued, particularly in the 1994 to 2014 period. The whole world knows this and any attempt to gain an advantage by currency devaluation will not help with weapon 4 - building new trade relationships. Surely the one lesson form China's WTO accession was do not let a country of China's scale enter the global trading system without a floating exchange rate or with capital controls. If "devaluation" were achieved by a combination of floating the exchange rate and easy monetary policy, this would conflict with the pressing and crucial policy goal of deleveraging the economy and would again jeopardize Chinese faith in their own currency and banking system. The CNBC article argued that an 8% devaluation would do the trick in negating the impact of tariffs but in reality the import content of Chinese exports is high - according to the OECD it is 30%. So a devaluation of more like 15% may be required to restore the level of value added diminished by a 10% tariff.  If every 10% tariff is going to make the Chinese economy 15% smaller in USD terms then this would appear to be a victory for the US not China!
3. Obstruct the operations of US companies operating in China. Welcome to the status quo. Ask any MNC about their operations in China off the record and they will tell you a story of woe about regulation selectively applied, forced JV, technology transfer, patent infringement and a generally hostile operating environment. The Chinese are keen for FDI that helps them not keen for FDI that helps foreign companies capture market share in China. Numbers have been reported that suggest  US companies sell about USD220bn of good in China (in addition to exports from US to China).  Assuming a profit margin of 10% means that at stake is about USD22bn of profits. The last reported corporate profit number for US corporate sector was about USD1.9tr. Profits made in China are a mere blip or rounding error. 
4. Make new trading relationships. The Americans are not the only people to have observed the mercantilist nature of China's economy they are just the ones trying to do something about it. Unfortunately, Trump's style has alienated many natural allies in the battle to bring China into line with regard to international trade but it is a mistake to believe others are falling over themselves to under-take unequal economic engagement with the PRC. In fact, there is every chance that the WTO adopts a more confrontational stance to China for fear of WTO disintegrating. It has not had the tools to deal with a communist mercantilist economy abusing the system to the degree the PRC has. Faced with America potentially leaving, other members may well be motivated to enhance the rule book. If China does not sign up they will be the ones risking isolation as a core of liberal economic countries could move to a onerous regime. 

If, as the CNBC article argues, these are the weapons in China's arsenal to win the trade war then I would argue the world economy has little to fear. A degree of disengagement from China, economically will still in my view prove a positive for the long run interests of capitalism. China makes very little that the US needs that cannot be made nearly if not equally cheaply elsewhere over the medium term. The biggest risk remains short term disruption to supply chains in my view. Engagement with China has been detrimental to liberal, property-owning democracies disengagement will be a boon. Asset prices however are vulnerable as outlined in The Trade War Heats up and Assets Respond but do not confuse equity markets with the economy or the broader geopolitical goals of the trade war

If you wish to read Stewart's book then you can pre-order here.