I wrote yesterday (see Why investors should look through trade tensions):
Calculated in economic terms, China would “lose” a trade war, but when calculated in political cost, America would lose as Trump does not have the same pain threshold as Xi.
Based on that analysis, I concluded that it was in the interests of both sides to conclude a trade deal, or at least a truce, before the pain became too great. In addition, the shallow nature of last week’s downdraft led me to believe that the market consensus was the latest trade impasse is temporary, and an agreement would be forthcoming in the near future.
I then conducted an informal and unscientific Twitter poll on the weekend, and the results astonished me. The poll was done on Saturday and Sunday, and a clear majority believes that it will take 10+ months to conclude a US-China trade deal, or it will never be done.
In view of this poll result, it is time to explore the stalemate scenario. What might happen if negotiations became drawn out, or if the trade war escalates?
Let me preface my analysis with the following: I am not trying to take sides in this dispute, nor am I trying to form an opinion on what should or shouldn’t be in any agreement. My objective is to analyze the situation, and determine the possible courses of action for each side, and determine whether they are bullish or bearish for risky assets.
So far, most of what the market has heard has been the story from the American side. It was said that an agreement was close, but the Chinese marked up the text at the last minute and made wholesale changes. That’s when Trump hit the roof and set a short deadline for negotiations under the threat of increased tariffs. That’s the American side of the story, or spin.
Here is the Chinese side. Bloomberg reported that Vice Premier Liu He set out China’s conditions in an interview in Beijing after he returned from the latest round of negotiations in Washington, and a similar account appeared in China Daily.
China for the first time made clear what it wants to see from the U.S. in talks to end their trade war, laying bare the deep differences that still exist between the two sides.
In a wide-ranging interview with Chinese media after talks in Washington ended Friday, Vice Premier Liu He said that in order to reach an agreement the U.S. must remove all extra tariffs, set targets for Chinese purchases of goods in line with real demand and ensure that the text of the deal is “balanced” to ensure the “dignity” of both nations.
The conditions are:
- Removal of all US tariffs
- Realistic targets for the Chinese purchase of US goods
- A “balanced”deal to ensure mutual “dignity”
Let me try and read between the lines and explain China’s view. There has been too much distrust on the American side, and they believe the deal is unbalanced. Lightizer’s insistence on not lifting tariffs and the imposition of compliance penalties on China, but not on the US, are some examples of the lack of balance in the nature of the proposed agreement.
There are two types of negotiations, ones between roughly equal partners, and between unequal partners. First, in any negotiation, everything is up for grabs until the agreement is final. In a negotiation between equals, there are trades. You may have to give up something to get something. I interpret Liu’s remarks as a belief that the American side believes it is in a dominant position, and it is in a position to ask for concessions without offering anything in return.
As for the issue of a last minute change in text, Liu insinuated that the American side also went back on previously agreed upon conditions:
Liu’s comments, however, revealed yet another new fault line: a U.S. push for bigger Chinese purchases to level the trade imbalance than had originally been agreed.
According to Liu, Trump and Chinese President Xi Jinping agreed “on a number” when they met in Argentina last December to hammer out the truce that set off months of negotiations. That “is a very serious issue and can’t be changed easily.”
So where are we, and what is the calculus for each side?
One school of thought is Trump believes he has the upper hand because of the strength of the US economy, which gives him the cushion to continue a trade dispute. Here is Bloomberg:
Donald Trump is making a high-stakes bet on his 2020 re-election with his decision to impose new tariffs on China: that the U.S. economy is strong enough to absorb an all-out trade war — and might even benefit.
Trump set out his rationale in a series of tweets Friday morning after raising tariffs to 25% on $200 billion in goods from China and threatening more. Chinese and U.S. officials held brief talks in Washington that were unproductive, according to people unfamiliar with the matter.
“Tariffs will make our Country MUCH STRONGER, not weaker,” the president predicted in a tweet. “Just sit back and watch!”
Should the president’s instinct prevail, he’ll enter next year’s election with the most powerful asset for an incumbent — a strong economy. As of now, he can boast of historically low unemployment numbers, positive economic growth and stock market highs. He’d also vindicate a more aggressive approach toward China than his predecessor Barack Obama — and by extension, former Vice President Joe Biden, whom Trump said Friday is likeliest to emerge as next year’s Democratic presidential nominee.
Obama and “the Administration of Sleepy Joe” allowed China to get away with “murder,” Trump said in another tweet.
Part of that “cushion” are the new tariffs pouring into the Treasury, which Trump has offered to use to buy American agricultural products to offset the loss of Chinese markets, which he will redistribute to starving nations around the world.
There are a couple of risks with such a course of action. First, the US economy may not be as strong as Trump thinks. While the headline Q1 GDP growth was very strong at 3.2%, final sales, which is reflective of demand after adjustments, was an anemic 1.4%. Initial jobless claims have also started to retreat from their recent record levels (inverted scale on chart), and initial claims has been highly correlated with Trump’s other favorite indicator, namely stock prices.
Rising tariffs and the expansion of the tariff list will hurt the US economy. CNBC reported that analysis from Goldman Sachs showed that the burden of rising tariffs has been borne by US consumer and businesses, not Chinese exporters. (Larry Kudlow was forced to admit on Fox that tariffs are paid by the US importer, not the Chinese exporter, via Axios):
Goldman Sachs said the cost of tariffs imposed by President Donald Trump last year against Chinese goods has fallen “entirely” on American businesses and households, with a greater impact on consumer prices than previously expected.
The bank said in a note that consumer prices are higher partly because Chinese exporters have not lowered their prices to better compete in the US market…
“One might have expected that Chinese exporters of tariff-affected goods would have to lower their prices somewhat to compete in the US market, sharing in the cost of the tariffs,” Goldman said.
“However, analysis at the extremely detailed item level in the two new studies shows no decline in the prices (exclusive of tariffs) of imported goods from China that faced tariffs.”
Bloomberg reported that Trump’s plan to cushion the agricultural sector by buying their product and redistributing it to poor countries faces a number of historical hurdles. Jimmy Carter banned grain exports to the Soviet Union, and tried to support farmers with purchases. That program didn’t work very well.
In the 1980s, crops expanded just as the export ban caused Soviet Union countries to start buying grain elsewhere. At the time, growers could deliver supplies to the Commodity Credit Corporation below certain loan rates.
It wasn’t until 1985 that the government cut that rate and stockpiles started to fall, said Pat Westhoff, director of the Food and Agricultural Policy Research Institute of the University of Missouri in Columbia. One of the worst droughts in history hit America in 1988, solving the overhang.
The purchases aren’t a “very effective” way to deal with overhang, “and that’s what the government eventually realized,” said Arlan Suderman, chief commodities economist at brokerage INTL FCStone Inc. “It does help support cash prices, but it limits rallies in the market because the market knows if it rallies too much, there are all those bushels still in the bin that will come out.”
The aid program also had problems. It was also the wrong kind of farm product for poor countries:
Aid programs are also too small. The U.S. government’s Food for Peace program usually buys and ships about $1.5 billion worth of goods a year to other countries. On top of that, the nations in need are usually seeking food-grade commodities, such as rice and wheat, said Joseph Glauber, former chief economist at the U.S. Department of Agriculture. The vast majority of U.S. corn and soy production is for use in animal feed or biofuel.
Many poor countries may also not have the facilities needed to process soybeans, which can also yield cooking oil. Some countries may also be opposed to large amounts of aid because it could hurt their farmers.
“Bangladesh does not want raw U.S. soybeans — they want wheat, or wheat flour, milk powder and such,” Basse said.
In addition, such an initiative amounts to dumping, and would be subject to WTO complaints.
Trump’s move could also generate disputes in the World Trade Organization as the measures can be seen as market distorting. The aid could send prices lower, hurting countries like Brazil and Argentina, which are also major corn and soybean exporters.
“You can’t just dump grain at concessional prices,” Glauber said. “That would constitute an export subsidy. That is something the WTO members agreed not to do.”
If Trump’s calculus is based on a strong US economy, it could turn out to be an enormous policy mistake which he will not realize until Q3 or Q4. By then, it will be too late to avoid a major slowdown in 2020 ahead of the election.
In response to the US raising the tariff rate from 10% to 25% on an existing list $200b of imports, China announced a retaliatory measure of up to 25% on a measly $60b of US agricultural exports.
Is that the only Chinese response? What else can China do?
A well-reasoned analysis by Brad Setser came to the conclusion that currency depreciation is the most logical asymmetric response, but it will be strictly China’s choice.
One view, more or less, is that China has no need to upset the apple cart. The yuan’s recent stability hasn’t required heavy intervention (at least so long as the financial account remains controlled) or forced China to raise interest rates, and China has shown that it can stabilize its domestic economy by relaxing lending curbs and a more expansionary fiscal policy. Letting the yuan move too quickly could upset the restoration of domestic confidence in China’s economic management, and, well, force China to dip into its reserves to keep any move limited…
I suspect that China has more than enough firepower to maintain the yuan in its current band if it wants to even with U.S. tariff escalation. The tariffs—plus the Iranian and Venezuelan oil sanctions—might be enough to push China’s current account into an external deficit (China is the world’s largest oil importer, so the price of oil matters for the overall balance as much as U.S. tariffs). But if China signaled that the yuan would remain stable, portfolio inflows would likely continue—and a modest deficit need not put any real strain on China’s reserves (especially if Xi insists on a bit more discipline in Belt and Road lending to avoid new debt traps).
The other view is that China has shown that it is firmly in control of its exchange rate and balance of payments, and thus it is in a position to let its currency weaken without putting its own financial stability at risk. Controlled depreciations are hard—the market (even a controlled market like the market for the yuan) obviously has an incentive to front run any predictable move (as China learned in 15 and 16). But I suspect China could pull that off —it would just need to signal at some point that once the yuan had reset down, China would resist further depreciation. The goal, in effect, would be to reset the yuan’s trading range around a new post U.S. tariff band, not to move directly to a true free float.
That would let Chinese firms (who have already started to complain) cut their dollar prices (offsetting some of the impact of the tariff) without reducing their yuan revenues, and help China make up for lost exports to the United States with additional exports to the rest of the world…
Obviously, a controlled depreciation would be highly bearish, as it raises the possibility of a currency war, especially in Asia.
Another option is to do nothing, other than the token tariff retaliation to save face. The fiscal drag of the new US tariffs amounts to a tax increase, and the US economy will slow. Trump’s support in the farm states will erode. China can engage in further stimulus of its economy, though that is not their preferred course of action. China’s Total Social Financing retreated in April, but levels are not out of line with debt growth seen in Q1.
The political decision
So what now? How long can the trade dispute last, and what kind of damage will it do to the economic growth outlook for China, US, and the world?
It ultimately comes down to a political decision. Brad Setser also made an astute observation in the course of his analysis:
At some point Trump will have to decide whether he wants to run for re-election as the “tariff” man who disrupted world trade, or as the defender of a reformed status quo (after a great deal, that inevitably would involve a lot of messy compromises that don’t change many Chinese trade practices).
Tariff Man would drag out the dispute, and frame China as the boogeyman in the 2020 election. A recent NY Times article hypothesized that was precisely Trump’s 2020 re-election strategy. Run as Tariff Man, and vilify the Democrats, and in particular Joe Biden and the Obama administration for being soft on China. That decision will cause a lot of pain, for both Trump politically and for the markets.
On the other hand, a conciliatory Trump who initially appears tough on China but makes a deal with only minor concessions, in the manner of the KORUS and NAFTA negotiations, will be bullish. This will be in keeping with his Art of the Deal persona, the person who can make a great deal after staring down the Chinese.
I have no idea how this will turn out. My rational brain tells me that the logical outcome is for both sides to come to an agreement quickly before real damage is done. But either the political dimension, or a miscalculation of the political calculus could alter that path.
There are a number of indicators that I would monitor. In the US, I would watch initial jobless claims for signs of job market deterioration, NFIB small business confidence for signs of flagging small business confidence, as small business owners form the bulk of the Republicans’ support, the yield curve, and the stock market. A flattening yield curve would be a sign that the bond market expects slowing growth,
As for China, I would watch the CNYUSD exchange rate. Can it rise to 7 or beyond? In addition, the relative performance of Chinese property developers. Continued outperformance by this sector is a sign of stimulus and plentiful liquidity, and cratering real estate stocks would be a sign of rising stress in the Chinese economy.
Watch these indicator to see how the pressure on each side evolves, and you will know the level of urgency each has to go back to the negotiation table for a deal.