23 May 2019

President Trump’s decision to raise tariffs to 25% on $200 billion of Chinese imports, and his suggestion an additional $300 billion of purchases could soon be subjected to similar levies has brought the trade conflict to a new level. China is certain to retaliate. Understandably , the escalation of the trade war has rattled financial markets. Even before these latest actions, the trade dispute had been taking a toll on global trade and growth. Worldwide PMI surveys, particularly in the manufacturing sector, have been flagging, and the Chart illustrates the slump in trade flows, especially throughout Asia.

Can cool heads prevail and a trade war be averted? Both nations have a common interest in forging a sustainable commercial relationship. China is America’s largest trading partner (#3 by exports). Likewise, the USA is the top destination for Chinese exports, and the country’s top partner overall. However, a comprehensive agreement may well prove illusive. On the one hand, America’s approach to its trade and overall macroeconomic policy is inconsistent, and lacks clear aims. And, China’s current overall economic strategy contains seemingly incompatible objectives. To be sure, common interests point to some agreement prior to next year’s US election. However, there is no quick fix (a Xi-Trump chat at next month’s G8 meeting will not do the trick!). The Sino-American rivalry will become increasingly complex in coming decades. However, there is a bull case scenario, but it will require political commitment and leadership from both sides — for years, not just a couple of months.

US Trade Strategy: Lack of Clear Aims Limits Progress

It’s never quite clear what are the objectives of the Trump Administration’s trade policy. Without clear aims, its difficult to judge its effectiveness. Is it to reduce the overall trade imbalance, and the nation’s reliance on the foreign capital inflows needed to finance America’s external deficit?

President Trump’s fixation on bilateral imbalances suggests otherwise, even though most observers accept that all nations will run both trade surpluses and deficits with individual nations according to their comparative advantages. The President’s justifiable focus on “fair and reciprocal” trade raises the question of whether the imposition of tariffs is not just a negotiating tactic, but rather a tool aimed at leveling the playing field.

Likewise, does the Trump Administration’s focus on China’s bilateral imbalance suggest a belief that there is something inherently problematic with a large gap with a single country? Alternatively, does it reflect disquiet about China’s rise as a region (and increasingly global) economic and political rival?

Surely, the goal of American trade policy should be to promote US export opportunities (both globally and to China) in a manner that does not stoke US inflation while keeping America’s reliance on foreign capital at sustainable levels. China should be viewed as one piece of that strategy, not the focal point.

What has been missing from America’s strategy is that trade imbalances are primarily driven by macro-factors. In particular, countries with low savings rates (compared to their investment ratio) tend to run external deficits, while high savings nations experience surpluses. The Chart above shows that the US savings rate is less than half China’s level, and American thrift has been steadily declining for decades. Low savings inhibit domestic investment in productive capacity, and increase reliance on foreign capital inflows to finance over-consumption. The swelling US budget deficit following the Trump tax reform will contribute to further declines in the national savings rate in coming years.

In trade negotiations with the USA, China highlights its success in reducing its savings rate in recent years (we will discuss China economic strategy later). As a result, China’s now runs only a small world-wide current account surplus compared to 5% of GDP in 2009. China argues, not without merit, that America must tighten its belt in order to reduce the bilateral trade gap.

Reflecting the inconsistency in the Trump Administration’s fiscal and trade policies, the US world-wide trade deficit has continued to swell: from $736 billion in 2016 to $879 billion last year. America’s bulging budget deficit will lead to ever increasing red ink in coming years. And, despite the aggressive approach to China, the bilateral shortfall has widened by 20% during the interval (The imposition of tariffs has curbed the imbalance fractionally in Q1 2019.)

Until America curbs its over-consumption — reduces the budget deficit in particular — the imposition of tariffs on China will not diminish the US world-wide trade imbalance. Sure, the bilateral imbalance may decline, but America will simply import from third countries. With the external deficit remaining large, America will remain reliant on inflows of foreign capital, including from China. Currently, China is the largest international holder of US Treasury securities at over $1 trillion, or 5% of the total outstanding amount.

Likewise, as the US economy is operating near full capacity, higher exports to China (if they were successfully negotiated) would simply stoke US inflation unless American over-spending were curbed. However, there is a the bull market scenario: higher US savings and expanded investment in America’s productive capacity combined with greater access to China’s domestic market. Unfortunately, this appears unlikely in the near term.

China: The Elephant in the Room

Even after acknowledging the importance of macro-factors behind trade flows, it is impossible to ignore there is a particular problem in the US-China bilateral relationship. And, it is correct for the Trump Administration to challenge China on its discriminatory practices, especially as China enjoyed preferential treatment for many years prior to emerging as a middle-income economy. The Chart above illustrates that American access to China’s market is considerable more restricted compared to its relations with other trading partners, and more limited than that offered to Chinese exporters into the USA.

However, China’s role in the global supply chain complicates efforts to deal with bilateral Sino-US trade issues. The Chart above illustrates the sharp rise in China’s share in American imports since joining the WTO. This shift, however, mirrored roughly similar declines in purchases from other Asian countries, especially Japan, as these countries relocated part of their manufacturing base to China. In many cases, the US is importing Japanese products, but are recorded as Chinese exports to the USA.

I estimate that nearly 40% of the rise in America’s trade deficit since China joined the WTO reflects these supply chain accounting issues. To be sure, tariffs may eventually lead Asian producers to relocate once again. Indeed, the first chart illustrates that Vietnamese exports are still growing strongly. Such changes would not impact the overall US trade deficit: China’s surplus may decline, but Viet Nam’s would grow! At any rate, such shifts in global supply chains would take time, despite US pressure on China.

Likewise, US negotiators should focus on improving market access in sectors where Chinese demand is growing strongly and in which US products enjoy a comparative advantage. The Chart above illustrates American producers may have failed to do so in the past. For instance, capital goods producing nations (Germany, Korea, Switzerland, and Taiwan) have enjoyed large surpluses with China, as have countries supplying natural resources. Both have been in high demand during China’s industrial modernisation.

The US enjoys a comparative advantage in sectors which will be in high demand in China’s next stage of development in coming years: e.g. services, medical supplies, pharma, telecoms, technology, and energy. As one example, the chart above illustrates how limited American access to China’s expanding market for services has been. Hopefully, China will appreciate the benefits they would enjoy by liberalising trade in these key sectors.

China: Confronting Numerous Headwinds

The Chinese economy will continue to confront numerous headwinds in coming years. And, although China’s overall economic strategic agenda should lead to a reduced trade surplus with the USA, it is easy to identify key sectors in which conflicting objectives of the two nations will make agreement problematic. In its approach to bilateral negotiations, however, China should not assume a Democratic victory in next year’s US Presidential election would alter the prevailing consensus that China is not playing by the rules (despite ill-advised recent comments from former VP Joe Biden). Moreover, while there are no victors in trade wars, China has more to lose than the USA: Chinese exports to America represent 4% of GDP, whereas US exports to China total only roughly 1% of output.

The next phase in China’s economic development involves a reduced reliance on exports and investment, and an expansion in consumption and the service sector. If successful, this would reduce China’s trade surplus, and create enormous potential opportunities for US exporters. The Chart above illustrates the strategy’s success, e.g. the sizeable expansion in the service sector. The earlier Chart, highlighting the declining savings rate, points to the large role played by the Chinese consumer of late. Likewise, the following Chart underscores the reduced role of net exports.

However, the previous two Chart suggest the pace of this internal and external adjustment has slowed during the past two years, e.g. the external sector has contributed positively to GDP and the share of services has stopped rising. Some suggest this reveals that President Xi Jinping is a reluctant reformer. Time will tell. Likewise, President Xi’s China 2025 (as well as the Belt and Road Initiative) focuses on state support for domestic technology firms. This discriminatory policy appears at odds with WTO norms, and will be a source of conflict with the US negotiators and tech firms seeking to exploit the considerable future opportunities in the Chinese market.

Chinese authourities will continue to use monetary and fiscal stimulus to offset the drag on growth from trade and other headwinds. Important distinctions should be made in assessing these policy actions. Corporate deleveraging will be an additional headwind for many years. Monetary stimulus which impedes this process could lay the groundwork for a more disorderly adjustment in the future. Unfortunately, there is evidence that most of the recent small decline in corporate debt has been in the private sector, while unprofitable state-owned enterprises (SOEs) have maintained government support. Meanwhile, depreciations in the Chinese currency should be viewed unfavourable, as it impedes the adjustment from exports.

On the other hand, government support should focus on fiscal policy. However, measures should prioritise supporting household incomes (e.g. the proposed VAT cut) and improving the safety net (e.g. pension and health care reforms). Both would contribute to the goal of lowering savings and promoting the role of consumer spending. Te recent rise inhousehold borrowing is encouraging. Again, unfortunately, the government appears to be relying on SOE budgetary support to boost GDP growth, as it has done many times in the past.

The Chart above indicates the amount of fiscal space at the government’s disposal may be less than widely assumed. The government projects a budget deficit of 4% of GDP and public sector debt of only 40% of GDP this year. However, the IMF’s “augmented” public sector (including local government and off-balance sheet items) puts these metrics at 10% and 75% of GDP respectively.

I expect the government to will continue to attempt to offset the headwinds posed by trade, deleveraging, and the transition to a consumer/service driven economy. However, as the scope for fiscal action is less than expected, I project Chinese GDP will continue to decelerate towards 5% during the next 24 month.

Strategic Considerations

• I expect common sense and mutual interests to eventually prevail, and anticipate an agreement before the US Presidential election in November 2020. President Trump may seek agreement or play hard ball depending on the his political assessment of rust-belt state voters.
• In an effort to save face, China may delay talks believing the post-election environment could not be any worse.
• The China 2025 program is likely to create conflict with US producers and negotiators hoping to exploit new opportunities in China’s market.
• A weaker CNY would be highly undesirable.
• The US twin deficits will grow in the next 2-3 years.
• If tariffs are hiked again, and remain in place for the next years, trend GDP will be reduced 0.5% and 1% in the USA and China respectively.
• A bull case exists: combining higher US savings/investment and Chinese recognition of the benefits of economic liberalisation and opening their local markets, especially for tech, health care, energy, and services. No quick fix.
• The Sino-US economic, political, military, and security relationship will become increasingly complex in coming decades. Putting commercial relations on a more sustainable basis would advance the prospects for a peaceful future.