The ongoing trade war between the U.S. and China has intensified to full pitch, and the likelihood of a compromise is fading fast.
Actions and Reactions
On August 1, Trump announced new tariffs of 10% on $300 billion of imports from China to take effect on September 1. These are on top of those already imposed on $250 billion in imports, and mean that almost all imports from China will be included.
China can’t match this total since it imports only $178 billion in U.S.products, so it retaliated promptly by letting the yuan slide below the previous boundary of 7 per dollar. China’s aim obviously is to offset Trump’s tariffs by reducing the dollar cost of Chinese exports while encouraging local production by raising the yuan prices of imports and discouraging the purchase of foreign goods. European producers of handbags and other luxury products are already feeling the negative effects of the falling yuan.
The seriousness of Trump’s intentions is shown by the fact that the previous tariffs were largely on industrial supplies from China, at least some of which are being absorbed by cost-cutting and profit margin squeezes, as we’ve noted in past Insights.
The latest round will affect American consumers more directly since they apply to retail goods ranging from electronics to cell phones to apparel. Citing slow progress in trade talks, Trump said, “If they don’t want to trade with us anymore, that would be fine with me.” The administration apparently wanted to alleviate the concerns of American consumers and businesses by starting the tariffs at 10%, not the threatened 25%, but that would allow the president to raise tariffs later if China doesn’t make concessions.
Can’t Appear Weak
It’s unlikely that Chinese officials will risk appearing weak by giving in. In fact, they retaliated immediately by suspending purchases of U.S. agricultural products—which Trump said they had failed to import, as promised—and may impose tariffs on U.S. farm goods purchased after August 5.Chinese leaders allowing the currency to depreciate not only displays their willingness to respond to Trump’s latest offensive but also their decision to accept negative blows to their currency’s reputation in international markets. Beijing’s long-run goal is to make the yuan an important global currency, and as we’ve discussed in past reports, global currencies need to be free from manipulations and have market-determined values.
This setback was driven home by the U.S. administration’s response to the devaluation—branding China as a currency manipulator, a label the U.S. has consciously avoided for 25 years.
The Treasury Department uses three criteria for currency manipulators: Actively intervening in their currency markets, large trade surpluses with the U.S. and large overall current-account surpluses. This designation also opens the path for more dumping charges against China—selling goods in the U.S. below costs.
Furthermore, the removal of the floor on the yuan may encourage capital flight from China, much as occurred in 2015-2016 when currency weakness forced the central bank to use $1 trillion of its currency reserves to prevent a collapse in the yuan by accommodating the outflow of money. Capital controls today make an exodus of that size unlikely, but not the problem of servicing dollar-denominated debt.
Chinese firms, especially property developers, have assumed currency stability will continue and have borrowed heavily with dollar-denominated junk bonds. A FTSE index of such debt has risen by 50%this year, and some $19 billion in offshore bonds issued by developers mature in the next year.
Nomura estimates that the value of offshore dollar bonds issued by Chinese companies has more than tripled since the end of 2014 to $842 billion as of the end of June. Real estate development is the biggest issues, with over $125 billion,accounting for about half of China’s junk dollar bonds. The weaker the yuan vs. the dollar, the more Chinese currency it takes to service these debts.
Still, Beijing may continue to weaken the currency as long as major financial disruptions to the local economy don’t occur. Competitive devaluations are a time-tested technique for unloading a nation’s economic weakness on its trading partners. The Trump Administration even considered such a maneuver recently, but ultimately rejected it. Besides, it would be difficult to devalue the greenback, the major global currency. Against which other currencies? Remember that exchange rates are also the relationship among currencies, not one in isolation.
After the initial round of U.S. tariffs last year, Trump apparently thought China would agree to U.S. demands for more U.S. imports of agricultural and other goods, less support for state-owned enterprises, fewer demands for the transfer of American technology to Chinese firms as the price of operating in China and less out and out theft of American technology.
At the same time, China seemed to believe that waiting would produce a better deal—waiting for a possible change in the U.S. Administration in next year’s election or certainly in 2024 and waiting for a U.S. recession to weaken Trump’s hand. Also, the Chinese are well known for their patience. Some believe they think in terms of millennia, not years, decades or even centuries.
Barring a compromise between Trump and Xi, China’s de facto president-for-life, the trade war has plenty of room to escalate. The U.S. could increase tariff rates on Chinese imports and China could do likewise on American imports. China can tighten controls on U.S. companies doing business in China. Some suggest that China could dump its huge holdings of Treasurys but, as we’ve explained in past Insights, is unlikely to do so. At the first hint of big selling, Treasury prices would nosedive, plummeting the value of the People’s Bank of China’s remaining holdings.
The U.S. could cut Chinese banks from U.S. dollar payments and clearing systems, much as the administration has done with Iran. It could also freeze the offshore assets of Chinese state companies and prohibit U.S. financial institutions from investing in Chinese bond and equity markets.
Given the recent intensification of the U.S.-China trade war and prospects of a further widening, it’s not surprising that financial markets reacted violently. Stocks sold off sharply to below where they were a year ago. Meanwhile, investors rushed into safe-haven Treasurys, pushing up their prices and lowering their yields and continuing the robust rally that commenced in late 2018. The total return on the 30-year Long Bond is more than 20% so far this year.
The drop in Treasury yields reflects not only their safe-haven appeal but also the growing recognition of a recession, which I continue to believe is already under way. Further confirmation of a U.S. and, indeed, global business downturn comes from the nosedive in the price of copper, which, I continue to stress, is an excellent indicator of global goods production. Almost every manufactured item from autos to machinery to appliances to plumbing fixtures contains the red metal.
Another recession indicator is the inverted yield curve, with the yield on the 3-month Treasury bill, 2.03%, exceeding the 1.76% yield on the 10-year Treasury note by just over 25 basis points, the widest margin since April 2007.
The yield curve usually inverts ahead of a recession because investors anticipate the business downturn’s effects in reducing inflation and credit demand and, therefore, rush into longer-maturity Treasurys, that also serve as safe havens.Meanwhile, the Fed, which controls short-term rates, waits to reduce them until the recession is underway or clearly in prospect. So longer-term rates fall below shorter-term rates. Then the Fed cuts short rates aggressively so they fall below long-term interest rates and the yield curve returns to normal. This time, the depression in longer-term rates has been enhanced by the growing realization, even by the Fed, that the world is in a disinflationary, if not deflationary mode.
Beyond the trade wars, I see a deeper struggle as China aims to replace the U.S. as the world’s major economic, political and military power.
With slower growth in North America and Europe since the 2007-2009 Great Recession, the growth in its imports has waned, much to the detriment of China, where exports are now flat. In June, Chinese exports fell 1.3% from a year earlier and exports to the U.S. dropped 7.8% on top of a 4.2% decline in May.
As exports as the engine of economic growth waned, China turned to infrastructure spending. My review of 5,000 years of Chinese history reveals that labor unrest led to the demise of many Chinese dynasties. So Job One of the current Mao Dynasty, as I’ve dubbed it, is to keep people employed. Infrastructure spending did so, but resulted in undesired massive excess capacity, ghost cities and an explosion of debt to finance them.
The central bank’s measure of total debt and equity financing rose 10.9% in June, the fastest in a year, and total debt as a ratio to GDP grew from 298% at the end of 2018 to 304% at the end of the first quarter, up $40 billion. Net financing by local governments using “special project bonds” surged.
Lightly-regulated trust companies have total loans and other assets equal to only 3% of China’s total bank assets,but make risky loans to finance new apartments, factories and highways.They then fold those loans into funds with higher returns than on bank deposits. The cooling housing market and slowing economy are pushing some of these trust assets toward default, and those at risk are up 90% from a year ago.
Overall economic growth is slowing in China, even with the official numbers that are undoubtedly overstated. Consistent overstatement of data is simply a scale factor. If Chinese GDP were always overstated by 10%, the growth pattern would be unaffected. Nevertheless, there’s probably more pressure to overstate the numbers now with growth slowing than earlier when the Chinese economy was actually growing at double-digit rates. I conclude that second quarter real GDP growth was closer to 3%, half the reported 6.2%.
Other data also suggest that Chinese growth is slowing faster than the reported small decline from 6.4% in the first quarter to 6.2% in the second. Real retail sales in the first half rose6.7%, the weakest since at least 2011 and real per capita spending grew only 5.2% in the first half from a year earlier, down from 5.4% in the first quarter.
Chinese fixed-asset investment in manufacturing rose just 3.0% in June from a year earlier, continuing the slide from more than 30% growth rates in 2010-2011. Meanwhile, house sales growth in the first five months of 2019 rose 8.9% from a year earlier, down from 10.6%in the first four months.
Chinese officials will no doubt attempt to stimulate the economy with credit ease, tax cuts and the usual last resort—more infrastructure spending. Still, the economy is fading fast with manufacturing employment falling at the fastest rate in June since 2009. Employers are adding to these woes by cutting staff in the face of falling inflation rates to protect profits, which are already weakening. Producer prices in June were flat for the first time since 2016. If producer prices turn decisively negative, repayment problems for debt-laden companies will follow.
In the second quarter, almost $300billion in stimulus through tax cuts and fee cuts failed to improve business confidence. A survey by IHS Markit found business confidence and hiring expectations in June at their lowest since at least 2009. Less than a tenth of the 7,000 respondents expect an increase in business activity in the next 12 months.
Beijing’s Long-Term Strategy
Chinese leaders plan to overtake the U.S. as the world’s leading nation.
Like the heads of previous Chinese dynasties, they believe they have a mandate from heaven that the rest of the world must recognize,sooner or later. With growth generated by exports and infrastructure essentially over, Beijing sees China’s salvation in tech-led domestic growth. Rapid productivity growth spawned by high tech is essential to not only promote economic gains but even to prevent losses, given the declines in the labor force in future decades due to the earlier one child-per-couple policy that was vigorously enforced. Even though two children are now allowed for urban as well as rural residents, few couples want more than one.
China is working hard on information technology and beginning to realize successes in areas such as artificial intelligence. But outside network equipment, that country hasn’t produced many global technological giants. China’s huge and protected domestic market can incubate potentially large companies, but readily-available financing and limited competition encourages inefficiency. Also, Chinese intellectual property enforcement remains weak, as many U.S. firms can testify.
So China desperately needs Western technology to achieve rapid economic growth and the resulting global political power. Trump seems well aware of this. The struggle between the U.S. and China for tech and therefore world dominance will probably continue well beyond the current trade war, which I continue to believe will be won by America.
With ample supplies of productive capacity in the world, the buyer—America—inherently has the upper hand over the seller—China.
For the 32 largest economies covered by the Organization for Economic Cooperation and Development, GDP is still below its potential so economic slack remains. Besides, where else can China sell all those goods except to America, especially U.S. consumers?
Nevertheless, the long-term gains for America come at the expense of short-term pain, which may be considerable as the trade war escalates and potentially turns an average recession into a deep one.
Beijing also can’t continue to watch the Chinese economy slide indefinitely. And the slide will intensify as Chinese and foreign producers accelerate the movement of their operations out of that country to those that have low or even lower labor costs and are out of the line of fire in the U.S.-China trade war. These include Vietnam, India, Malaysia, Taiwan and Thailand. Already, the direct and indirect effects of the U.S.-China trade war have reduced China from being America’s largest trading partners to third place behind Mexico and Canada. In the first half of 2019, U.S. bilateral trade with China fell 14%.
Declining imports from China have been at least partially offset by purchases from other lands. Imports from Vietnam, which was attracting low-wage manufacturing from China even before the trade war, leaped 33% in the first half. U.S. purchases from Japan,South Korea, Mexico and Europe also rose.
This shift involves moving equipment,training employees and reconfiguring supply lines. But goods ultimately destined for the U.S. and other Western economies are already produced in many stages in numerous Asian countries. About half of Chinese exports go to other Asian countries,with 17% headed for Europe and 21%to North America (Chart 32). But as I’ve analyzed, these numbers are highly misleading because of multiple counting of the entire value of exported products.
Increasingly, U.S. imports from China are being replaced by imports from other Asian countries. In June, exports to the U.S. from South Korea, Taiwan, Japan and Singapore combined rose 9%, using a three-month moving average, while their exports to China fell 9%. Still, Asian economies beyond China are suffering from the global slowdown and the depressing effects of the trade conflicts. South Korean exports in May fell for the sixth straight month. Semiconductor exports, a bellwether for global trade, fell 31% in May from a year earlier, according to the South Korean trade ministry.
As another measure of the shift of production out of China, Singapore’s shipments to that country plunged 23% in May from a year earlier, the fourth drop in five months. Many of those imports from Singapore are components that China assembles into final exports to the West.
Rising costs in China have encouraged manufacturing of apparel, footwear and other low-margin consumer items out of China in recent years. China is increasing minimum wages in order to generate the consumer purchasing power needed to fuel a domestic spending-led economy. But the departure of electronics and other high margin products is not desired by Beijing. And Chinese leaders are aware that once these facilities leave and labor is trained and supply chains established elsewhere, they are highly unlikely to return.
While China suffers from the departure of high margin production, the U.S. will still enjoy low-cost imports from other Asian countries. In a world of surplus goods and services, the buyer has the upper hand. Therefore, the U.S. should win the trade war with China. But the long-term gain that follows the short-term pain may be limited by China’s determined challenge for world domination.