Trade, the Dollar, and the Week Ahead

China is isolated on trade.  No one supports its trade practices.  The idea that China was going to “naturally” evolve to be more like the US, or Europe for that matter, was always fanciful and naive. The emergence of China, as Napoleon warned two centuries ago, would make the world shake.  

US administrations adopted a multi-prong strategy of managing the rise of China.  On economic issues, the focus was on working through multilateral institutions, like the G7, G20, IMF, and WTO. The US did not block China joining the WTO in late 2001 when many feared 9/11 was the end to globalization.  The US did not prevent the Chinese yuan from being included in the SDR (Special Drawing Rights) starting in October 2016.  It insisted that China was a non-market economy, which made it easy to take action against dumping.   At the same time, considering it an emerging market economy would qualify China for different types of development assistance, which may no longer be necessary.  Past Administrations formally objected to many Chinese practices, challenged them before the WTO and often won.  

There are numerous ways to measure China’s integration into the world economy, which shares much in common with a basketball or football game where the violation of the rules is part of the game itself.  That the US had a widening bilateral trade deficit with China is not proof of anything by itself.  It is especially not evidence of the failure of the multilateral approach. A balanced reading of the modern Chinese economic history, since Deng Xiaoping’s reforms, shows a clear evolution of policies, and often in the broad direction that the international community finds agreeable.  It has made sufficient reforms, for example, that its stock and bond markets are increasingly included in global benchmarks.   Despite threats to the contrary, no President since Clinton has cited China as a currency manipulator. 

At the same time, the US challenged China on other fronts, like selling advanced weapons systems to Taiwan, bringing nuclear-armed ships into the Straits of Taiwan, protesting its human rights practices, and limiting some technology transfers. It pursued freedom of navigation and periodicadlly sent ships into waters that China claimed. Chinese direct investment plans in the US were put under closer scrutiny with some deals rejected.  The Trump Administration has continued these measures and more.  It has stepped up the campaign against two policies thrusts of President Xi: the Belt-Road Initiative (BRI) and Made in China 2025. Last week, the FCC barred Chinese Mobile from entering the US and announced it would review the authorizations previously given to China Telecom and China Unicom.

However, getting other countries to match US efforts have been challenging.  Like Obama campaigned in vain to boycott China-sponsored Asian Infrastructure Investment Bank, so too has Trump failed to convince more than a few countries (e.g., Japan, Australia, and Vietnam) to ban Huawei.  Half of the EU members have signed memorandums of understanding with China on BRI.

The tariff truce that began in December ended abruptly.  American marketing prowess was on full display as the US framed the issue as China reneging on what had already been agreed before Beijing had breakfast Monday morning. US negotiators have accused others of this as well, including Europe on whether agriculture will be included in the bilateral trade talks.  

Rather than simply take the US framing, as investors and the media accepted at face value the nearly daily US claims that progress was being made,  it behooves us to find a larger perspective.  The fact of the matter is that in these negotiations, nothing is agreed until everything is agreed. That means that using the time-tested tactic like the Gulf of Tonkin incident, American medical students in Grenada, weapons of mass destruction in Iraq, and the sinking of the Maine, the US found a pretext to do what it wanted.  

The question is why did President Trump conclude that it was in his interest not to reach an agreement.   As in most important decisions, it is over-determined (the opposite of mono-causal).  First, it became clear that a comprehensive understanding that went far beyond trade was unlikely.  It had been oversold.  Second, like the recent overtures to Democrat leaders Pelosi and Schumer on infrastructure initiative, being hard on China is one of the apparently few areas of bipartisan agreement.  In fact, shortly after Trump’s tweets on May 5 declaring the end of the tariff truce, Schumer sent an encouraging and supportive tweet.  

Arguably, after the media, Trump has railed hardest against the Federal Reserve.  The rates and an economy that has grown at an annualized pace above 3% for three of the past four quarters and unemployment is sitting near 50-year lows.  The 12-month moving average of non-farm payrolls is above 200k, a full decade since the economy troughed during the Great Financial Crisis.  Despite this, and the fact when adjusted for inflation, interest rates are only a little above zero, Trump has called for the resumption of the asset purchase program and 100 bp cut in interest rates. His senior economic adviser has called for an immediate 50 bp cut.

The economic logic is elusive, but the political motivation is obvious.  Just like the investment bank that suggested that based on economic growth and unemployment forecasts thought the odds favor Trump’s re-election, Team Trump recognize that should the economy weaken so will the re-election chances.  An amped-up economy also gives the President the latitude to be Disruptor in Chief.  

Trade conflict with China can do what all the moral suasion and chest-thumping could not do, and that is to prod the Fed into cutting rates.  Recall that after a week after much stronger than forecast Q1 GDP, the US reported that more jobs were grown in April than February and March put together.  The implied yield of the January 2000 funds futures contract was a little more than 2.26%.  It had bottomed in late March just above 2.05%. This is to say that the market had discounted more than one rate cut this year at the end of Q1 now was nearly evenly split one cut.  Then the tariff truce ended.   The January contract closed the week at 2.15%, down nine basis points on the week.    

Labeling Obama as soft on China, Trump can use the same brush to tar Biden, the leading Democrat challenger.  The attempt to make it seem like a first-term Congresswoman from New York has taken control of the Democrat Party and has turned it into early 20th century Socialists that want to re-make America into Venezuela has not worked.  Biden, another white male senior citizen is seen as a moderate and is running ahead of the crowded Democratic field.  Despite gender, ethnicity, and age, Biden is the anti-Trump candidate and represents a return to “normalcy.”  This is may prove problematic because it was that “normalcy” that produced the excesses that made room for the populist right in the first place.  The link between Biden and China was made by the President himself, claiming Xi would rather deal with Biden. 

Why did China give Trump the opening for which he may have been looking? Chinese officials also seemed to reach the reasonable conclusion that the Trump Administration was intent on checking its rise.  It fought every Chinese initiative.  Sure, Made in China 2025 is an import substitution strategy, no less than Make America Great Again.  In the world of slow growth and declining international trade, it is not coincidental that the world’s two largest economies are pursuing similar strategies.  Moreover, there is much talk from the American side that China was reluctant to commit to changing their laws.  Yet, it would be an executive agreement in the US, which does not have the same legal status as a treaty.  Nor does need congressional approval.  

We suggested the Chinese officials had their “Draghi moment” earlier this year.  By that, we meant that they become notably determined to do whatever it took to prevent the US from threatening it.  It shifted economic policy from one of consolidation to support.  China just commemorated the 100th anniversary of the May 4 Movement that gave rise to the Communist Party.  It is the 70th anniversary of the Communist Revolution.   Although censorship and social repression appear to be as strong as ever in China, senior officials seem worried about a growing gap between the party and the people.  This reportedly was behind the extension of the May Day holiday.  Extra force may be brought to bear on the 30th anniversary of the Tiananmen Square demonstration.

Like Mexico is going to pay for the wall, Americans have been told by the President that China is paying for the tariffs.  In practice, the situation is more complicated.  The importer pays the tax to get access to the goods.  As the Fed’s Bostic explained last week, the companies he spoke with were willing to absorb the 10% tariff but the 25% tariff they will have to pass on to their customers.  The initial tariffs were on capital and intermediate goods, which also helped minimize the direct impact on consumers.  Consumer goods account for around a quarter of the $200 bln of goods that will be subject to a 25% levy instead of 10%.  One study by an economist at the University of California, cited by NPR, estimated that last year’s tariffs cost the average American consumer about $760 last year and the new tariffs will cost an extra $500 a year.

Even if Chinese exporters do not really pay the tariff, they are at vulnerable to reduced demand.  With the caveat against reading too much into a single trade report, this is what seemed to show up in the March US trade data.  China’s share of US imports fell to 15%, an eight-year low.  

Many observers are waiting for some kind of formal announcement from China.  It may or may not be forthcoming.  China may be best served to enact its retaliation quietly.  This is what it did to Canada’s canola and pork from a couple producers.  It is like the episode “Slapsgiving” from the US sitcom “How I Met Your Mother,” where the uncertainty of the punishment was more offputting than the punishment itself.

Whenever something goes even slightly awry, like last week’s soft reception of the 10-year US Treasury note sale, some will see the long arm of China.  The yuan weakens amid the broader risk-off move in the face of the tariff escalation, and there are whispers that China is seeking to devalue to offset the increase levies.

The old fear of China selling Treasuries gets recycled, but there are many hurdles to this, including what to do with the proceeds.  What bond markets can absorb $1 trillion?  The 10-year German Bund and 10-year Japanese Government Bond yields are below zero.  Similarly, the devaluation card is trotted out, but it does not seem to be Xi’s way to cut the nose to spite the face.  China’s broad development strategy requires a broadly stable.  Firing up mass indignation and consumer boycotts has been used in the past against South Korea and Japan, but mass mobilization is a dangerous card to play for the authoritarian regime jealously preventing other power centers from emerging.

Many observers and journalist have a penchant for skipping steps in an escalation ladder and jump to the largest boldest actions.  The lower rungs can be just as effective, even if more subtle, like increased customs scrutiny, more regulatory enforcement, and sourcing from non-US suppliers.  It can also quietly frustrate US goals elsewhere, like North Korea, Iran, and Venezuela.  

The US-China trade talks will most likely resume shortly and again, it will be spun to be constructive with progress being made.  There is a three or four-week period that it will take for the process of applying a 25% tariff to the remaining Chinese imports to the US that have not been penalized. If a deal is not reached by the end of June or so,  the new tariffs will be implemented.  It is what comes after that that is being gamed out now.   Too many in the West seem to think that because China is a one-party state and it is homogenous.  However, it is quite clear that it is a spectrum of views within China.  There are some reformers, but the US actions will strengthen the hardliners, who would prefer ripping the proverbial bandage off quickly and dramatically reducing ties to the US.    

The dollar was firm last year, but it is hard to isolate trade tensions as a causal variable.  The Fed was in a tightening mode, while Germany, Italy, Japan. Sweden and Switzerland contracted in Q3 2018.  The dollar had already entered a technical corrective phase before the end of the tariff truce.  This was illustrated by its heavy tone despite the strong Q4 GDP and employment reports.  Next week’s US economic highlight include April retail sales and industrial output figures.  Consumption is likely to slow from March’s heady 1.6% headline. Half that strength in April would still be seen as strong.  US manufacturing output has not risen since December, and Q19 has been the weakest quarter since Q1 15.  The weakness in the April manufacturing PMI and ISM warns of downside risks.  The interest rate premium the US offers is still wide but has trended lower recently.   


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