The US and China recently came to a partial deal agreement, termed “Phase I” by the Trump administration. US tariff threats against China remain, but were pushed back by two months.
(Mini) Deal Overview
As we believed from the start, some form of a “mini deal” or “truce” could be viable in terms of the US and China agreeing on the low hanging fruit involved. China already buys US agricultural products and natural gas. China could agree to this in exchange for the US agreeing not to press forward with additional tariffs. Or at least delaying them.
So, naturally, we saw a mini deal with China agreeing to buy a certain amount of agricultural goods from the US, with the US delaying tariffs that it’s not keenly wanting to go through with at the moment. Avoiding tariffs, or at least delaying them, helps the stock market. The Trump administration bases at least some of its success based on the performance of the US stock market.
The reason why it helps the stock market is because lower trade barriers help facilitate commerce and boost global growth. When two parties can freely transact with each other, and both can help each other in a mutual way, this tends to benefit both parties.
Ultimately, the US wants this, but only if it can extract concessions out of China on various matters. These include some very complicated and difficult issues, such as intellectual property, non-tariff barriers such as market access for US companies, government subsidies, coerced technology transfer for US companies seeking to do business in China, cybersecurity and cyberespionage, and how to divvy up competing spheres of geographical influence.
Agriculture purchases are the easiest. The US has traditionally met almost all of China’s fourth quarter soybean needs. Soybean purchases account for the large degree of seasonality in US-China trade.
If China were to buy $50 billion in US agricultural products, this is about twice what they normally do. Where do they find the extra $25 billion of goods?
1) China can buy fewer agricultural products from its southern hemisphere trade partners, such as Brazil and Australia.
2) China needs pork due to its recent hog issues. There have been bouts of swine fever for almost the entirety of 2019. About half of the world’s hog population is in China. Disease has been restricting supply relative to expectations, driving prices upward. Buying pork from other countries can help alleviate this issue.
3) It can buy indulgence items, such as wine, seeds, and nuts, from the US as well to help bridge any additional gap.
The risk is that China doesn’t lean on the US to meet its agricultural needs. When tariffs were in effect last year, China didn’t buy soybeans from the US even though they were on sale. They found enough supply through Brazil and Argentina.
(The US is the largest soybean producer in the world, producing approximately 110 million metric tons per year. Brazil is the second-largest at just shy of 90 million metric tons. Argentina is behind them at about 55 million metric tons. After that, it’s a steep drop-off, with China producing a bit above 10 million metric tons.)
A single state owned enterprise largely controls the buying of agricultural goods in China. The US is largely opposed to this type of market interference, though top-down central planning is prominent throughout China’s economy. This type of structure won’t change in China.
China’s independence from the US on agricultural needs means it can divert to other countries if it needs to. The “US agricultural imports switch” can be turned on and off as needed through fairly straightforward political decisions within China.
All structural issues mentioned above were kicked down the road.
How can China offset US tariff threats?
A general trading principle: Whenever any country gets hit by tariffs, that’s an adverse external shock to its terms of trade and national income; consequently, it will see its currency decline if free-floated. A free-floating currency means its exchange rate against other currencies is set by the market, largely free from government or quasi-government intervention.
Whenever a currency depreciates, this is a form of stimulation assuming that domestic borrowers’ debt (at all levels – consumer, corporate, and government) is chiefly denominated in its own currency. When the debt is denominated in domestic currency and the currency depreciates, this benefits debtors relative to creditors. In other words, creditors – the people who lend money – see their real returns reduced while those borrowing money benefit. Foreign creditors get paid back in depreciated money.
For example, let’s say an entity invests in foreign debt yielding 4 percent. If the currency the debt is denominated in declines 4 percent against the investor’s domestic currency and they are not hedged, there is no nominal return generated on the debt.
Typically, when a country is facing this type of trade shock, the currency will adjust automatically in the open market. The Chinese renminbi (also known as the yuan, CNY, or RMB), however, is a managed currency and keeps it within an unofficial band against the CFETS basket and against a fix to the world’s reserve currency, the US dollar.
In pegged currency systems, devaluations often aren’t viable. For example, when Greece went through its debt crisis in 2012, the traditional way of conducting policy would have been to spread the effects externally by devaluing its currency. Foreign creditors get less of a return, helping domestic borrowers, and it helps generate demand externally for its goods and services because they are cheaper in relative terms.
But Greece was pegged to the euro. It abandoned the drachma, its former domestic legal tender, in 2002. Therefore, it didn’t have autonomy over its monetary policy, which was largely under the purview of the ECB. If it had stayed on the drachma it would have lowered the interest rates and devalued its currency as necessary to help debtors relative to the creditors. But being monetarily linked to everyone else in the EU, it didn’t have control over its situation. So, it had to take the effects internally, with GDP decreasing some 40% peak to trough.
This type of pegged structure makes the euro zone the most vulnerable of developed market economies. Namely, individual countries pegged to the euro lack the tools to combat their problems.
With respect to China’s situation, one option it has is to offset US tariff threats through the currency.
Tariffs: How they impact exchange rates mathematically
Let’s look at the math behind the tariff effects to calculate the potential influence of upcoming US tariffs on the USD/CNY exchange rate.
If the threat is still another 15 percent in additional tariffs on up to $250 billion worth of goods, that’s $37.5 billion.
The US imports ~$540 billion annually from China.
$37.5 billion divided by $540 billion is 6.9 percent.
Some part of the exchange rate already reflects tariff expectations. But if we ignore that, with the current exchange rate of 7.09, the new rate that’d be guaranteed to offset the effects would be 7.09*1.069 = 7.58.
The current USD/CNY quasi-peg is just under 7.10. This is up from 6.90 earlier this year.
The differential between the actual USD/CNY rate and the USD/CNY fix has regularly been the widest since before the 2015 devaluation.
It also begs the question, if China has all these reserves, why not spend the money to close the gap?
This would help get rid of the depreciation expectations that accompany a wide differential between the official exchange rate and the fix instituted by the PBOC (central bank) and its associated state banks.
The current decoupling isn’t sustainable. Doing a “managed depreciation” burns through reserves. Speculators pick up on the intentions of what’s going on and will pile on shorting the currency, and resident and investment outflows will pick up. Controlling the descent is expensive for central banks.
In 2018, the move from 6.40 to 6.90 in the exchange rate helped offset 25 percent tariffs on $50 billion worth of goods and an additional 10 percent on $200 billion.
Ideally, if China does choose to devalue, they should do it all at once and communicate that there won’t be any additional depreciation thereafter. This will help to keep the speculative flows out and manage capital flight.
When a country wants to manage its stabilize its currency through a fixed exchange rate yet wants the ability to run an independent monetary policy, then they will need to tie up their capital account (i.e., prevent resident and investment inflows and outflows).
The impact of a renminbi devaluation on global equities would be bad. It would lead to a higher US dollar. Many debts and commodities around the world are denominated in dollars, making them more expensive and tightening global financial conditions. But it would be a one-off event if doing it all at once. China’s 2015 devaluation was not handled well, but they learned from that experience.
Trade flows, in general, are negotiable.
However, the broader picture is that the US and China are engaged in a battle for global dominance in various sorts – economically, militarily, and technologically.
A geopolitical battle over intellectual property and how to divide the world into agreed upon spheres of influence – or to co-exist in overlapping areas – are tense issues that will need to be confronted down the line. There are the issues of market access, market competition, cybersecurity, and militarism that are as equally intractable.
The dispute is heavily over where and how each country will compete. This is why matters involving whether having separate supply lines is necessary. Will there be technological decoupling where neither country cooperates on building and using each other’s technology? This could include bimodal developments in, for example, 5G, artificial intelligence chips, information and data management, and quantum computing, where each country brings these technologies along independently.
China’s government is heavily involved in helping companies that have the most strategic importance to the state as a whole.
This means more state support toward technology and less toward the indebted “old economy” sectors of the economy, such as manufacturing, as it shifts away from an export-based economic model toward one more focused on consumption and development of digital technologies. The country that is the most technologically developed tends to be more advanced in most other ways as well.
The US-China trade dispute is following the standard template we’ve seen historically – an emerging power gains in economic, military, and technological power relative to an incumbent. The incumbent recognizes the economic and geopolitical threats. This makes the two countries less likely to do business with each other.
So, it starts with trade flows, then spreads to capital flows, and then becomes geopolitical in most other ways going forward. It often, but not always, spreads to a military conflict. This can be avoided, but depends on how the relationships are managed.
The basic issues are the most conceivable to resolve. But any resolution of the various structural issues that would undermine China’s long-term strategic objectives is not likely. One can expect that these will be long-simmering conflicts that will go on for decades moving forward.
If they do ostensibly agree to anything on this front, then China will not have much incentive to hold up their end of the bargain.
This type of conceptualization of the “trade war” is becoming more popular. When President Trump first slapped tariffs on China over a year ago, the purpose was ostensibly narrow and transactional: reduce the bilateral trade deficit and achieve better treatment of US companies doing business in China.
Since then, the deeper structural and ideological elements have become more appreciated. Events recently, such as the quarrel with the National Basketball Association over one employee’s pro-Hong Kong tweet and the blacklisting of 28 China entities, illustrate this split. The mini deal also didn’t roll back any tariffs. It simply delayed any tariffs to a couple months down the road. China agreed to purchase more of its agricultural products from the US, but the timing and scale is still uncertain.
Part of the underlying conflict has to do with culture.
China rules primarily from the top-down, viewing what’s good for the whole as good for the individual. However, even though China’s ruling party calls itself the “Communist Party”, it is not traditional communism. It’s not the form of central planning that characterized the Mao regime, where China had a “closed door” policy globally and the state allocated resources very inefficiently. Now, its economy is broadly a form of socialism or “state capitalism” with neo-Confucian characteristics (e.g., emphasis on the family, social cohesion).
The US has traditionally been a place where people came from different countries, so most were brought up in a different system. Accordingly, the US is more bottom-up, prizing the freedom, liberty, and actions of the individual as being good for the whole. Therefore, centralized power has been traditionally scorned in American culture and centralized planning of the economy has been done to a lesser extent than what you’ll see in many other countries. The US didn’t even have a central bank until 1913.
There are pros and cons to each approach – top-down versus bottom-up – but this is broadly part of the conflict from a big-picture view.
US Trade War with the EU?
The US recently scheduled tariffs on imports from the European Union over Airbus subsidies. This was part of a $7.5 billion ruling from the World Trade Organization.
Bundesbank president Jens Weidmann asserted that a trade conflict between the US and EU would have “adverse effects might be considerably larger than in the case of the current trade spat with China.”
Trump tends to view bilateral trade balances as indicative of the direction and magnitude of the “give and take” relationship. Trump didn’t seem outwardly concerned about any potential effects from a US-EU trade conflict: “We can’t lose that particular war of tariffs because the trade imbalance is tremendous.”
(In the long-run, the influence of tariffs on trade balances is offset by currency moves, with deficit countries seeing a depreciating currency in relative terms and surplus countries appreciating.)
The US exports three times as much to the EU as it does to China. Accordingly, the EU, in terms of the tit-for-tat response, has greater scope to retaliate relative to China. According to the Bundesbank’s figures, a 25 percent tariff on imports and exports between the US and EU would reduce US GDP by up to 1.5 percent, and world growth by up to 3.5 percent.
Trump has until November 14 to decide whether he would like to impose tariffs on the EU’s car imports for national security reasons. If he follows through, the EU is likely to retaliate.
The US and China reached some type of very basic deal pertaining to agricultural purchases. China buys soybeans and related food products in exchange for the US delaying tariffs that were set to go into effect.
US tariff threats remain and the market expects them to go into effect in December. US tariffs have a bullish effect on US Treasuries, gold, and the US dollar relative to the renminbi. We can calculate this effect on the relative exchange rates.
The total amount potentially impacted ($37.5 billion) is about 7 percent of the total amount of goods the US imports from China each year. Therefore, we can expect a similar effect on the relative exchange rate, with the USD appreciating against the CNY as US tariffs against China escalate.
Longer-term structural issues remain and will be much more difficult to resolve. Those will be more drawn out conflicts that will be with us likely for decades to come.