Trade Wars Part 2

Trade War Musings – Part 2

It’s the 1st of March as I write this. The date President Trump set in early December as a deadline for an agreement to be reached in trade negotiations between the US and China. If not, tariffs on Chinese goods will jump from 10% to 25%.

I therefore thought I’d be able to talk about the agreement reached. Unsurprisingly, no deal has been reached. Apparently talks are progressing nicely and the deadline has now been delayed “until further notice”.

What Trump is supposedly pushing for is some sort of binding agreement. With repercussions if targets are not met. Not just some “oh yeah we promise to try” sort of agreement. Fair enough, I guess.

Last time I focused on the slightly more intangible aspect of the trade war – intellectual property protection. To me, the evidence is that we’re not going to see any true resolution on this. Handshakes and promises which will not be honoured. What I intended to focus on today is the other aspect of the trade war, being the trade imbalance. Specifically, I intended to talk about the real probability of this being able to be addressed and the potential financial ramifications if it is. The lack of “agreement” to date doesn’t really matter…

I wrote about the history of the US-China relationship and how the trade imbalance basically came about back in September. To briefly recap, trade relationships started back in the ‘70’s with Deng Xiaoping forging relationships with the Carter administration – a major objective being to acquire US technology to assist in modernise the Chinese economy and military. Things chugged along during the ‘80’s – the US being quite pleased with this big new customer which posed no perceived threat to the US given they remained one of the poorest nations on earth. There was consternation back then about the lack of progress on intellectual property protection, but the Clinton administration saw great opportunity in the Chinese market and lobbied for their inclusion into the World Trade Organisation, which was granted in 2001.

This is when the “made in China” world we are now familiar with took off. Foreign companies were keen to take advantage of China’s cheap labour pool and invested heavily in Chinese operations.

In recent years, the USA-China trade deficit has held pretty steady at around US$350 billion. Trump blames the trade deficit for the loss of American prosperity – the kind that older Americans like himself remember from the post-war boom times when the US was global leader is pretty much everything. And Trump blames the Chinese for the trade deficit.

It’s understood that the trade talks include reaching a deal to eliminate the trade imbalance completely. It’s also understood that Trump would like this done in a couple of years where the talk is that Chinese officials have proposed to eliminate the imbalance by 2024. What I’ve been thinking a lot about is whether this is even possible…and what are the potential economic consequences if it does dramatically change?

The bigger picture

Understandably, Trump is focused only on the US – only on the bilateral trade balance between them and the Chinese. This is unrealistic in this modern world full of global trade where trade is settled multilaterally. But it’s logical that Trump is only focused on the US.

Its worth noting that China’s trade with the rest of the world is much more balanced. In fact, their current account is getting very close to breakeven.

Remember that the current account is basically a ledger of transactions with the rest of the world – trade and also investment. It makes sense that it would be overall relatively balanced – looking at the bilateral Australia-China trade position, China runs a deficit with Australia – we import mountains of stuff from them but not nearly enough to offset the mountains of dirt we send them. Further, programs such as their Belt and Road initiative which sees them invest large sums in other countries on infrastructure projects in order to buy political influence foster mutually-beneficial economic efficiencies, subtracts from trade surpluses it runs with the rest of the world.

These factors aside, make no mistake – exports are a big part of the Chinese economy and an aggregate decline in exports will really hurt them. Similarly, China is by far our biggest trading partner and destination for around 1/3 of total exports. Whilst our aggregate global trade position is quite balanced, make no mistake that a decline in our exports to China would hurt us quite a lot.

Can the US-China imbalance disappear?

Is this even possible? What needs to happen to make the imbalance disappear?

There’s a couple of ways this could happen. If China could find an alternative buyer for abunch of exports whilst leaving its US purchases unchanged, that would work. Can it somehow divert US$350 billion worth of exports away from the US and to other markets?

There are some problems with this. Firstly, they need to find a market big enough. This is one of the key reasons why the US-China trade balance is what it is – the US is a massive market.

But aside from the issue of finding another market for the goods, something needs to happen to diminish the US’s demand for the goods. It works both ways – when Trump simplistically says to the Chinese “stop running a trade surplus with us”, the Chinese can snap back “well you stop buying our stuff!”.

If we keep thinking along these lines, we see another way in which the trade imbalance can be reduced. Instead of the Chinese reducing its exports to the US, the Chinese could increase its imports from the US – this would bring down the imbalance.

If we look at some of the trade data, we find some real potential for this. China imports around $160 billion worth of oil each year with very little being from the US. Simply diverting purchases from current suppliers to the US would have a dramatic impact.

There’s the scope to divert significant purchases of agricultural products from current sources such as Australia and source these from the US – that would help (although be bad for us).

In this sense, the numbers do potentially add up. China could plausibly source more of its imports from the US, bringing down the trade imbalance without doing itself too much damage in terms of reducing exports. It wouldn’t be enough to eliminate the imbalance, but it would be a huge start.

There would be a need to increase purchases in other areas – such as machinery or technology. This probably means abandoning economic plans such as their “Made in China 2025” initiative where they seek to move the country’s manufacturing capacity up the value chain – away from cheap crap and towards high-tech fields like computing, aerospace and robotics. Essentially, a goal of competing with the US as manufacturer in these fields.

There is a clear downside for China in increasing US imports. They have the potential of becoming highly reliant on the US for key supplies. Referring back to my musings from last time, China surely doesn’t have plans to become highly reliant on the US for anything other than customer for its goods and supplier of intellectual property.

In summary, it’s mathematically implausible that the US-China trade imbalance can be eliminated in the short-term. Over a longer period (say through to 2024), it’s actually plausible, although that’s not to say it will be easy and/or not inflict any collateral damage.

As a side-note to this, it’s worth bearing in mind that all the above requires significant state intervention in the economy – Trump has been critical of Beijing’s central planning economic model and wants to see them do exactly the opposite. But you can’t have both…

But what if Chinese exports simply fall?

The trade imbalance with the US could of course diminish simply via a fall in Chinese exports to the US. As noted earlier, aside from the overall relatively balanced global current account, exports are a key component of the Chinese economic model and a material decline will hurt a lot. There’s already signs that the trade war is hurting.

For a change in the bilateral US/China deficit something needs to induce this. One way would be for Chinese exports to become less appealing – less “cheap”. A material increase in the RMB/USD exchange rate would work. But given currencies – like trade – settle “multilaterally”, engineering a rise in the RMB/USD exchange rate without impacting other crosses is impossible.

Another option would be tariffs – they do work – they do have the effect of making imports far less attractive.

One other option would be for China to step in and ban certain exports – that would work! This last “option” above perhaps highlights best that there must be economic implications associated with a narrowing of the trade balance via a decline in exports. The implications are quite easy to understand (although they do involve some rather hardcore economics) – terms of trade accounting is governed by accounting identities and we’re not needing to rely on controversial economic theories.

If China is forced into a contraction in its current account, this forces a contraction in the gap between savings and investment. Note that in this context “savings” is a little more abstract than money in the bank – savings is a function of production and consumption – producing more than you consume = savings. “Savings” can be exported”, which is what a trade surplus represents.

If exports fall, one of two things must happen (or a combination) – the investment share of GDP must rise (a rise in inventories) or the savings share must decline (less production). To bring things back into balance, there are just four options:

• Reduce savings by letting unemployment rise. This is basically a “do nothing” response. The government could just let factories close, unemployment rise which will automatically reduce China’s savings rate and re-establish equilibrium.
• Raise investment. To offset the decline in production, investment elsewhere needs to be ramped up. In the simplest sense, pull the “build stuff” lever.
• Reduce savings by allowing private debt to rise. Engineering an increase in debtfuelled consumption will reduce savings and restore equilibrium.
• Reduce savings by boosting household consumption. Without increased debt (as per the previous option), this option entails increasing household incomes in order to allow households to consume more. At around 40%, Chinese household consumption as a percentage of GDP is absurdly low – around 55% is a more normal number globally (even among developing nations). What this option basically entails is transfers – transfers from government and/or wealthy individuals to the average household. Very politically complex.

All four of these options either raise investment or reduce savings thus reducing an excess of savings over investment. This somewhat complex economics terminology is what is meant by a contraction in the trade surplus.

Within China’s economic system, “option 2” has been their go-to response in the past. Indeed, they hit this hard during/after the global financial crisis. The thing is… the funding mechanism is via more debt.

Its now quite universally accepted – even within China – that debt is becoming a problem. The “borrow to build” lever is getting very fragile.

Of course, Beijing wants to avoid a rise in unemployment – social unrest is not good for a centrally-planned nation. Just ask Nicolas Maduro down in Venezuela. But it also wants desperately to reign in debt.

Macroeconomics is complex with an incredible number of moving parts. I find it highly useful to develop a conceptual framework around an economy based on the key drivers of activity and grounded in sound economic principles.

Nothing has changed in China’s economic situation for some time – their economic framework focused on exports and investment has been much the same. This trade war doesn’t change anything, but it sure has the potential to induce some effects.

I’ll be watching with great interest what unfolds with these trade negotiations and the subsequent actions. The above acts as the framework to assess likely ramifications.