Trade Wars

Trade Wars

There’s no real way of denying that the USA and China have now entered a pretty full-on trade war. There are other “allies” and “enemies”, but USA-China is the frontline at the moment.

It all started…well, when Trump managed to get elected President. “Make America Great Again” – its somebody’s fault that the US economy isn’t the same booming world-leader it was after the Second World War through to the ‘80’s and Trump seems committed to finding and punishing the culprit/s!

A Brief History:

The USA and China have had an up-and-down relationship over the last century. The two were friendly for most of modern history. The friendship reached its climax with the two nations fighting alongside one another in World War II. The friendship dissolved in 1949 with the Communist Party’s victory in China’s civil war. The following year, 1 million People’s Liberation Army members filed across the border to fight United Nations troops in North Korea. That resulted in a trade embargo that lasted 21 years.

By the time they started talking again in the ‘70’s, China was one of the poorest nations on earth, posing no threat to the USA. By that stage, the cold war with the Soviet Union was upon them and the US had other things on its mind.

The Soviet emergence as a superpower can in many ways be attributed as the start of one of the US’s current biggest grievances with China – “acquisition” of US technology (I think the word “theft” is often used in this matter, but let’s be a bit more polite).

Watching the Soviet military build-up on their northern border, certain Chinese leaders realised that they needed technology to modernise their military and economy. In the late ‘70’s, Deng Xiaoping succeeded in trade talks with Jimmy Carter and was soon touring the US, charming the locals and discovering what they had missed out on during their three decades of isolation.

Deng’s key focus of the trip was to start the process of acquiring US technology. Apparently, during the visit there were signs that Deng had no comprehension of the US framework of patents and copyrights and the role they played in incentivising companies to investment in the development of technology – knowing their inventions would be theirs to monetise and any infringement on their intellectual property could be defended against. Any concerns the Carter administration had were ignored and this big new customer was embraced. Those early businesses to go into China soon learned that China in fact had no legal framework at all for the protection of intellectual property. From a lot of the stories you hear today, not all that much has changed.

China deliberately kept a low profile during the Reagan years of the ‘80’s and given the US’s continued focus on the Soviets, along with the Japanese – who were seen as the economic enemy at that particular time – the Chinese managed to largely fly under the radar. The US was broadly happy with the Chinese relationship – the Chinese were buying significant amounts of US goods and seemingly beginning to move towards a more capitalist – perhaps even democratic – future.

Whilst the US may have been pretty comfortable with the relationship, the trade imbalance that is the focus today was already becoming entrenched – in 1990 China imported US$4.8 billion worth of US goods. The US imported US$15.2 billion worth of goods from the Chinese.

This didn’t go unnoticed, nor did the lack of progress on implementing protections for intellectual property. A memorandum was signed in 1992 which included Chinese promises to protect intellectual property and to address the trade imbalance. The Clinton era during the ‘90’s saw continued pressure including talk of a trade war in the mid-‘90’s. There were promises from the Chinese to fix things (such as shutting down factories producing pirated CD’s) although scepticism was high.

These events didn’t deter the Clinton administration supporting China’s acceptance into the World Trade Organisation. After a lengthy process that required US Congressional approval, China was accepted into the WTO in 2001… and then the trade deficit really took off!

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 a global leader in pretty much everything. And Trump blames the Chinese for the trade deficit.

But is that really fair?
“Globalisation”, along with technology, has changed the world dramatically in the last 25 years. Manufacturing has gravitated to the lower-cost regions and whilst we in the higher-cost regions sure enjoy the inexpensive “stuff” globalisation has provided, there needs to be an acceptance that globalisation has had negative implications as well.

Mapping out the mechanics of trade, the winners and losers from globalisation is a rather complex and somewhat philosophical task which I don’t intend to delve into today. I want to focus on where this “trade war” may lead with some observations about possible collateral damage.

What’s the financial implications?

There’s ultimately no winners in a trade war. The IMF has warned that they think the current tariff threats could cost the global economy US$430 billion in lost GDP.

They also warn that the US could be the real loser as they find themselves the focus of global retaliation – with tariffs against them having a greater impact than the tariffs imposed.

Then there’s the argument that the Chinese have the most to lose. This argument focuses on the fact that China – as the supplier of goods – faces the risk of a significant decline in exports. This could result in factory closures, layoffs, debt defaults and the like.

The obvious financial implication on the US is an increase in prices for the affected imports. This has logical inflationary implications. Will the effect be significant? It’s a little difficult to say.

Inflationary pressures within an economy that is already theoretically close to full employment and being further prodded with planned infrastructure spending isn’t a great scenario. There’s a potential effect on interest rates if inflation expectations increase and that can have farreaching effects (say, a banking system in Australia heavily reliant on global wholesale funding).

What’s Trump’s Plan?

So far, we’ve seen Trump seek to impose tariffs on goods including steel and aluminium. According to the administration, these are necessary to protect national security, intellectual property and to help reduce the trade deficit with China.

History suggests that opening formal investigations into trade practices – so-called section 301 investigations (stemming from section 301 of the Trade Act 1974), is a fruitful way of forcing talks for a trade agreement. Could this be the plan? Does Trump seek to use this as leverage to try and force real change in terms of intellectual property protection that has eluded successive US administrations for decades?

There’s some other vastly more sinister theories about what Trump’s intentions could be. Some respected observers posit that the true intention is to try and stop the Chinese rise in its tracks – to try and crush the Chinese economy. The view is that China has become a real adversary in terms of global dominance and a military threat.

If Trump really presses hard with tariffs, there’s little doubt that China will suffer some significant economic damage. Their economy is heavily reliant on manufacturing and exports and the US is a major customer.

We need to really pay attention to the prospect of this scenario as it potentially has dramatic implications for Australia. We’re in the “supplier” role in another major Chinese trade alliance – the supply of raw materials. Just like the prospect of a major decline in demand for Chinese “stuff” has the potential for major consequences to them as the supplier, the prospect of a resulting decline in demand for our “stuff” could be equally damaging.

We’re already seeing China nudge on the other lever of their economy – “building stuff”. An increase in construction activity is clearly good for us. But this model is getting very long in the tooth. The accumulation of debt associated with building stuff is reaching problematic levels. The Chinese leaders know this. If the exports side of its economy really starts to suffer, this will flow into other areas. Its capacity to pull the “build stuff” (increase debt) lever hard to offset a material downturn will be tested. If the economy as a whole starts to sputter, we have a real issue on our hands.

So it’s a case of wait and see. My sense is that the Chinese will want to try and settle the dispute as I think they know what damage it could have on them. But they also have a need to appear strong against the US.

There’s other complex factors. Military tensions in the South China Sea are running pretty high. Stories of fighter jets shadowing US drones and the like. You can’t help but feel we’re one misunderstood order away from an accident that might push things to a whole new level.

Even if they do want to broker a deal with the US, is that what Trump really wants? Time will tell. Frustratingly, I feel that there’s some real ramifications to Australia in all this…