Who holds the Trump card?

The exponential growth in China’s economy over the past forty years has brought hundreds of millions of Chinese citizens out of poverty and advanced the Chinese people’s standard of living and personal wealth. This has been done through a command economy based upon deeply protectionist policies that prohibits foreign ownership of Chinese companies. A portion of their significant industrial growth has come from hacking the West’s business and technology secrets which Donald Trump has called ‘the biggest theft in global history’. The US is now taking a far harder line on market access, hacking and patent theft than ever before.

In September 2018, the US imposed a 10% tariff on a further US$200bn of Chinese imports. This brought the amount of goods hit by new border taxes to around half of the total imports to the USA from China. The new tariff rate was set at 10% but will rise to 25% in January 2019. The US has threatened further tariffs on the remaining US$267bn of imports from China to start in January 2019.

In response, China placed tariffs on an additional US$60bn of imports from the USA taking the total to US$110bn which is 90% of all US imports to China. These figures expose the difference between the respective import levels. China is clearly exporting a far greater level of goods to the US. This is one of the issues driving Donald Trump’s desire to level this uneven playing field.

Any further trade tariffs will hit China harder than the US. This is the reason that the trade war has hit the Chinese stock market far harder. If the US impose a third round in January this would hit 3.5% of China’s GDP.

China can also retaliate against these new tariffs in other ways. China holds US$1.2tn of US Treasury stock, making them the largest single foreign holder of US treasury debt. China, therefore has a significant influence on bond prices. American companies such as General Motors and Apple, who sell more of their products in China than in the US, could be targeted by excessive regulation.

This trade war has all the hallmarks of a deep and prolonged dispute before it is resolved. China sees its trade policy as an essential part of its growth strategy to bring higher standards of living to its citizens. President Trump sees the trade deficit as benefiting the Chinese ahead of American workers and wishes to deliver on his America First rhetoric and sees China as the root cause of the decline in parts of the US economy that form his base support.

In the wider context, this dispute is also affecting whole supply chains in emerging Asian economies such as Korea, Taiwan and Malaysia. This is why emerging markets have struggled in 2018.

There are likely to be both winners and losers. Both China and US companies may seek new suppliers to avoid paying these expensive additional import costs. US companies will face a difficult decision over whether to pay the tariffs and pass the cost onto their customers or absorb them in their margins. The former leads to inflation while the latter hits profits. President Trump is hoping that more US companies will bring overseas production back to the USA but this will involve set up costs and higher labour costs given the shortage of US workers.

Making imports more expensive through US tariffs are designed to boost US home-based manufacturing, push domestic consumers to buy local, boost US manufacturing and bring manufacturing jobs back to America. But major industrial manufacturers are not seeing it that way. For example, Stanley Tools are seeking to make cuts of US$250m in order to cover the new additional Chinese tariffs of US$200m that they are paying on imported parts from China. Harley Davidson is moving some manufacturing from the US to Thailand to avoid the US$100m retaliatory EU tariffs on US goods imported to Europe. Major companies such as Caterpillar and 3M have stated that tariffs are impacting on their costs and profits.

On the back of these tariffs, China has suffered months of falling export sales. The Chinese authorities are using tax cuts, infrastructure spending and lower interest rates to support the economy through this squeeze.

Washington is using these new tariffs to bring Beijing to the negotiating table and see this as a temporary necessity to secure a better deal. Recent talks between the two sides stalled as the White House pushed for an end of alleged intellectual property theft by Chinese companies and a reduction in the trade deficit.

With stock markets in both US and China having responding badly to this ongoing dispute it is not surprising that there has been encouraging news after the dinner between President Trump and President Xi Jinping. Both leaders met at the G20 Summit in Argentina on 1st December and agreed that the proposed January increase in US tariff rate from 10% to 25% be postponed for 90 days to allow both sides to negotiate a settlement over trade tariffs as well as technology transfers, intellectual property protection, non-tariff barriers, cyber intrusions and cyber theft. President Trump indicated that China will start purchasing more American goods in order to reduce the current trade deficit as well as reduce the Chine import tariff of 40% on US cars. However, this has so far not been confirmed.

There are strong incentives for both Washington and Beijing to reach a truce on trade. The US has been tough on China and this played very well ahead of the midterm elections but the political benefits are now diminishing as the cost of high tariffs are expected to fuel higher inflation in the US. With fiscal stimulus fading and the US Democrats controlling the House of Representatives, the Trump administration may want to avoid conflicts that hurt the stock market.

Analysts feel that China is willing to reach a deal as the economic cost of tariffs is quite high and the planned increase of US tariffs from January would reduce China’s GDP by 0.6% over 12 months. Markets rallied on the news with the Hang Seng rising 2.6% and Shanghai Composite Index up 2.9%.

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