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August 20, 2018

Why China Is No Trade Ware Pushover

The consensus story line is that the U.S. has more leverage on China since they exported $505 billion of goods into the U.S. in 2017, while the U.S. only shipped $130 billion of stuff to China. The target is much bigger on China’s back than on the U.S., since the U.S. can slap tariffs on more goods than China can. Chalk one up for the U.S! China’s stock market as measured by the Shanghai Composite is down -17.1% through August 3, while the S&P 500 is up 6.0%. For the vast majority of investors who actually believe that markets discount the future, the only conclusion one can draw from this performance disparity is that China is losing and the U.S. will win. Chalk up another one for the U.S! In the second quarter GDP grew 4.1% in the U.S., while economic statistics in China are showing a slowdown as the recent figures for China’s manufacturing and non-manufacturing illustrate. With the U.S. economy on the rise this is the perfect time for the U.S. to be pressing China, as opposed to a period when the U.S. isn’t as strong. The fact that China’s economy is weakening makes this advantage an even a bigger point of leverage. Chalk up another win for the U.S.! 
China has been ripping off the Intellectual Property of U.S. companies for too long, costing millions of middle class Americans their livelihood as factories closed, and stealing hundreds of billions of dollars from the U.S. each year through the trade deficit. Clearly the U.S. is justified in demanding free and fair trade. The U.S. is standing on the righteous moral ground in this dispute, which China will recognize and accept and thus seek to avoid a trade war. Another point for the U.S., which makes the trade negotiation tally 4 for the U.S. and 0 for China. We’re shutting China out!

While this analysis is neat and tidy it does manage to overlook what could be a number of salient points. The first is perspective. In the U.S. time is measured by quarters, but in China it is measured in decades. China’s leadership is not immune from short term considerations, but their focus is not centered on the next year or two but where things will be in 5 to 10 years and beyond. President Trump faces reelection in 2020 while changes to China’s Constitution will allow President Xi Jinping to remain in office until he dies. China is the country of Confucius, “If you think in terms of a year, plant a seed; if in terms of ten years, plant trees; if in terms of 100 years, teach the people.”

Actions speak louder than words or Tweets and China has been taking steps to insulate and bolster its economy from any short term negative impact from trade. In April, the Peoples Bank of China (PBOC), lowered its Reserve Requirement Ratio (RRR) by 1.0%, from the current 17% for large institutions and 15% for smaller banks. By reducing the amount of cash most commercial and foreign banks must hold as reserves, the cash can be used for funding new loans to stimulate growth. The PBOC has aggressively lowered short term interest rates especially since mid May. The 3 month Shibor rate has been lowered from 4.91% last December and slashed since May’s level of 4.33% to 3.17% in early July as trade tensions escalated. 

In late July the State Council encouraged local governments to issue bonds so the proceeds can be used to stimulate growth locally. The issuance of municipal bonds has soared from zero in January to $80 in June and will likely climb further after the State Council’s urging. In the last week of July the PBOC injected $74 billion into the banking system, the largest since 2014, so banks can increase lending. These steps indicate that China is easing fiscal and monetary policy in a myriad of ways as an insurance policy and to enable China to extend negotiations. China knows there is an important election in November in the U.S. The constituencies that supported President Trump that are now being hurt the most (farmers) can be counted on to apply more pressure directly on President Trump than China can through trade negotiations. According to Chinese philosopher Sun Tzu, “The supreme art of war is to subdue the enemy without fighting.”

By stimulating its economy, China can weather the storm in the short term and achieve its long term goals. It’s possible that Sun Tzu may possess more wisdom and negotiating prowess than the guy who wrote the ‘Art of the Deal’.

In recent years China has expanded its military reach to a number of islands in the South China Seas despite Chinese President Xi Jinping’s 2015 pledge to President Obama that “China does not intend to pursue militarization” on the Spratly Islands. President Obama’s restrained response as China proceeded to expand only encouraged China to proceed. Satellite imagery now shows China has installed radars and communication jamming equipment in the Parcels and Spratlys Islands. In May China landed a long range heavy bomber on Woody Island which is claimed by Vietnam, Taiwan, Malaysia, Brunei, the Philippines, and China. The bomber has a range that covers almost the entire South China Sea. More than 30% of global trade passes through this area, which is also thought to contain large deposits of oil and natural gas. China says it has historical claims to almost the entire area and the right to defend those claims. One island in the Spratly Islands, which a UN court ruled belongs to the Philippines, now has a two-mile runway, a port and multi-story concrete barracks for Chinese military personnel. China claims the reefs are being developed to facilitate marine rescues, disaster relief, oceanic research, ecological protection and navigational safety. And if anyone believes that, China has an island it might sell you – for a price. Coincidently, the linkage of the bases in the Parcels and Spratly Island provides China an umbrella of coverage to control the South China Sea in all scenarios short of war with the U.S. In June it was reported that U.S. fighter pilots had been blinded in 20 instances since September 2017 by lasers coming from Chinese fishing boats, which are considered part of China’s militia. The US and China are signatories to an international treaty which bans the use of blinding lasers as a weapon of war, for what that’s worth. China’s military expansion reflects a mindset that is focused on the long term and an attitude that China will not be bullied nor dissuaded by any country.

On July 31 the Trump administration said it was considering increasing the tariff on $200 billion of Chinese imports from 10% to 25%. Comments by a spokesman for China’s Commerce Ministry didn’t sound as if China is cowed. “The U.S. unilaterally exerting pressure on China will get the opposite of what it wants.” Discussions haven’t even produced a plan for additional negotiations. The Commerce Ministry also issued a statement on August 2. “China has been fully prepared and will have to retaliate to defend national dignity and the people’s interests.” The word dignity caught my attention since it indicates that for China the trade negotiations represent something much bigger. China wants to be treated as an equal to the U.S. and respected, and that’s something China is not willing to trade away.
Courtesy of Jim Welch, Macro and Technical Strategist
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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