Sino-US Trade: First Step on a Long Journey

20 January 2020

A comprehensive trade agreement between the United States and China was never a realistic possibility: these take years of skillful negotiations to conclude. To be sure, the recently-signed plan has many shortcomings. Predictably, the deal fails to address many of the most contentious issues, e.g. state subsidies and cyber-security. Likewise, the dispute resolution arrangements offer little more than a return to the trade war, and the treatment of technology transfer and intellectual property theft require considerably more detailed work.

Nevertheless, Phase 1 signed last week should be viewed as a positive first step in what will be a long (and quite possibly unsuccessful) process — as Chinese philosopher Lao-Tzu opined centuries ago. Encouragingly, however, despite deploying confrontational tactics and often tense negotiations, both countries appear to have concluded that the existing bilateral trade imbalance was unsustainable. Moreover, both sides seem to acknowledge that their own national interests would be advanced by reducing tensions and establishing a more viable long-term commercial relationship. More broadly, the ability to constructively seek solutions to difficult problems is encouraging, as the two nations will remain rivals in coming decades, and their interests will not always be aligned on security and foreign policy issues. One of the most remarkable (and surprising) aspects of Phase 1 was China’s willingness to make wide-ranging, largely unilateral concessions.

To be sure, efforts to reduce America’s overall trade deficit (not just its bilateral shortfall with China), to liberalise China’s domestic market, and to expand global trade would benefit both countries and the world economy. Investors would be encouraged at the prospect of halting the recent slide in global manufacturing, and the reduction of uncertainty and risk premia. Unfortunately, however, I believe Phase 1 is more likely to simply re-direct trade, rather than expand it. That is, any rise in US exports to China will come at the expense of other nations. That may not be important to President Trump, but it will be to financial markets. Therefore, I do not expect the agreement will alter significantly overall global growth prospects during the next 24 months, especially as the bulk of existing tariffs will remain in place. However, there will be winners and losers. As investors, it’s our job to identify them!

Will Phase 1 Reduce US Trade Deficit?

The centrepiece of Phase 1 is China’s pledge to lift imports of US goods and services by $200 billion during the next two years. Is this plausible, especially as China’s promise depends on favorable “market conditions”? In short, no. In 2017 (the baseline year), US exports of goods and services to China amounted to $186 billion. Certainly, American sales will not more than double in just two years, as they expanded only 9% annually during the last decade.

No doubt, China would not have made the promise, if they did not intend to make some progress. American farmers and energy producers should be winners in this accord. US agricultural exports to China have declined 60% in recent years, and sales could recover $15-20 billion by 2021 (compared to the $32 billion goal). Likewise, while a $52 billion gain in US energy exports appears wildly optimistic, an additional $15-20 billion is possible. Meanwhile, China’s service sector represents a huge opportunity for US exporters, and the inclusion of this key market in Phase 1 is encouraging. However, the promised $38 billion increase in purchases appears ambitious as they now amount to only $56 billion. An additional $10-15 billion is more plausible, with the financial sector the main beneficiary. Total likely gains amount to $50 billion compared to the $122 billion goal. Even this lower tally is optimistic, as China’s existing trade contracts with other countries may delay potential purchases of American commodities.

I am even less optimistic about boosting US manufacturing exports to China in the near term, let alone by the agreed $77 billion. The US economy is now operating at full capacity. The proposed $200 billion export expansion is equivalent to an additional stimulus of 0.5% of GDP per year, at precisely the wrong time in the economic cycle. One of two outcomes is likely. American firms could divert sales to China from other destinations. The Chart above illustrates that has already been happening during the two-year trade dispute. US sales to China have declined nearly 20%, while sales elsewhere have advanced a modest 4% per annum. American firms took advantage of opportunities in rapidly-growing Asian countries, but also redirected exports from China to other partners. Alternatively, stronger exports from a fully-employed economy will lead to higher US inflation. As a result, I expect the next move in US Federal Reserve monetary policy will be to hike interest rates, although this may not happen until next year.

Will the trade deal help shrink the swollen US trade deficit? Again, no. During the past two years, America’s overall external shortfall has risen by over $50 billion, despite a $25 billion decline in the bilateral gap with China. America’s foreign deficit reflects the nation’s low, falling savings rate, which has continued to produce double-digit import growth from non-Chinese partners during the past two years (Chart above). As Phase 1 does not impact US spending patterns, the world-wide deficit will continue to expand until American savings rise (e.g. the budget deficit is reduced). Continued swollen twin deficits suggest the US dollar’s rally is nearing its end.

The Chart above illustrates that trade uncertainty has led to a slump in US capex. As tariffs will remain largely in tact, and export growth will likely disappoint, business invesment will not recover quickly. Overall, I expect Phase 1 to add less than 0.25% annually to US GDP during the next two years.

Will Trade Deal End China’s Slump?

As I wrote last week, I believe the headwinds of deleveraging and the process of transitioning towards a service economy have played a larger role in China’s economic slowdown than the trade war (see previous blog). Indeed, the Chart above illustrates that rather than reducing leverage, borrowing continues to rise. Likewise, the next Chart shows that reform delays have led to slower productivity growth in China’s service sector, which is meant to be driving the economy. Even though the trade deal should reduce uncertainty and boost private sector capital spending, I expect Chinese domestic spending growth to decelerate further this year.

Meanwhile, despite the trade war, China’s external sector surprisingly has contributed positively to GDP growth in 2019, as imports declined more sharply than exports. In contrast, I expect China’s foreign sector to be a drag on growth in 2020. First of all, Phase 1 will lead to higher imports. And, even though exports to the USA may recover somewhat as tariffs are lowered, sales to the rest of the world should advance only modestly again this year, reflecting the weak global economy (next Chart shows exports to non-US markets rose only 2% in 2019). Overall, I anticipate Chinese GDP growth will slow towards 5% or below during the next 24 months.

Rising tariffs contributed to last year’s RMB depreciation (next Chart). The prospect of lower levies and the US decision to remove China from its list of currency manipulators has led to some FX recovery. And, Phase 1’s implementation may boost the RMB towards USD6.7 in the near term. Eventually, however, additional Chinese monetary and fiscal stimulus in reaction to weakening GDP growth will lead to renewed RMB weakness. I expect another test of the critical RMB/USD 7.0 level later this year.

Spillover to the Rest of the World

The following Chart reveals that the pain of the trade war has been felt widely, especially in key Asian and Emerging market economies.

What are some of the broader implications of China’s pledge to sharply boost imports from the USA? To be sure, any reduction in uncertainty would bring relief to Emerging markets in particular. However, the following Chart illustrates there may be winners and losers. First of all, observe that in addition to a sharp decline in the purchase of US products in 2019, Chinese imports from the rest of the world also slumped last year, reflecting weak Chinese demand overall (next Chart). It’s quite likely, therefore, that higher imports from America will come at the expense of other partners.

The following Chart helps identify some of the likely victims. Brazil and Australia would lose as US agriculture exports rise. OPEC and Russia would give ground to US energy suppliers. In the manufacturing sector, the European Union, Switzerland, Japan, and Korea potentially would be the big losers if China purchased additional US capital goods and autos.

The trade war has also begun redrawing global supply chains, especially throughout Asia. The earlier Chart illustrates that Chinese exports to Vietnam and other frontier Asian economies have been growing rapidly. To be sure, some of these products were simply re-exported, perhaps to the USA. More importantly, however, manufacturers (both Chinese and others) are relocating part of their manufacturing base to these low-cost locations in reaction to higher US tariffs on Chinese products. I expect this trend to continue, as US-China trade disputes will not be resolved quickly.

Strategic Implications

  • Phase 1 is a positive first step towards establishing a healthy, long-term bilateral relationship between the USA and China.
  • However, the deal may face legal challenges in coming months. Discriminating in favour of US products appears at odds with the WTO’s Most Favoured Nation principle. Discriminatory bilateral deals tend to divert trade, not expand it.
  • Additional Chinese purchases of US goods and services are likely to be half the headline-grabbing amounts, at best. I project US GDP will be boosted 0.25% annually or less in the next two years.
  • The bull case for financial markets will require a combination of additional Chinese market access and higher American savings, especially a reduction in the US budget deficit. This outcome is unlikely, particularly prior to this November’s US election.
  • The US Federal Reserve is likely to resume rate hikes by next year, if inflation accelerates.
  • Continued large US twin deficits will soon end the US dollar’s multi-year rally. America’s bilateral gap with China is likely to narrow further, but the shortfall with other partners will expands as exports are diverted.
  • Brazilian and Australian commodity producers will be losers. OPEC and Russian oil producers will lose ground to US competition.
  • European, Japanese, and Korean auto and capex suppliers will lose market share.
  • Reduced uncertainty will help Asian emerging markets in the near term. Moreover, the trend towards relocating manufacturing supply chains to low-cost Asian frontier economies will continue — Vietnam will be the largest beneficiary.
  • US trade negotiators may now turn more attention to the European Union. But, bilateral trade imbalances are small, and Europe will push back aggressively.