17 April 2018
As with any disputed relationship, there are three sides to every story: my version, their version, and the truth. So it is with the deepening Sino-American bilateral trade conflict. In order to reach a workable resolution to the current dispute (which I fully expect), policymakers on both sides need to consider the other’s perspective. Investors, likewise, need to diagnosis the issue correctly both to anticipate what policymakers may do, and how financial markets will react to whatever policy decisions may be implemented.
Despite the current confrontational posturing, both sides have huge vested interests in striking a deal, and easing tensions at least for now. The United States remains the biggest market in the world. US imports from China have increased 5-fold since China’s WTO accession in 2001, and the USA is China’s top market (see Chart above). Access to American technology will be a key ingredient to the next phase of China’s economic development. Meanwhile, China is the USA’s top trading partner overall (no.1 for imports/no.3 for exports). And it can be easy to lose sight of the scale of the future opportunity China represents. In 2017, for instance, the growth in China’s economy added over $1-trillion to the nation’s GDP. Just this incremental annual gain is roughly the size of the overall Mexican economy — the 15th largest in the world! From an US perspective, China’s annual gain was larger than the economy of every American state, except California, NY, and Texas (and more than the total output from the smallest 15 US states)! To be sure, the rivalry between these two economic heavyweights will only intensify in the future. Quite simply, however, there is too much is at stake not to resolve this dispute promptly.
China: It’s Not Me, It’s You!
Since China joined the WTO, the bilateral deficit between the two nations has surged from $83-billion to 375-billion in 2017, and China now represents nearly half of America’s overall external deficit compared to 20% earlier. In fact, as a percent of GDP, the shortfall with China has more than doubled, while it has actually declined with the rest of the world in this period since 2000. First of all, China correctly insists currency misalignment is not at the heart of the imbalance. To be sure, the Chart illustrates that a decade ago China did use an undervalued FX rate to support export-led growth. More recently, the real exchange rate has appreciated over 50%!
China, again correctly, contends America’s overall external deficit largely reflects macroeconomic imbalances in the US economy: specifically, the nation’s low-level of national savings. In fact, America’s paltry savings require that the nation run a current account deficit in order to attract the foreign capital needed to fuel its over-consumption. China has capitalised: supplying both imported goods to satisfy the seemingly insatiable US consumer and financing it in the form of over $1-trillion of purchases of US Treasury bonds.
The next Chart shows the US household savings rate is nearing record lows, reflecting consumer confidence and rising asset values. In fact, the current account deficit would have been even larger in recent years, had it not been for the improvement in US public finances. However, with the US government budget deficit expected to expand towards 5% of GDP during the next two years, the current account deficit could swell to over 4% of GDP (2.5% in 2017). Therefore, even if the Trump Administration succeeds in reducing the bilateral imbalance with China, the overall deficit will grow until America lifts its savings rate. The twin deficits are set to grow.
China also argues that the absence of export opportunities is not the key factor in the bilateral imbalance. Indeed, China’s overall external surplus is only 2% of GDP, and China runs deficits with many large, important countries. China’s industrial emergence has relied heavily upon imported capital equipment from Japan, Germany, Korea, Switzerland, and Taiwan. Likewise, resource-rich Brazil and Australia also enjoy surpluses with China. These countries, China asserts, supply the products that were needed to fuel its industrial renaissance.
The sectoral breakdown of trade between the two nations is revealing. Nearly 50% of US exports to China are in the relatively slow-growing sectors of food, fuels, metals, and basic materials. Indeed, with the exceptions of aerospace, autos, and some capital goods, American products have not exploited the potential of the Chinese market as Asian/European equipment suppliers have achieved. On the other hand, American imports from China are in expanding, high value-added sectors, e.g. computers, cell phones, telecom equipment, apparel, household appliances, etc. As an example, aerospace ($25-billion) and soybean ($12-billion or 10% of total sales) are among America’s top exports to China, while China exports computers ($75-billion), cell phones ($70-billion), and household appliances ($60-billion).
These patterns reveal that a large part of the bilateral imbalance reflects each nation’s role in the global supply chain that has developed in recent decades. Put simply, the USA designs and consumes desirable manufactured goods, while China has been the assembly factory for these craved products. The following Chart illustrates one way this has impacted trade flows. As Asian nations/firms have relocated the assembly of manufactured products to low-cost China, nearly 60% of American imports of Asian manufactured goods now comes from China compared to less than 10% in 1990.
Much of the value-added of these products is actually Japanese, Taiwanese or Korean, but are recorded as US imports from China. As these supply chains developed, America’s imports from China have risen from 8% to 20% of overall US purchases from abroad; meanwhile, the share of imports from Japan and Taiwan has declined from 13% to 7%. This suggests that as much as half of the swing in the US-China bilateral imbalance has resulted solely from altered supply chains between China and its two Asian neighbours! The computer industry — America’s top import from China –is illustrative. Since 2000, the Japan’s share of the US computer market has declined from 20% to 3%, while China’s share has risen from 12% to a staggering 60% (even though some of these will be HP, Dell, and Japanese branded)!
The OECD has estimated the impact of these supply chain shifts on recorded US trade flows. For example, what happens if US import data only reflected the value-added of the assembly of these products in China, and excluded the value of the intermediate goods/product design that came into China from other countries (including the USA)? The following chart suggests that the bilateral deficit would decline by over 30% if calculated on this type of value-added basis (note the same pattern within the NAFTA supply chain).
Can Trump Pry Open China’s Markets?
So, while it may be true that US over-consumption and shifting global supply chains help explain the Sino-American bilateral trade imbalance, so too does the high degree of protectionism of China’s domestic market. While not a perfect metric, the ratio of US exports/imports of goods with China is the lowest of major countries, suggesting China enjoys greater access to the US market than is reciprocated. And, this gap can not be explained simply by China’s lower income level, as India and other developing countries have higher readings. If China’s ratio was in line with the US average, for example, the bilateral deficit would be over $200bn lower (over 50%).
The is true also for the trade in services where the US enjoys a considerable comparative advantage world-wide (recording a global surplus of $243bn last year). And, even though US service exports to China have surged 11-fold since 2000, the following Chart illustrates that the penetration of US services into the Chinese market lags its access elsewhere. To be sure, China’s relatively low incomes are a partial explanation, but again other developing nations do better. In addition, China’s consumption of crucial US business services (info tech, intellectual property, and finance) is well below its peers. This will be a crucial issue, as China’s consumption of services will be a key growth sector. Even lifting this ratio to India/Brazil’s level would add $60bn to US service exports (reducing the bilateral deficit by 1/6th).
To be sure, Chinese tariffs remain higher than elsewhere, although they have been halved since WTO accession (unfortunately these levies have not declined much in the past decade). However, the bigger issue is the myriad of non-tariff barriers restricting imports, which seem at odds with the WTO’s principles of nondiscrimination/national treatment (foreign products/firms should enjoy the same regulatory treatment as domestic equivalents). These needs correcting!
Determining whether China is a non-market economy (NME) is now being hotly debated, as its current NME status provides the USA various WTO grievance remedies which otherwise would not be available. Currently, roughly 30% of sales and 20% of employment is in Chinese state-owned enterprises (SOE) compared to roughly half these levels in the other BRICS. SOE assets also represent 145% of GDP — again twice the other BRICs. In France, where SOEs still remain prevalent, asset/GDP is 40%. SOE reform is a key priority, especially as these firms are often unprofitable and highly indebted. The success of these reforms has been patchy, and the US focuses more on the subsidies provided, and the market distortions caused by excess capacity, etc. At any rate, it seems premature to lift China’s WTO NME status.
Not surprisingly, treatment of intellectual property and the requirement to transfer technology to Chinese firms to gain market access is a major issue with both the US and other trading partners. The National Bureau of Asia Research estimates pirated US goods and services cost US firms $50bn annually (they suggest that up to 90% of software sold in China is illicit). Of even greater importance, the NBAR suggests that trade theft and technology transfer may cost American companies over $200bn annually (1% of GDP). This is another crucial issue, although President Trump’s concern about technology transfer is rather ironic, as it largely impacts US direct investments in China — something he wants to reduce!
Despite China’s need for advanced technology, the transfer requirement is one of many impediments to greater direct investment between these two economic giants. To date, foreign direct investment (in both directions) has been remarkably modest, but has the potential to expand greatly. To be sure, China has made progress in liberalising its FDI regime; but, it remains still one of the world’s most restrictive. Nevertheless, the stock of FDI into China totals $3-trillion (although the pace of inflows has cooled in recent years), or 25% of GDP. However, the USA accounts for only $100bn, or 3% of this total. By stark contrast, US FDI into tiny Ireland and the Netherlands stands at $400bn and $850bn respectively. Meanwhile, the USA has not been a major destination for Chinese FDI –totaling less than $30bn (of China’s $1.5-trillion FDI abroad). China’s priority appears to center on the One Belt One Road initiative. Since the program’s 2013 launch, China’s FDI abroad has surged by nearly $1-trillion.
China: They’ll Never Change!
China’s critics in the USA suggest it was always naive to expect WTO membership would alter China’s behaviour and acceptance of the organisation’s market principles. Consequently, they predict the current conflict will not end well. This is false. To be sure, China is not a Jeffersonian democracy (indeed, political liberalisation has lagged economic progress in many successful Asian nations) , but they have often been willing to dramatically change course when it is in their interest and when confronted by international pressure.
- I have already pointed out the reduction in tariffs and FDI restrictions since 2001. More can and must be done, but the direction of travel is clear.
- In 2007, likewise, China had a current account surplus of 10% of GDP. In response to foreign pressure, the RMB has appreciated over 50%, and the surplus is now 2% of GDP.
- As part of that effort, China recognised it needed to reduce the role of exports/industry and raise the share of output in services/domestic spending. The Chart shows the progress.
- WTO principles are not compatible with large state sectors. China is responding (see chart). It is true that China takes a long-term view of this process, which will cause problems with Twitter-driven policy making (as Rex Tillerson discovered). The current “Made In China 2025” program does seem at odds the WTO norms of non-discrimination and national treatment. But, so too does “America First”!!
Strategic Implications
- There is much room for compromise, and it is in the interest of both to do so. I am optimistic a face-saving deal will be reached prior to the US mid-term election.
- Without progress in encouraging US savings, however, efforts to boost American exports to China will have no impact on the overall US trade deficit — even if the shortfall with China declines. Rather, larger US budget deficits will reduce national savings. Swollen twin deficits will be a headwind for the US dollar. The mega-bull case for equities would be a trade deal aim higher American savings — this is unlikely.
- With the US economy near full employment, stronger exports to China would contribute to higher inflation unless the savings rate rises. This adds to risks to the US bond market. Alternatively, if negotiations fail, the imposition of higher tariffs would also stoke inflation, and heighten downside economic risks.
- A trade deal would support my over-weight position in Asian equities. The Trump administration may eventually turn attention to other Asian nations with large external surpluses. It seems, however, the President’s bark is worse than its bite: Witness the back-pedalling on both the TPP and the steel/aluminium tariffs.