A Sino Trade Curveball

Ivan Martchev  |

Image: iStock.com/Goldcastle7

I do not believe the stock market expected the recent reneging of the trade deal by the Chinese, due to the overselling of progress in the trade deal by president Trump and some of his administration officials. That the Chinese would come back in late April to renegotiate terms that they had agreed to in January and February is not surprising. It is the number of terms that they wanted to renegotiate that raises eyebrows. Virtually every major concession they had made for the previous three months was suddenly off the table: Forced transfer of technology, changing of Chinese laws to protect foreign intellectual property and the increased purchases by Chinese state buyers to be sourced from the U.S. – all are suddenly in limbo.

The conclusion one could draw from this is that the Chinese never wanted to make a trade deal but only buy time while they dealt with their domestic economic problems. Or, as Mr. Trump so eloquently put it in his relentless Twitter diatribes: “I think that China felt they were being beaten so badly in the recent negotiation that they may as well wait around for the next election, 2020, to see if they could get lucky & have a Democrat win, in which case they would continue to rip-off the USA for $500 Billion a year…”

To be fair, both Democratic and Republican administrations are to blame for letting China play this clever game of purposefully buying more from their neighbors and key trading partners, to increase political influence, while buying less from the United States – because they could get away with it. That game is up as there is a new sheriff in town and he is not respecting old arrangements. His name is Donald Trump.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The biggest current account deficit as a percentage of GDP that we have seen in recent years is 6% during the George W. Bush administration. That coincided with oil going to $150 and U.S. crude oil production at multi-decade lows. Back then, if the U.S. economy grew and crude oil production fell, the trade deficit grew, as we had to import the oil. But crude oil production has tripled since 2008 due to the shale boom, so the overall trade deficit has shrunk from 6% of GDP to 2.4%, but oil is only part of the problem.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

As the overall trade deficit has shrunk as a percentage of GDP, the U.S. bilateral trade deficit with China has exploded. China is the biggest driver of the overall U.S. trade deficit as the U.S. economy grows – GDP is up 50% since 2008. Many electronic goods, like HDTVs and iPhones, are no longer made in the U.S., so our imports from China grow. If China does not divert their army of state buyers to buy more from the U.S., as they have been doing for at least 15-20 years, the trade deficit is guaranteed to expand.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I think that the trade deal can still be saved, but I also believe that the Trump administration oversold its progress. Up until a couple of weeks ago, officials described it as “90% done,” or “on the 5-yard line.” On the other hand, I also believe it is plausible that they were misled by China, who agreed on a number of key concessions and in a calculated manner reneged on them in order to see if they can get away with it.

Not with a President like Donald Trump, they can’t.

A Hard Landing in China is a Matter of When, Not If

I have been amazed at the ability of Chinese authorities to arrest any economic downturn. I am beginning to think the Chinese government thinks that they can eliminate the economic cycle and fuel a perpetual economic expansion. I do not believe that they can do that, but I do believe they believe they can do it.

Every time the Chinese economy weakens, Beijing injects new loans via lending quotas, reserve ratio cuts for banks and other interventions. (In late 1993, they devalued the yuan to the tune of 34% in one move.)

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

These aggressive monetarist interventions in the Chinese economy have helped create one of the biggest credit bubbles the world has ever seen. As the Chinese economy has grown from a little over $1 trillion in the year 2000 to over $13 trillion in 2018, the total value of credit in the Chinese financial system has increased over 40-fold (to 300%+ of GDP), if one counts their infamous shadow banking system.

Amid this high level of indebtedness, a major trade war can cause their credit bubble to burst. This is why I believe the Chinese have every incentive to make a trade deal. Watch the value of the Chinese yuan, which weakened notably to close at 6.84 last Friday, and the level of foreign exchange reserve outflows, which resumed in April. A major escalation in trade-talk rhetoric can turn this trade conflict into a major economic event for China. It’s not too late to save the deal, but a lot can change in the next six months.

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