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Inside China 27 March 2018

Trade war: cool heads are required (Erratum)

Jeremy Stevens

A trade war is in the making. Washington is talking things up; Beijing is playing them down. Behind the scenes, however, talks covering a wide range of areas, including financial services and manufacturing, are underway between Liu He – the most important economic policymaker in China – and US Treasury Secretary Steven Mnuchin and trade representative Robert Lighthizer.

The US and China could therefore reach an agreement, and avoid a trade war.

So far, the US has demanded (i) a reduction in Chinese tariffs on automobiles; (ii) increased Chinese purchases of semiconductors; and (iii) improved access to China’s financial sector. China has taken a mostly placatory stance, offering to buy more semiconductors, at the expense of South Korea and Taiwan. Also, China aims to announce before May that foreign financial groups may take majority stakes in securities firms.

A trade war would hurt China proportionately more than the US, given that China relies much more on the US market than vice versa. The total export value of steel and aluminum from China to US amounted to less than 1% of China’s sales to the US last year. Reducing net trade with the US by USD10bn would shave roughly 0.1pps off growth in 2018. Reducing exports to the US by 10% would reduce the deficit by around USD43bn and reduce growth by 0.38pps. And, if Trump can reduce the deficit by USD100bn, US growth could slow by as much as 0.8pps. 

China’s trade surplus with the US has surged at an average growth rate of around 8.3% y/y over the past decade, from USD143bn in 2009 to USD277bn in 2018. That said, as a share of China’s GDP, it has fallen from 2.8% to 2.4% over the last 10 years.

China’s exports of electronic goods, such as telephones, TVs, computers and so on have grown to tens of billions of USD each year. In fact, sales to the US account for nearly 20% of China’s total annual exports. Even though China purchases significant volumes of soybeans, aeroplanes, motor cars and electronic integrated circuits from the US each year, China’s overall imports are dwarfed by its exports.

It is against this backdrop that Trump’s campaign promise to “cut US trade deficits with China” is benchmarked; he will be more hawkish now given that midterm elections are approaching. Steel and solar panels are merely the opening salvo. Trump has invoked Section 301 to investigate alleged Chinese violations of intellectual property rights. A bad review means that further Chinese exported products, including machinery and electrical products, would be eligible for tariffs. And, China’s Ministry of Commerce has already drawn up plans for retaliatory tariffs.

Already, relations are frosty: the Trump administration ended the Comprehensive Economic Dialogue with China last year. A ban on exports of hi-tech products to China remains in place. Criticism about China’s lax patent protection is rife. The US regularly launches anti-dumping complaints against China.

Trump’s administration will have to go harder on the deficit because it was central in justifying the tax cuts. In fact, USD1.74 trillion of tax cuts over the next 10 years are expected to be filled by trade policy (see Appendix further down). In reality, eliminating a trade deficit does not automatically result in an equitable increase in GDP, which is what Trump’s advisors seem to believe.

However, flawed and mercantilist policies foretell of a more material chasm ahead. In recent weeks, the Party’s grip on society, the military and the economy has tightened. It seems that the leadership believes that the Party is best placed to oversee important issues such as reducing leverage, financial de-risking, ensuring finance serves the real economy and aids industrial policy, environmental protection and rejuvenation, the property market, excess supply and overcapacity, reforming SOEs, and so on. 

The Party also recognizes – as evidenced by the “Made in China 2025” plan – that China needs to shift from “made in China” to “designed in China”. Future China is about artificial intelligence, big data, drones, driverless-cars, facial recognition and voice technology, online education, machine learning and virtual reality. Therefore, the most important goal for future China (and the Party) will be to (i) create incentives, the financial arteries and regulatory scaffolding to enable large private companies to drive innovation in China and create jobs; (ii) bring such companies under the control of the Party – directly or indirectly; and (iii) ensure that the wealth they create is captured on the Mainland.

This is unlikely to unfold in a market-friendly manner, and may involve what other players consider “anti-competitive behavior”. Remember, China treats markets and companies as tools of national policy. To the Party, business needs to be part of the larger national strategy – to be shaped, encouraged, and used as means of assuring national goals. Indeed, this placed into sharp focus an institution like the Committee on Foreign Investment in the US (CFIUS). CFIUS, which can block inward investments, is a mix of national security and economic agencies. As sentiment on China worsens, issues around national security tend to upstage the economic ones.

Appendix: Trumps trade policy and tax cuts make no sense

The Trump administration claims that eliminating a USD500 billion trade deficit would lead to a USD500bn increase in GDP and, from that:  

  • Assuming that labour is 44% of GDP, eliminating the deficit would result in USD220bn of wages, and tax revenues of USD61.6bn.
  • Businesses would earn at least a 15% profit margin on the USD500bn, translating into pre-tax profits of USD75bn and USD11.25bn of taxes.
  • If businesses pay out one third of this profit as dividends, which are taxed at 18%, a further USD3.8bn would accrue.
  • Reinvesting USD42.5bn would generate a further USD120bn of pre-tax profits and taxes of USD18bn over the standard 10-year budget window.
  • They have applied an inflation factor of 1.1082; and a multiplier of 1.0 which produces a grand total from trade of USD1.74trn of additional Federal tax revenues.

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