According to President Trump, “trade wars are good, and easy to win.” This controversial hypothesis is currently being put to the test, as the U.S. has become engaged in its biggest trade dispute since the Great Depression.
Trade War 2018… So Far
In the first six months of 2018, the United States and its trading partners put new tariffs on $165 billion worth of foreign goods. Then, on July 6, the U.S. hit an additional $34 billion worth of Chinese imports with 25% tariffs. Auto parts, electronic components, jet-engine parts, and machinery were among the goods targeted.
President Trump warned China not to retaliate, but Beijing paid him no mind. China’s State Council swiftly slapped tariffs on $34 billion worth of U.S. goods, most notably agricultural exports. China accused President Trump of “launching the largest trade war in economic history,” and said they would continue to retaliate, tit-for-tat.
Five days later, the U.S. escalated things further by announcing that another $200 billion worth of Chinese goods will be hit with 10% tariffs. This caused Li Chenggang, an assistant minister of commerce for the Chinese government, to liken Trump to a “bull in a china shop.”
Now the U.S. president is threatening to raise tariffs on all $500 billion worth of China’s exports to the United States. The trade war is heating up, and chances are it’s going to get a whole lot hotter before things cool down.
Why Launch a Trade War?
“Trade wars are almost without exception a desperate measure taken by an ailing economy,” according to Egon von Greyerz, founder and managing partner of Matterhorn Asset Management. “A trade war, especially between the two biggest nations in the world will indisputably lead to a downturn in world trade and therefore also a major global economic downturn.”
But there are experts who believe the U.S. can win a trade war with China.
Mohamed A. El-Erian, best known as CEO of PIMCO from 2007-14, acknowledges that a prolonged trade war between the United States and China would be painful for both countries. But he also says that the U.S. has less dependency on foreign markets, deeper domestic markets, and a generally more resilient economy. Thus, in his view, the U.S. “would do better than most others in a contracting world economy,” and that might mean victory in a trade war with China.
What would a victory for the U.S. mean?
“Trump started the trade war for facilitating free trade with China,” according to Katy Puiman Chan, writing for Mises Wire. She believes that Trump’s tariffs are “a temporary measure in a long game for the ‘greater good’ of the free market.”
Mr. El-Erian cites China’s “intellectual property theft, asymmetrical technology transfers, and non-tariff barriers” like requiring U.S. firms to form joint-ventures with Chinese companies in order to do business in China, as “genuine trade grievances” on the part of the United States. China also taxes its citizens as much as 30% when they purchase automobiles made in the USA, while the U.S. caps automobile tariffs at 2.5%.
A trade-war victory for the United States would force China to lower its trade barriers, creating a fairer playing field and freer overall trade.
Trade War Risks
El-Erian thinks the trade war with China could lead to a “Reagan moment” for President Trump. He likens Trump’s escalation of tariffs against China to Reagan’s acceleration of the arms race with the Soviet Union. The latter is considered to have bankrupted the USSR, whereas the former could cause China’s Communist Party to throw in the towel and declare fair, reciprocal trade with the U.S.
“Like under Reagan, the U.S. is better placed to win the current competition with China,” according to El-Erian, “but the risks are sizable.”
Those risks include causing another event like the Great Depression, since the original was sparked by the protectionist Smoot-Hawley tariffs. But there are geopolitical concerns, too, such as the rise of Chinese nationalism and China forming stronger alliances with Russia and Iran to consider.
Thus far, the U.S. stock market hasn’t been very considerate of any risks.
The Market’s Response… So Far
Trade fears slammed global markets in the first seven months of 2018, but U.S. stocks have been resilient amid the trade war thus far. As of July 21, China’s Shanghai Composite had lost 14.45% in 2018, whereas the S&P 500 was up 4.80%.
Mark Rosenberg, CEO of GeoQuant, thinks market participants are making a mistake by “treating the trade dispute as cheap talk.” His firm uses artificial intelligence to project geopolitical developments and their impacts on markets, and he feels there’s “going to be some concrete damage” before it’s all said and done.
UBS analysts don’t necessarily agree with Mr. Rosenberg that damage is inevitable, but they do believe things could get bad if the relationship between the U.S. and China deteriorates further.
In a report, UBS said the S&P 500 could lose 20% if the U.S. and China slap 30% taxes on each other’s goods and global auto tariffs are levied. But Keith Parker, UBS’s chief U.S. equity strategist, thinks markets are “ascribing a very low probability” of a worst-case scenario because “there’s too much at stake on both sides.”
Is the Stock Market Wrong?
The bond market disagrees with the stock market, and its trading action indicates that a recession may be on the way.
The spread between the yields on 2- and 10-year U.S. Treasurys has been steadily contracting and last week tightened to 25 basis points, making for the flattest yield curve since July 2007. Flattened or inverted yield curves often predict recessions, and the July 2007 flattening portended the Great Recession that started five months later.
Meanwhile, Main Street business owners are less sanguine than Wall Street stock traders. The University of Michigan’s latest survey, released July 13, showed a sharp deterioration of business expectations. Negative responses about government policies tied their all-time low, last reached during the 2013 government shutdown.
U.S. business owners expect or are already experiencing pain from the trade war. While stock traders can quickly move out of their paper assets if tensions between the U.S. and China get too-hot-for-comfort, business owners don’t have the same luxury. They need to budget and plan, and the uncertainty of the trade war makes that impossible.
Businesses scaling back capital investment in anticipation of a weakening economy can work like a self-fulfilling prophecy. But few pundits have suggested a trade war with China would be pain-free. The question is: Can the U.S. really win?
Who Has the Leverage?
From the Trump perspective, the U.S. has been victimized by “unfair trade” with China for years. Trump, in this view, didn’t start the trade war with China – he’s just the first U.S. president to stand up and fight back.
The Trump objective is to reduce or eliminate the trade deficit between the U.S. and China. He believes having a trade deficit means the U.S. is “losing” in its trade with China. “We’re down a tremendous amount,” he told CNBC, referring to the trade deficit, on July 20.
Trump thinks the trade deficit is the result of China assessing higher tariffs on imports from the U.S. than the U.S. charges on its imports from China. He hopes that by raising tariffs on Chinese goods, China’s producers will feel economic pain and urge their political leadership to submit to the U.S.’s demands for freer, fairer trade.
But this strategy can only work if China needs the U.S. more than the U.S. needs China.
Does the U.S. Have Leverage on China?
In 2016, the U.S. imported $462.6 billion worth of Chinese goods, whereas China only imported $115.6 billion worth of American goods. Obviously, the U.S. is a more lucrative market for China’s producers than the other way around.
But China’s producers have plenty of other markets for their wares. The country’s trade with Arab nations, to cite just one example, grew from $145 billion in 2010 to $250 billion in 2014, and is still rising. China is the largest exporter to the Middle East and North Africa, and its grandiose Belt and Road Initiative will connect western China to the Mediterranean, facilitating even more trade.
According to Alasdair Macleod, China will eventually have trade agreements with the rest of the world, excluding the United States and European Union. The size of the world market, ex- U.S & EU, is $70 trillion, out of a world total of $125 trillion.
Chinese officials have downplayed the trade war’s potential impact on their nation’s $12 trillion domestic economy. Ma Jun, an economist and member of the PBOC’s monetary policy committee, forecasts that $50 billion worth of U.S. tariffs would dent China’s economic growth by just 0.2 percentage point.
The idea that the U.S. has leverage on China is premised on the notion that China benefits more from trade between the two countries than the United States does. President Trump is putting this notion to the test.
Does China Have Leverage on the U.S.?
Our trade deficit with China is their trade surplus with us. This means Chinese producers sell U.S. consumers more goods than Chinese consumers purchase from U.S. producers.
In 2016, Americans purchased $462.2 billion worth of Chinese goods. In return, China spent just $115.6 billion on U.S. goods, resulting it a $346.6 billion trade deficit for the U.S., and a $346.6 billion trade surplus for China. To China, this is surplus cash in the form of U.S. dollars.
One of the things China does with this surplus cash is purchase U.S. Treasury bonds. These, of course, are bonds issued by the U.S. federal government to cover the shortfall between the taxes it collects and the money it spends. Thus, our trade deficit with China helps fund the budget deficit of our federal government.
As a result of the U.S.’s long-running trade and budget deficits, China owns a staggering $1.17 trillion worth of U.S. government bonds. If China decided to sell these bonds, it would cause interest rates in the U.S. to soar and wreak havoc on global financial markets.
Mohamed A. El-Erian admits that China holds a “massive volume” of U.S. Treasury bonds and, “if pushed too hard,” China could sell the bonds and imperil the health of the entire global financial system.
But selling its hoard of U.S. bonds would pose risks for China, too. Doing so would weaken the U.S. dollar and strengthen the Chinese yuan, which would help reduce the U.S.’s trade deficit with China. Katy Puiman Chan says “this is exactly what I would like to see if I were Trump.”
Which Country is in Better Fiscal Shape?
China’s domestic economy is loaded with debt. Its domestic stock and real estate markets are in bubbles. While the U.S.’s fiscal health is nothing to boast of, China’s less well-established economy may be on even shakier ground, and this could make China the first to tap out in the trade fight.
China’s total debt has soared from 141% of GDP in 2008 to 256% of GDP in 2017. This total debt includes money borrowed by China’s government, businesses, and households.
It’s certainly not a healthy sign that China’s debt-to-GDP ratio has surged so much in such a short time; and as a “middle income” country, China’s debt-to-GDP shouldn’t be as high as the ratios of developed economies like the U.S., U.K., and Italy. But to put things in perspective, U.S. total debt is 370% of GDP; much higher than China’s in both relative and absolute terms.
Moreover, China’s household and government debt levels are comparatively low. The largest chunk of Chinese debts can be found on corporate balance sheets, with Chinese corporate debt at 163% of GDP in 2017. While this doesn’t mean China’s record debt levels are nothing to worry about, it does mean that the country’s fiscal situation is a lot different from the U.S.’s on the eve of 2007’s Great Recession.
Meanwhile, China’s reported gold hoard is second only to Russia’s in size, and China is the largest foreign holder of U.S. Treasury bonds in the world. While many analysts believe China’s domestic economy is in a bubble, the fact is that China has gold and IOU’s undergirding its financial house of cards, whereas the U.S. has nothing.
China Says It’s Ready for War
For its part, China’s Communist Party leadership says it’s ready for a full-bore trade war. Communist leadership referred to Trump’s actions as “trade bullying,” which has forced them to “strike back.”
China’s retaliation so far has been targeted at U.S. farmers, which has resulted in U.S. soybean prices falling to their lowest levels in a decade. This might be good for the tiny population of U.S. vegans, but it could be deadly for American farmers, who are already facing staggeringly high suicide rates.
Farmers are a source of support for President Trump, but that might not be the case again in 2020 if they continue to struggle – and losing their support could result in first Congress, and then the White House, falling under control of an increasingly hard-left Democrat Party.
“As a competent dictatorship, [China] can decide to do things and then do them,” says Lew Rockwell columnist Fred Reed. “America often seems unable to do either.”
Trump’s antagonism of China is pushing China closer to Russia and Iran, in direct opposition to the stated goals of the National Security Strategy he unveiled in 2017. Meanwhile, Trump’s attempts to make nice with Russia also contradict the tone and spirit of his own NSS.
The haphazardness of Trump’s recent actions underscore division within his administration and the U.S. government in general, whereas China’s uncontested one-party state allows its leaders to act more boldly and to stay the course. China’s leaders don’t have to fear the results of midterm elections whenever their citizens feel a tinge of economic pain, and this could be a critical difference in the ongoing trade war.
Trump’s Gorbachev Moment?
It could be that China needs the few items it imports from U.S. more than its leaders admit; or that the nation’s indebted business sector will be unable to sustain the pain of losing American customers. In either case, Trump’s trade-war gambit might work, and China’s Communist Party could be forced to lower trade barriers or face the wrath of its populace.
But Trump’s trade war is not without its risks. Indeed, the dollar’s status as reserve currency of the world may be in danger. This could flip Trump’s “Reagan moment” into a USSR-style collapse for the United States and an end to its status as global superpower. As Mohamed A. El-Erian said, “the risks are sizable.”