And they sold in May

With a stroke of a tweet, risk aversion dominated financial markets for the better part of May. US-China trade negotiations failed to secure a deal and tariffs were raised on US$200 billion worth of Chinese imports from 10% to 25%. The process of formalising 25% tariffs on a further US$300 billion worth of Chinese imports is now underway and might be enforced as quickly as end June if a deal cannot be inked.

The conflict extended beyond the realm of physical trade into the technology space, with the US choosing to weaponise its high-tech exports. Under the banner of national security, the US Commerce Department stamped Huawei - the crown jewel of Chinese hi-tech manufacturing - on their export blacklist, preventing the telecommunications maker from buying US parts and technologies without permission from Washington. This policy was clearly aimed at choking off Huawei’s access to key US technology instrumental in their production, thereby inflicting a supply shock on their business.

US business uproar was loud and swift, leading to a softening of the rules. A transition period was granted to allow US suppliers to adjust to the ban while the prohibition of Huawei sales in the US was enforced with immediate effect. The export blacklist is expected to grow since the announcement of the Huawei ban.

Companies like Broadcom, which supply to Huawei, have already revised down their earnings guidance on the back of trade tensions.

China fights back

Not one to sit around, China responded with their own set of targeted tariffs on US imports, aimed primarily at hurting businesses in red states, the key source of President Trump’s political legitimacy and support.

President Xi Jinping had also made a rare public visit to China’s rare earths mining base in the landlocked province of Jiangxi in a not-so-subtle signal to the US that they too can play the export restrictions game. As the world’s leading producer of processed minerals which are essential in the production of high-tech goods such as computer chips, electric cars and wind turbines, China holds immense leverage. This is especially considering that the US derives 80% of its rare earths supply from China.

President Xi’s visit to the Jiangxi province bore historical import as well. The province was the starting point of the 1934-1935 Long March, a 6,000km-long military retreat by the Red Army - the forerunner of the People's Liberation Army - that took more than a year and would ultimately lead to the ousting of the Kuomintang nationalists from China 15 years later. Decades after this significant event, President Xi would find himself calling for “a new Long March” against foreign challengers, reminding the proud nation of the painful and long-drawn struggles their ancestors endured during China’s formative years. It was a rallying cry for the Chinese people to unite in the face of a possibly long-drawn struggle against the US, which seems focussed on undermining their economic power.

The anti-US sentiment has hardened in recent weeks with anti-American movies making a comeback on public television. For instance, China’s state film channel began re-running the 1956 movie “Shangganling”, based on a real battle in late 1952 when lightly armed Chinese troops successfully defended a mountain ridge against American and South Korean forces. Despite suffering terrible casualties during the weeks-long campaign, the Chinese were victorious at the end, painting an image of rewarding resilience in the face of adversity.

Short-term pain for long-term benefits seems to be the central message by Chinese leaders. Indeed, rhetoric from Chinese officials seem to indicate that they may be hunkering down for a long-drawn conflict. From a political standpoint, perhaps no deal may be better than a bad one. Political resolve is one thing, but such determination would be for naught if the Chinese economy trembles under the weight of the US’ restrictive economic policies. This begs the question: Does China have the economic wherewithal to endure a long-drawn struggle against the US?

Finding resilience in policy flexibility

Tariffs on Chinese exports are a huge burden for sure, but this would have been a bigger problem in the past given that China has rebalanced its economy somewhat away from trade. The value of total trade as proportion of GDP has fallen from more than 50% in the mid-2000s to about 34% in recent years. While exports to the US accounts for one-fifth of the total value of exports, it forms about 4% of China’s GDP. There’s little doubt that the direct impact from tariffs will hurt exports and therefore pinch growth in the near term, but it is unlikely to be catastrophic for the economy. Yet, the secondary effects on supply chains and business sentiment could still weigh heavily on growth as well. These effects should not be underestimated.

Fortunately, China has numerous policy levers to help support near-term growth. As it stands, monetary and fiscal policy actions undertaken last year during the height of trade tensions had led to a broad stabilisation of the economy. Stimulus efforts will likely continue in the face of fresh challenges. The governor of the People’s Bank of China had also said that the central bank has “tremendous” room to adjust monetary policy via liquidity channels, interest rates and reserve requirement ratios should the trade war deepen. There is little doubt that the state apparatus will pull every lever in the monetary and fiscal policy toolkit to engineer a soft landing should trade tensions escalate dramatically.

A managed depreciation of the yuan against the US Dollar will also make Chinese exports cheaper in US Dollar terms, offsetting somewhat a part of the tariff increase. A broad weakening of the currency against other trade partners will boost exports in those regions as well. Cognisant of the debt bubble, China will likely favour fiscal efforts in the form of tax cuts and increased infrastructure spending to prop up growth, as opposed to loosening the credit and liquidity tap too much. However, solving the debt bubble will likely take a back seat should trade tensions worsen further. Should China’s domestic equity markets flounder on the weight of these tensions, state-linked funds are largely expected to offer some downside support as was the case in March.

The upshot is China has the flexibility in the policy space to respond to rising trade pressures. But these are just near-term stabilisers. Long-term development, growth and stability ideally require peace with the US on the trade front.

Waiting for a new president?

In an administration decked with many admitted China hawks and with the US Presidential election closing in, one could make the case that China intended to wait out the storm, in hopes that a new Presidential administration may offer a softer stance.

However, they would be mistaken in this regard especially given that taking on China on strategic issues share bipartisan support in the US Congress. One need only read the slew of public statements by Democratic leaders to glean that there is a strong desire to renegotiate trade relations with the country. They may voice disapproval at Mr Trump’s methods, but they approve the eventual goal. It does seem like this conflict was a long time coming.

US’ view

The US-China conflict in its current form may well be one that was 19 years in the making, ever since then-President Bill Clinton made the case for endorsing China’s bid to be a member of the World Trade Organisation (WTO).

In a lengthy speech delivered at the Johns Hopkins University on 9 March 2000, President Clinton said “By joining the WTO, China is not simply agreeing to import more of our products; it is agreeing to import one of democracy’s most cherished values: economic freedom. The more China liberalises its economy, the more fully it will liberalise the potential of its people – their initiative, their imagination, their remarkable spirit of enterprise. And when individuals have the power, not just to dream but to realise their dreams, they will demand a greater say.”

That economic progress would necessarily lead to a democratic government was always political fantasy. 19 years later, central leadership in China has never been stronger. China is no less communist than the US is democratic. The benefits of free trade and a more open economy have improved their economic state but has done little to change their political one. Indeed, President Xi has consolidated control and tightened his grip over the communist party, with some political observers naming him the most powerful Chinese leader since Chairman Mao. All these years later, supporting China’s bid to join the WTO has not reaped the political results that the Clinton administration had hoped and supported.

With China injecting serious investments into building up its technology sector in a bid to scale up the production ladder, the contest for global economic power inevitably enters the picture. There are valid concerns for sure in terms of allegations of intellectual property theft, forced technology transfer and spying efforts which, in the US’ view, have unfairly benefitted their Chinese rival and pose a credible strategic threat. These are issues they should rightly bring against China and seek an amicable resolution. Alas, when such issues are conflated with other political considerations, trade becomes but a veil for a strategic battle for economic supremacy.

Challenging China on this front share wide public support. Indeed, a recent poll by Pew Research showed that most American respondents were more concerned about China’s economic strength as opposed to its rising military might. Many also view China unfavourably. Not only is challenging China a bipartisan issue, it shares much public support as well.

Hence, there is arguably great political capital in taking on what the US has always viewed as a strategic rival. Coming into an election year, one could not ask for better optics than a strong man muscling his opponent into submission.

Ready for battle too

On the economic front, the US looks well positioned to ride through President Trump’s tariff predilections. From the outset, the US economy is primarily consumption-driven, with household spending accounting for about 70% of US GDP. Hence, retaliatory tariffs on US exports by China will not dent growth by too much.

On the import-side of the balance sheet, China supplies about 21% of US imports, but this is only 2.6% of US GDP. There are two countervailing effects from taxing imports. For one, it could shift consumption towards domestically-produced goods which boosts net exports and encourage domestic production – a positive for the economy. On the other hand, higher import prices could hurt spending power which then curbs consumption and hurts aggregate demand. This is especially problematic for goods which have few cheap alternatives.

For the most part, US tariffs have been targeted at intermediate goods for which US producers are able to source for substitutes. This will change if the Trump administration were to follow through with 25% tariffs on a further US$300 billion worth of Chinese imports. The inclusion of consumer goods like toys and sports equipment, footwear, textiles and clothing will surely impact the pocket books of US consumers. Finding cheap alternatives for a broad set of final consumer goods might be challenging, given that few countries have the production capacity to meet the scale of US consumption demands, if at all. A tax in consumption goods, which is what tariffs essentially are, will still weigh on overall consumption.

As it stands, business sentiment has weakened from a buoyant 2018, anticipating that heightened trade tensions will hurt already slowing demand, increase production costs and adversely impact supply chains. Consumer sentiment appears to be holding up, but persistent trade uncertainty will likely dampen confidence, especially if tariffs lead to a tangible and noticeable spike in prices. In addition, growth looks likely slow down further, with the US economy coming off a sugar high following 2018’s tax cuts. The good news is, recession risks do not seem particularly salient.

Amid signs of a softening growth outlook, Fed policymakers seem receptive to ease policy to support near-term growth. Interest rate cuts are in the horizon should economic data soften, and the outlook turn sour. Yet, this may just harden the White House’s position. After all, President Trump had said that if the Fed played ball by easing policy “it would be game over, we win!” Fiscal policy boosted growth in 2018; monetary policy – the only policy game in town at the moment - looks likely to pick up where tax cuts left off.

Looking ahead to Osaka and beyond

The recent expansion in US efforts to undermine China, extending beyond tariffs to include targeted export and business restrictions, alongside the emergence of nationalistic rhetoric in China indicate to us that the road to an agreement is long and rocky. Our baseline scenario remains that President Xi and President Trump would meet at the G20 summit in Osaka later this month and agree to continue trade talks.

The question of tariffs on a further US$300 billion worth of Chinese imports is still up in the air, and likely depends on the outcome of the meeting. As it stands, it is difficult to fathom a scenario where China accepts the deal as is without any modifications to its terms. It is just as hard to imagine a situation where the Trump administration compromises on key positions without incurring domestic political costs. What was problematic weeks ago, seems unlikely to be acceptable now – certainly not when political rhetoric has hardened as much as it has. Hard economic data, while having shown some weakness in recent weeks, do not exhibit the sort of trouble that tends to inspire compromise.

On a more fundamental basis, if taking on China were more a challenge of strategic economic dominance than it is about ensuring fair trade, we would kid ourselves to believe this would be a short-term kerfuffle. An agreement to resolve trade matters is plausible. But that will hardly mark the end of US-China tensions.

The US has shot the first salvo in the tech turf in an obvious challenge for technological dominance. This is unlikely to be the only domain the US and China will contest. If it is not technology, it would likely be something else. The methods employed would vary from one presidential administration to another, some more disruptive than others.

Indeed, other Presidents have tried to contain China’s economic ambitions before, the Obama administration’s Trans Pacific Partnership (TPP) being a key example at doing so. The US’ current exercise at containment is far more jarring because President Trump’s methods are neither discreet nor elegant. It is blatant and potentially disruptive to markets, especially given how integrated supply chains have become. Like it or not, both countries are tied to the hip. Undoing these linkages will be disruptive and result in immense pain for both parties. But it doesn’t mean they won’t try. It just means that the rest of the world will bear the brunt of their periodic flare-ups. Markets beware.

Other countries beware

Recent events have also shown that the Trump administration’s sights are not just focused on China.

The recent episode with Mexico reminds us how unpredictable US trade policy has become. Importantly, it shows the extent to which President Trump is willing to wield economic tools for foreign policy objectives, in large part because he doesn’t need congressional approval to use these tools. It is the most expedient way to elicit concessions. Germany, Japan, Canada, India and France found themselves on the receiving end of veiled and sometimes blatant tariff threats by the US.

Meanwhile, the US Treasury Department stunned market watchers by including countries like Singapore, Malaysia and Vietnam in their watch list for currency manipulation.

Importantly, the US Treasury Department lowered the criteria for inclusion in the watch list including redefining “material” current account surplus to be 2% of GDP from the 3% standard previously. The definition of persistence of net FX purchases was also eased from 8 out of 12 months to 6 out of 12 months. The Treasury Department also expanded their coverage, from monitoring FX activity of the 12 largest trade partners to any country that conducts more than US$40 billion worth of trade with the US. The Department also gave themselves the discretion to include and keep on the official Monitoring List any major trading partner that accounts for a large and disproportionate share of the US’ overall trade deficit, even if these countries do not meet 2 out of the 3 criteria stated above, which was the initial standard for inclusion in the watchlist in accordance to the 2015 Trade Facilitation and Trade Enforcement Act. If deemed to be a currency manipulator, the US could impose trade sanctions, a move they have avoided for now.

The Trump administration’s recent moves underscore the difficult reality that no country is entirely out of the US’ line of sight where trade policy is concerned.

Bottomline: Mainly a matter of face

In essence, this was not a fight that China was seeking. In fact, China’s economic focus had always been on rebalancing its domestic economy, with its reform agenda broadly moving in the direction that the US had initially favoured, albeit perhaps not at a rapid pace that was expected. Lasting reforms are after-all long-drawn even in the best of circumstances.

In the 19th Communist Party of China (CPC) National Congress in 2017, President Xi Jinping’s address to the party was heavy on the need for domestic economic reform. He highlighted six key imperatives to modernise China, among which included a plan to break new ground in opening-up the economy. In a translated version of President Xi’s address published by Chinadaily.com, President Xi said, “We will expand foreign trade, develop new models and new forms of trade, and turn China into a trader of quality. We will adopt policies to promote high-standard liberalisation and facilitation of trade and investment; we will implement the system of pre-establishment national treatment plus a negative list across the board, significantly ease market access, further open the service sector, and protect the legitimate rights and interests of foreign investors. All businesses registered in China will be treated equally.” This was to happen with or without US’ coaxing.

Yet, recent trade pressure from the US threaten to arrest the political narrative, changing it from one of a country’s self-directed and self-driven reforms to one seemingly of subservience to a foreign power. The narrative that accompanies the negotiation of the US-China trade deal matters greatly for the political legitimacy of both parties. One seeks to be treated as an equal, while the other seems committed to reassert its position as an unchallenged superpower, in which case there must necessarily be a winner and a loser in the negotiation.

In May, Vice Premier Liu He called for the text of the deal to be “balanced” such that it ensures the “dignity” of both nations. This may never come to pass if strategic objectives on both sides are uncompromisingly divergent. The hope is for both the US and China to compromise in some way for the greater good and survival of a highly integrated global supply chain. Yet, as it stands, the word “compromise” may well be the dirtiest word in this negotiation process. In which case, prepare for a long night ahead.