Trade War: Easy to Start, Hard to End

Friction with China is Likely to Escalate in Coming Months

In the August 2018 Macro Tides entitled “China, No Trade Pushover” I discussed why the trade negotiations might prove more difficult than expected. “In the U.S. time is measured by quarters, but in China it is measured in decades. China’s leadership is not immune from short term considerations, but their focus is not centered on the next year or two but where things will be in 5 to 10 years and beyond. China has been taking steps to insulate and bolster its economy from any short term negative impact from trade. By stimulating its economy, China can weather the storm in the short term and achieve its long term goals. According to Chinese philosopher Sun Tzu, “The supreme art of war is to subdue the enemy without fighting.” It’s possible that Sun Tzu may possess more wisdom and negotiating prowess than the guy who wrote the ‘Art of the Deal’. In recent years China has expanded its military reach to a number of islands in the South China Seas despite Chinese President Xi Jinping’s 2015 pledge to President Obama that “China does not intend to pursue militarization” on the Spratly Islands. China’s military expansion reflects a mindset that is focused on the long term and an attitude that China will not be bullied nor dissuaded by any country. On July 31, 2018 the Trump administration said it was considering increasing the tariff on $200 billion of Chinese imports from 10% to 25%. Comments by a spokesman for China’s Commerce Ministry didn’t sound as if China is cowed. “The U.S. unilaterally exerting pressure on China will get the opposite of what it wants.” Discussions haven’t even produced a plan for additional negotiations. The Commerce Ministry also issued a statement on August 2. “China has been fully prepared and will have to retaliate to defend national dignity and the people’s interests.” The word dignity caught my attention since it indicates that for China the trade negotiations represent something much bigger. China wants to be treated as an equal to the U.S. and respected, and that’s something China is not willing to trade away.”

China’s response during the trade negotiations since last October and after Trump’s escalation in the Trade War on May 5 is instructive. China controls the media in China and uses it to shape public opinion. From the end of last September the frequency of the phrase ‘trade war’ declined to almost nothing by the end of April, which suggests the leadership didn’t want the Chinese people to be fully aware of the negotiations. By keeping the trade negotiations off the radar it would be much easier for China’s leaders to control the narrative after the trade negotiations ended, rather than having to reshape public opinion.

After President Trump threatened and then followed through on 25% tariffs on $200 billion worth of Chinese imports, the frequency of the phrase ‘trade war’ soared. It has also been reported that Chinese media is showing old movies of the Korean War to remind their people of another time when relations between the US and China were bellicose. Now China can easily cast the US as the aggressor that has instigated tariffs, increased the tariffs to untenable levels, and made unreasonable demands.

This last point was probably one of the sticking points that caused the negotiations to collapse. As you likely know, the US intended to keep some of the tariffs in place as leverage to encourage the Chinese to uphold any trade deal. China’s track record in adhering to the details of prior trade pacts has been not good, so seeking some assurance makes sense. However, the idea that the US would continue with tariffs after a trade deal was struck was incomprehensible and reprehensible to the Chinese, a point they likely made abundantly clear to the American trade delegation. Here’s a good analogy: A young couple is engaged and going to be married next Saturday. One of them tells the other, “I love you very much and I’m going to hire a private investigator to follow you for the first year of our marriage to make sure you remain faithful.” That would certainly make ones heart beat faster but not in a good way!

All eyes are now on the G20 meeting in Japan on June 28 and expectations are high that a trade deal can be resurrected before then. That’s not likely to happen especially if Treasury Secretary Mnuchin and US Trade representative Lighthizer don’t announce plans to travel to China to resume talks soon. Nothing of substance can happen at the G20 meeting unless negotiations restart weeks before the meeting. At best the G20 meeting will provide a photo opportunity for President Trump and Xi Jinping with the possibility of an agreement to resume negotiations. Given the message being delivered to the Chinese people by the state controlled media, the prospects of new ‘productive’ talks soon may be optimistic.

While negotiations were moving forward between last September and April, China allowed its currency to appreciate against the Dollar from 6.95 to 6.73. (top chart) That literally changed overnight and now the Yuan is approaching levels only seen in December 2016 and September 2018 at 6.95. Should the Chinese allow the Yuan to rise above 6.95 (depreciate), it would signal that China had decided to use the depreciation of the Yuan as part of the Trade War and reflect a toughening in their trade position. If the Yuan does trade above 6.95 for a few days, global financial markets are going to respond negatively.

It is becoming clear that the trade negotiations are just part of a larger realignment of power between the US and China, as both countries wrestle with non trade issues that have the potential to shape which country dominates the world in coming decades. With so much at state a quick resumption of talks seems unlikely. 

Jim Welsh

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