US-China: A Different Take

A basic building block of matter, electrons, are so complicated that it is recognized that by deciding to measure the speed, one cannot determine location, and if one tries to measure location, speed is indeterminant. The principle was applied to Europe during the crisis. If investors acting as if the eurozone was going to break, it would.  Perhaps, the principle applies to US-Chinese relations now.  

America seems of two minds. On the one hand, many fear that China's version of state capitalism or authoritarian capitalism has economic advantages over the US.  It can also harm the US through competitive devaluation of the yuan and by selling Treasuries (and other securities). Through its One Belt One Road and the Made in China 2025, it combines a foreign infrastructure investment program with an emphasis on exports and import substitution, it is challenging the US dominance.  

On the other hand, many investors see a highly-levered financial system that is springing various leaks. The lack of transparency coupled with chronic moral hazards makes for an unfriendly investment climate. The One Belt One Road effort is plagued with corruption and is aggravating the indebtedness of many developing countries.  China is incurring animosity as it takes possession of the collateral, which as was the case in Sri Lanka, was a major port (concession was a 99-year lease--shades of Hong Kong).  Domestically, China's economy is slowing down and given the poor demographics, the country is older faster than it is becoming rich. 

Many American critics are reluctant to recognize the large strides China has taken in recent years. First, on the macro level, China's current account surplus has been dramatically reduced.   In 2007, it was at 10% of GDP.  Last year, it was about 1.3% of GDP. Of course, this is using Chinese data, and many economists think that officials under-estimate the current account surplus. Still, even private sector estimates see a dramatic decline in China's surplus.  There has been an important reduction of this source of global imbalance.  

Second, China's currency is heavily managed, but it is not pegged to the dollar as it was until the middle of 2005. The US had been critical of the peg.  It does not like the dirty float, but such a regime has not prevented the correction of the extreme under-valuation of the currency to levels now that are broadly consistent with equilibrium exchange rate models.

Third, China, with the approval of the US, joined the IMF's Special Drawing Rights (SDR). It has also agreed to adopt the IMF's best practices in terms of reporting the currency allocation of its reserves. This has taken place rather smoothly over time and appears to be nearly complete.  

Fourth, household consumption accounts for a greater share of Chinese growth. Consumption has accounted for nearly 80% of China's recent growth, up from less than 50% in 2010.  This is also a development that the US had encouraged.  

While the many in the US prefer market-based solutions and often consider non-market solutions to be socialism, China has no such preference.  In this way, it may be that China is more pragmatic than America, which prides itself as the birthplace of the philosophy. What is more pragmatic than "it doesn't matter if a cat is black or white as long as it catches mice?"  

The Chinese system has many inefficiencies, and be reducing them it can absorb some of the disruption emanating from trade and, importantly, its own evolution.  Marginal tax rates are high by international standards, for example, and China has already signaled income tax cuts are coming.  It is also considering halving the tax paid on the purchase of new cars. It has already cut required reserve ratios at the banks but they remain high, and there is room for more reductions. Also, China has reduced tariffs to many of its trading partners in Asia. There is scope for additional reductions in tariff schedules.  

After warning that if China does not offer some concessions, the Trump-Xi meeting next month may exclude the topic of trade entirely, the US issued a new ultimatum:  if there is no progress on trade, the US will begin the process of imposing new tariffs on the remainder of Chinese imports ($250 bln). The process means that the new tariffs could be implemented in February 2019. On January 1, the 10% tariff the US has levied on $200 bln of Chinese goods will be increased to 25%.  

It is increasingly a realistic assumption that the US tariffs on most Chinese-made products reach is 25% next year. Economists estimate that it would slow the Chinese economy by 1-2%. It also risks disrupting the US economy and especially squeezing American households purchasing power. Savings has fallen to maintain strong consumption levels, but interest-rate-sensitive sectors are also softening, especially the housing market. 

One need not seek to block the rise of China by insisting that it adhere to fair trade practices, which it committed to upon joining the WTO. However, that distinction may not be particularly sharp.  One can complain about China's trade behavior as a way to forestall its rise, which in 18 of the past 20 century, it was the world's largest economy and a technology leader.  

American negotiators can begin with the attitude that China has taken some significant steps in the direction the US wanted in past years. Alternatively, the US can have the attitude expressed by a presidential adviser that China has not made a single concession. The latter guarantees a poor outcome.  It makes good on a fear of some Chinese officials that the US is trying to do to it what the US has done to Japan. No matter how much the yen has appreciated, it does not satisfy many Americans.  Similarly, no matter what China does it is not sufficient.  

There are several investment implications of this sketch.  First, the yuan is likely to weaken further based on macro fundamental considerations, not manipulation. The CNY7.0 has psychological significance, but it is not economically important.  We suggest a CNY7.15 three-to-six month target.The PBOC management of the currency presently is to prevent a sharper decline.  Second, China will continue to seek alternative suppliers to Americans.  This creates opportunities primarily in Asia. Third, China will look for new markets.  Asian countries may be vulnerable to import surges. Fourth, direct investment in China will likely emphasize domestic demand rather using China as an export platform.