Fighting the trade war from within

15 Aug 2018

In war, you can only be killed once, but in politics, many times. Winston Churchill

While Trump may be intensifying the trade-war pressure on China, witness his latest threat (on 20 July) on imposing new tariffs on all Chinese exports (USD500 bn) to the US, Beijing seems to be retreating from offensive responses and resorting to fight the trade-war impact by adjusting its demand management policy to bailout its economy.  The change in Beijing’s tactics may help reduce trade tensions and, thus, the uncertainty overhanging its asset market, and risk assets in general.

To see this, China has not released any tit-for-tat retaliation plans after Trump’s USD500 bn tariff threat as it did with earlier US tariffs on steel and aluminium products and the 25% tariff on USD50 bn Chinese exports.  Instead, it is taking the US to the WTO for arbitration.  Most interestingly, despite Trump’s saber-rattling, Beijing approved in July Tesla’s plan to build a US wholly-owned 500,000-unit Gigafactory in Shanghai.

 

Compromise but no compromise

This indicated that Beijing was willing to hold off, at least for now, the “nuclear options” that it could use[1] against Trump (by hitting US investment in China).  But Beijing is not compromising its bottom lines.  Indeed it has been strategic and coordinated in its responses to the US so far.  If push comes to shove, the first “nuclear trade weapon” that it would use to retaliate against Washington’s escalating tariffs may be cybersecurity standards.

Ostensibly, these are government guidelines deemed “recommended” to foreign firms in China and are technically voluntary.  In fact, compliance is often required to do business in China, especially with the SOEs and large private companies and companies in their supply chains.

If China were to weaponise the tech guidelines to hit American companies, they could easily cause significant difficulties for operating in China and even shutdowns.  A recent research[2] argues that the cybersecurity standards purposely use vague language around testing and verification so that Beijing has broad discretion in assessing and, hence, taking actions against, foreign firms.  These standards could affect not only tech firms and social media but all businesses that rely on information and communications technology, including retail, fashion, e-commerce, services and manufacturing etc.

In Beijing’s view, losses from the higher US tariffs will be tangible but also manageable.  The decline in the renminbi since June this year has also helped offset some of the tariff impact.  And it seems to understand that Trump’s strategy is not only to cut the Sino-US trade deficit but also hit China’s high-tech industries and force US industries, including those in the critical parts of the global supply chain, to move back to the US.  Clashing head-on with Trump would only help his re-shoring effort.

 

Fighting the trade war from within

Complementing the moderation of its trade-war strategy, Beijing is turning inward to adjust its demand management policy to counteract the potential tariff impact on GDP growth while at the same time trying to stick with its debt-reduction effort.  Since 20 July, it has signalled clearly a policy shift towards more selective easing measures in both the monetary, fiscal and regulatory areas.  The coordinated policy adjustment includes:

  • Delaying and easing regulations on restricting/banning asset management companies’ investment and shadow lending activities
  • The PBoC injecting liquidity via its medium-term lending facility (MLF) and encouraging banks to buy high-yield bonds and increase lending to the private sector, and easing bank capital requirements to encourage lending
  • Increasing infrastructure spending, easing restrictions on the PPP projects and encouraging private equity participation in the transport, oil & gas and telecommunications sectors, and in water supply and drainage system and shanty town renovation
  • Cutting corporate tax and speeding up the implementation of personal income tax cut to as early as 1 October
  • The MoF instructing the local governments to speed up issuance of special local government bonds for funding infrastructure spending and help ease the prevailing liquidity squeeze[3].

Nevertheless, there is still no wholesale policy easing like the RMB4 trillion liquidity injection in 2009-10 to save the economy from the impact of the US subprime crisis (Chart 1).  Arguably, Beijing is compromising its deleveraging efforts by scaling back on both the pace and extent of debt-reduction in light of escalating trade-war conditions.  GDP growth is still going to slow in 2H 2018, which the market has over-discounted the weakness (in my view), and companies and sectors that rely heavily on shadow banks for funding will still find it hard to borrow in a selective-easing environment.  However, the poor market sentiment should be bottoming out soon.

So far, only the pace and magnitude but not the direction of policy is being adjusted.  As Beijing has been reiterating its strong deleveraging/tough housing policy stance at every policy discussion meeting at the State Council and the Politburo, its policy response is clearly of a measured easing rather than massive reflation.  This will not change unless the risk of an economic hard-landing rises sharply.

 

Investment implications

These coordinated, albeit selective, easing measures are aimed at stabilising both GDP growth and investor sentiment.  More easing is in the cards if the economy fails to stabilise.  Bond yields should fall further and growth should start stabilising by 4Q 2018, in my view.  Such a combination of proactive fiscal and financial policies should build an increasingly positive tone for equities and credits in the coming months.

Signals for market recovery will come from:

  • Stabilisation of GDP growth
  • Stabilisation of CNY-USD cross-rate
  • Stabilisation of, and eventually decline in, the onshore credit spread
  • Further increase in liquidity, as reflected by the decline in the 7-day repo rate towards 2.0% (2.65% at the time of writing) and
  • Easing of the trade tension, hopefully

In fact, onshore credit spread has shown some initial sign of easing along with PBoC liquidity injection recently (Chart 2).  We have some early indications that Beijing is bailing out the economy to help stabilise/improve market sentiment: the sovereign fund CIC is planning to buy domestic stocks (pending approval), the PBoC is asking banks to buy junk bonds and lend more to the SMEs, the State Council is coordinating efforts to increase fiscal spending and Beijing is moderating its stance in both trade retaliation and domestic deleveraging.

 

Appendix: Some practical questions

So how fast does it take for the announced policy to be implemented, and how long is the time lag between implementation and results?  Can we quantify the market impact of the bailout measures?

Monetary easing has an almost immediate effect on market liquidity because the monetary transmission mechanism in China is much simpler than in the developed markets (DM).  The DM monetary policy transmission mechanism involves multiple channels, which the central bank influences market interest rates and expectations through signalling to the market players by changing its official policy rates.  The policy signal then filters through the exchange rate, domestic interest rates, money and credit growth and the asset market to affect aggregate demand and price development (Chart 3).

In China, the mechanism is different, due to its underdeveloped capital market and controlled financial system that is dominated by the banking sector (which listens to Beijing).  The PBoC still relies on its control of the domestic credit channel to influence aggregate demand and prices (Chart 4), though the trend is for it to eventually reduce control.  The roles of expectations, asset market, market interest rates and exchange rate are still not as crucial as in the developed markets in affecting the final demand and prices.

Typically, it will take a couple of months for monetary easing to show up in the credit numbers and about three months for the easing impact to be felt in the economy.  The time lag between fiscal spending and the economic impact is also much shorter than in the DM (usually within a quarter) because government spending does not necessarily have to go through any long legislative process if Beijing so desires.

Only if China’s economy, policy and market function in a perfectly behaved model can we get some definite answers for these questions, especially the market impact of the bailout measures.  The Chinese market is very retail orientated (over 80% of the daily trading is done by retail investors), so herd behaviour often overwhelms rational decision.

For example, if there is any policy announcement that is perceived as “enough” to turn the tide, the market impact could be instantaneous.  But how do we judge ex ante what is “enough” in a herd-instinct environment, which is often rife with rumours, scandals and policy flip-flops?  Combined with the unstable structural parameters in the economy, all this creates lot of “noise” in the market, weakening (or even destroying at times) any systematic relationship between economic and policy variables and market movement.