“You must not fight too often with one enemy, or you will teach him all your art of war”- Napoleon Bonaparte
Sino-US economic conflict is on the rise. Late 2017 saw the release of US strategy documents on national security, defence and trade, all of which for the first time defined China as a strategic competitor and disavowed America’s long-standing policy of constructive engagement.
Our base case remains that there will be no full-scale trade war between China and the US. But even trade frictions could have a long-term impact on global trade, investment flows, and the political power balance in the Asia-Pacific region. The short-term effects would likely be unevenly distributed across global markets. The impact on China may be far less than US President Trump expects, but the collateral damage to Asia’s regional economies could be significant and would have asset allocation implications for the region’s financial markets.
America’s stubborn trade deficit with China
The pressure point of Sino-US trade frictions lies in the stubborn trade deficit that the US has with China. It is more than five times larger than the US’ second-largest bilateral trade deficit, with Mexico. Furthermore, China’s trade surplus with the US has climbed to record highs while its surplus with the rest of the world has declined (see Figure 1).
Figure 1. China’s trade balance
Data as at 22 February 2018. Note: ROW = Rest of World. Data is rolling 12-month sum.Sources: CEIC, BNP Paribas Asset Management.
So President Trump believes he has strong justification for pursuing a tough trade stance against China, and things seem to be moving in that direction. After imposing import duties in late January this year of 30% and 20% on solar panels and washing machines, respectively, the US Commerce Department proposed in mid-February to impose high tariffs or quotas on imports of steel and aluminium. China is the world’s largest producer of both commodities.
The collateral damage
Financial markets see these moves as evidence of President Trump’s protectionist policies. Gross trade data can be misleading, however, because over one third of China’s exports, including those to the US, are goods that China has added value to, but that were mainly produced in other Asian countries.
This means that rising US protectionism, as manifested in Sino-US trade frictions, could hurt other economies that supply parts and components to China. The potential collateral damage can be estimated by stripping out the added-value portion of China’s gross exports and reassigning it back to its original source countries to assess their ultimate export exposure to the US (see Figure 2).
Figure 2. Final vs direct export exposure to the US
Data through 2016 as at 22 February 2018. *Asia excluding Japan and China. **Exports that cater for US domestic demand, excluding goods that are re-exported from the US to third markets. Sources: UN Comtrade, Eurostat, OECD-WTO TiVA database, IMF, national statistics, CEIC, Nomura, BNP Paribas Asset Management.
The point is clear: An escalation of US trade protectionism would be quite damaging to most of Asia’s export-oriented economies, with six of the top 10 most-exposed countries being Asian. The damage to China should be somewhat limited. From an asset allocation perspective, ceteris paribus, it would appear that China would be the least-affected Asian market should frictions in Sino-US trade increase.
A market study1 also finds that in the Asian countries most exposed to the US, the industries that could be hit hardest by US trade measures are textiles, leather and footwear in Vietnam, computers and electronics in Taiwan and Malaysia, and chemicals and petroleum products from Singapore.
The US’s strategic calculations
The US does not seem to be bluffing. In 2017, US trade policy was subordinated to the goal of gaining China’s help on dealing with the North Korean crisis and passing a tax cut bill. Now, with the North Korean crisis risk stabilising and the tax bill passed, tough trade policy has taken priority in President Trump’s political agenda.
President Trump and many US officials seem to think that China still depends heavily on foreign trade for growth and that it has such a fragile financial system that unilateral pressure from the US could force China to cave in to its demands. In my view, they have overestimated America’s ability to force China’s hand and their understanding of China’s economic structure is outdated. Since 2009, the contribution of net exports to China’s GDP growth has largely been zero or negative (see Figure 3), suggesting that its economy has already shifted from export- to domestic-led growth.
Figure 3. Growth contribution to China’s GDP
Data as at 22 February 2018. Sources: CEIC, BNP Paribas Asset Management.
The reality of China
Market research suggests that a permanent 10% fall in China’s exports to the US would cut Chinese GDP by about 0.3 percentage points. This is material but can easily be offset by domestic infrastructure spending and/or an increase in Chinese exports to other markets under the Belt & Road initiative.
Furthermore, the power of China’s domestic innovation to generate growth has improved significantly. Its industrial upgrading process under the “Made in China 2025” industrial policy has been backed by hundreds of billions of dollars in government venture-capital funds in addition to traditional subsidies.
The question for most foreign investors is whether — with an opaque political system, onerous regulations, and lack of market access — they still want to pour money into China? China’s foreign direct investment (FDI) rose by almost 10% to USD 144 billion in 2017, according to the UN, while the total amount of global FDI fell by 16% to USD 1.52 trillion. The chances are that, so long as China remains the world’s fastest-growing major economy, the lure of its market size and momentum, together with economic reform progress, will outweigh the complaints about an uneven playing field and the fear of technological leakage.
In the short term, a persistent US campaign of economic pressure on China would bolster the view that the US has embarked on a long-term fight to reduce its trade deficit, possibly using a weak dollar as a tool. US Treasury Secretary, Steven Mnuchin, stoked exactly this fear in late January by commenting on the benefits of a weak dollar. Although senior US officials hastily reaffirmed a strong dollar policy afterwards, the market has grown sceptical. Cutting the trade deficit is now a stated policy goal of President Trump and think-tank research shows that cutting the US current account deficit from 4% to 2-3% of GDP would require a 10% depreciation of the US dollar real exchange rate2.
Over the longer term, both China and the US seem to be striving to on-shore the globalised production chains developed over the past three decades, with China doing this through import substitution to minimise the foreign share of its industrial base and the US via America-first policies. Even a partial success of these initiatives could be damaging.
Firstly, the breaking-up of the global supply chains will likely bring back inflation by reversing the disinflationary forces brought about by globalisation. Secondly, I would argue, cross-border production chains are a force for peace and stability as they raise the stakes should armed conflict break out. Reverting back to domestic production structures raises the possibility that major countries would try to settle their differences by force. It may be too early to be alarmed, but the possibility is worrying.
Complications for Asian currencies
In broad terms, Asian currencies would be exposed to the risk arising from US protectionism. They would face depreciation pressure as trade slows and local policymakers shift to expansionary policies to protect growth. If, alternatively, the US dollar remains weak despite the expected Fed rate increases, it would mitigate the protectionism risk for Asian currencies and would even allow Asian central banks to lag the Fed in raising interest rates.
The relative strength of these two forces is unknown. Much depends on the direction the dollar takes which, in turn, depends on whether the Fed raises rates by more, or faster, than currently expected.