Perspectives: Our Latest Views on U.S.-China Trade Dispute

Perspectives: Our Latest Views on U.S.-China Trade Dispute

Andy Rothman, Investment Strategist

In my December issue of Sinology ("A Truce Over Steak and Malbec") I wrote that "prospects for real progress on substantive issues with China are now better than at any point in the Trump administration," because Trump recognized that "a trade war with America's largest trading partner would damage the U.S. economy and equity markets, and thus the president's re-election chances."

The ensuing 11 rounds of negotiations over five months appeared to be on track for a deal—until they weren't. The president tweeted in early May that “China should not renegotiate deals with the U.S. at the last minute."

But I remain optimistic, based on my view that Trump continues to believe that his re-election prospects are best served by a deal.

At a late-May press conference in Tokyo, Trump responded to a question by saying that although China "would like to make a deal . . . We're not ready to make a deal." A moment later, however, he added, "But with all of that being said, I think that there's a very good chance that the United States and China will have a very good trade deal."

Trump and Chinese leader Xi Jinping are scheduled to meet again in late June at the G-20 summit in Osaka, and we are likely to have more visibility at that time.

Not Just About Trade

Far more than trade will be on the table when the two leaders next meet. Trump will have to accept that the U.S. must share economic and strategic power with a rising China, while continuing to take steps to help shape how Beijing uses its influence. Washington will also have to accept that while the past three decades of economic engagement have promoted significant change within China—from no private sector, to an economy where 85% of urban employment is with small, entrepreneurial firms; accompanied by a broad expansion of personal freedom—fundamental changes to China's political structure cannot be dictated by outsiders, but are very likely to evolve as the country becomes wealthier.

The Xi administration will have to accept that along with its professed desire to use its rising power within the existing global infrastructure, comes a responsibility to follow the rules of that system and to be transparent. Xi will also have to accept that his policies have consequences outside of China, and take responsibility for them. For example, just as the U.S. had to consider the impact of China's new WTO commitments in the 1990s on its then-impoverished northeastern rust belt, Beijing must deal responsibly with the impact of its industrial policies on employment in developed countries.

In short, the two leaders will have to agree that rising competition between the two nations does not have to be a zero-sum game, and that it is cooperation and concessions, rather than confrontation, that will leave both sides better off.

In more practical terms, this will require Xi to agree to give American and other foreign firms the same market access that domestic firms receive, and to strengthen protection for intellectual property for all companies. Xi will also have to stop his security services from stealing foreign technology and handing it to Chinese companies.

At the same time, Trump will have to abandon his misguided focus on the bilateral trade deficit and take a more rational approach to issues such as visas for Chinese students and researchers in the U.S.

Remember the Rebalancing

While we wait for Trump to decide if he does in fact wish to close a deal with Xi, we should keep in mind that the Chinese economy is no longer export-driven, so the impact of tariffs is limited.

Net exports (the value of a country's exports minus the value of its imports) account for less than 1% of China's GDP, down from a peak of 9% in 2007. In seven of the last 10 years, net exports were a negative drag on economic growth. By contrast, domestic consumption now accounts for more than two-thirds of China's economic growth and more than half of its GDP.

Last year, Chinese exports to the U.S. accounted for only 19% of total Chinese exports, limiting significantly the impact of new tariffs applied only by the U.S. Moreover, several studies by economists in the U.S. have concluded that most or all of the burden of the tariffs now in place have been borne by American consumers. Economists at the New York Fed, for example, found a “complete pass-through into domestic prices of imports, which means that Chinese exporters did not reduce their prices. Hence, U.S. domestic prices at the border have risen one-for-one with the tariffs levied."

Even if some of additional tariffs are absorbed by exporters in China, it is worth noting that much of that impact will not fall on Chinese companies, as about two-thirds of the 25 largest exporting companies based in China are foreign-owned.

It is also clear that Xi's government will step in to provide financial aid to companies that are hurt by any Trump tariffs. Despite a tax cut of almost US$200 billion last year, China's fiscal revenue increased 6% compared to 2017. Beijing has the resources, as well as the political will, to support its exporters, just as it did a decade ago during the Global Financial Crisis (GFC).

Even without a deal, China is likely to remain the world's best consumer story. Remember that last year, inflation-adjusted household income growth of 6.5% (vs. 2.2% in the U.S.) led to real retail sales growth of 6.9% (vs. 2.4% in the U.S.)

Andrew Mattock, Portfolio Manager, Matthews China Strategy

Trade conflicts between China and the U.S. have been an overhang for global equity markets for the past year and a half. Market observers worry that trade disputes could severely impact business environments in China. Over the short term, we may see potential supply chain disruptions as local businesses react to changes given political uncertainties and increased market volatility arising from the trade conflicts. We remain optimistic on the longer term opportunity set in China and are focused on investing in growth opportunities that benefit from the rise of China's domestic economy over the next decade.

China today also relies mostly on internal sources for growth and this can be seen from its services economy, which now contributes more than half of its GDP. As a result, the country no longer relies on trade as a source of growth and has other ways to spur domestic consumption and demand. As compared with a year ago, China has now completed its financial de-risking campaign and stands on stronger footing economically to deal with these uncertainties. While China is not shielded completely from external forces, we believe it will be able to weather most of the negative implications of global politics. Still, a full-blown trade war would be detrimental not only to both parties but also to the global economy. Accordingly, we believe it is in the interest of both the U.S. and China to eventually reach a deal.

Overall, we continue to invest according to our long-term beliefs that China's domestic economy remains healthy, and that there are secular growth opportunities in both China's new and old economy sectors that stand to benefit from the rising levels of affluence among domestic consumers.

Disclosures

Investments involve risk. Past performance is no guarantee of future results. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation