The China-US Trade "War": And The Winner Is… - Part 3

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Special Advisor and Resident Senior Fellow - U.S. and Asia

The trade "war" between the United States and China is a misnomer for several reasons. One is of course that only real wars, not trade conflicts, kill people. Morally, the abuse of this term in advanced societies merely reflects the fact they haven’t experienced actual war on their turf for decades, if ever. In China, its growing use is essentially a propaganda prop.

The second reason is that direct trade flows between China and the US, as impressive as they seem, are minuscule relative to GDP: 1% of US GDP for American exports to China, 3,6 % of China’s GDP for exports to the United States (it was 7% a decade ago). Assuming the tariff increases diminish but do not wipe out these trade flows, their immediate impact is of course lower. This, however, does not consider the psychological impact on consumers and investors, or the sector-specific targeting that can be harmful to long-term development, especially for China. Within this targeting, the denial of some tech inputs, or the ban on public purchases of critical equipment is beyond our present scope, which is on the tariff issue.

Coincidentally, China launched a massive domestic stimulus program in December 2018 that will last throughout the first half of 2019. This boost to the economy – perhaps USD 320 billion of new infrastructure projects, and USD 300 billion worth of tax cuts (including VAT rebates for sectors that were hit by tariff increases), was accompanied with claims that China was immune from the effects of trade sanctions, before trade talks were held again. Also, deals were made with selected foreign companies, and there was a further opening to foreign investments in some key sectors, such as finance and automobile. BASF, Exxon, Tesla, BMW, and on a smaller scale Allianz, AXA and BNP were allowed to increase their participation up to 100 % in their joint ventures. During this period, the three main measures – managed import reductions, stimulus to the economy, selected concessions to foreign partners – could give the impression of a China that made the United States suffer the consequences of its own trade tariffs, remained on a strong growth path and was also flexible and ready to reform the economic structure. But on its own terms and schedule.

The real impact

The conflict’s actual impact could also be temporarily blunted. First, the incremental nature of US trade tariffs and their advance notification have actually brought short-term spikes of imports from China. Chinese exporters and American importers rushed to beat announced tariff deadlines. This has been the case from June to December 2017, and from April to October 2018.

US exports to China have gone down by 10% since 2017.

In the other direction, China’s managed trade system has been able to enforce quick and sharp reductions in US imports from December 2017 to February 2018. US exports recovered briefly in March 2018 but have been on a downward trend since then, with the exception of March 2019. Overall, US exports to China have gone down by 10% since 2017.

Sharp monthly variations in China’s imports from the US – only matched in intensity in 2019 by US imports from China – are consistent with a war-war, jaw-jaw tactic by China. It has been alternating policies to find the chink in the US armor. Meanwhile, the command of escalation by the US president revived in effect the "madman theory" of Vietnam war fame. It is a strategy to confuse "the enemy" and persuade him that one can take unpredictable and irrational decisions.

Both trends – an initial rush for imports into the US, a state-run clamp down on Chinese imports from the US – have led to the erroneous view that the Trump tariffs are backfiring and that the American economy and consumer were the losers. Large price increases to the consumers have been and are still predicted.

What China did not do

Alternatively, there have been expectations of currency manipulation by China – a voluntary fall of the RMB. Indeed, when the RMB broke the barrier of 7 per USD in August 2019, this seemed like a possible scenario. In reality, China’s central bank has held the line, and a look at the USD/RMB curve shows that from November 30, 2017 to November 30, 2019, the RMB went down by only 6,4% - over the same period, the change mirrors closely the euro’s exchange rate with the USD. At the end of 2019, with adverse macro-economic trends in China, the issue of a devaluation arises again, but is rejected. Yi Gang, the governor of the central bank, comes out against quantitative easing and vows to maintain the currency’s stability, and the early December Central Economic Work Conference concludes with a call for "stability" and "caution". One can safely bet that, as long as hope remains for a short-term trade deal with the US, China will hold the line on the currency, so as to avoid a political reaction from the Trump administration.

Source: ExchangeRages.org.uk

Similarly, there were both expectations of price increases to consumers, and/or price dumping by Chinese producers on exports to the United States. Neither have happened.

A very popular case was often cited in 2018: that of washing machines, whose price tag increased by 16,8% in that year. But this is the result of the domination by one company with a 43,7% share of the US market. Whirlpool’s 2018 annual report for North America shows a gross margin of 18,9% of sales, a notch higher than 2017, "due to the favorable impact of product price/mix which was partially offset by raw material inflation, tariffs and higher freight costs". Whirlpool’s EBIT in North America actually rose from 11,4 to 12,2% of sales in the last quarter of 2018 YoY, due in part to "successful execution of price increases".

The case of washing machines proves to have been an outlier. There were more often reduced margins for importers and distributors. Prices (before tariffs) for imports from China dipped by only 2% between June 2018 and September 2019 – a trend that is consistent with that of imports from Mexico or the Asian New Industrialized Countries. There may be various reasons for this unexpected price stability. Intra-firm decisions by foreign companies producing in China matter, since they represent nearly two-thirds of China’s sales to the US. Producers based in China have mostly not used the slow depreciation of their currency to limit some of the impact of tariffs on their profit margins.

Source: CPB World Trade Monitor

But as a fact, it is striking that final prices have not reflected the rise in tariffs. Instead, it is retail distributors in the United States that appear to have often reduced their margins, so that a large part of the price increases were not passed on to consumers.

Instead, Chinese exporters have accepted a loss in market share. We come to the issue of the volume of trade between China and the US since the tariff increases took hold. 2019 is coming to an end. The outline of a “Phase 1” trade deal has been agreed, even if its terms remain imprecise: we understand that China commits to agricultural products and some other purchases, that the US does not press the new tariffs and conditionally rolls back some, but by no means all, of those already in place. Since early 2017, this is the fourth time the “trade war” is declared to be over, and caution on interpretation is in order. Nonetheless, it is time to take stock.

Both China and the US win

Both countries have “won”, in fact. But in very different ways, and at a very different cost to their economy. China has curtailed its imports much more than it has limited losses in exports, particularly in trading with the US. By October 2019, its global exports for the year were down by 0,2 %, but its imports were down by 5,1 %. The trend was even more pronounced for the month of October, and reportedly also for November. The result: a very large trade surplus of USD 395 billion for the first ten months of 2019. A corollary is that China’s current accounts, which had earlier been expected to go in the red, are likely to show a 200 billion surplus by the end of this year. China’s external accounts have not capsized, and the country retains sizable financial abilities. In fact, over the last two years (from November 2017 to November 2019), China’s exports rose while global exports stagnated and Euro area exports declined. China’s share of global exports has increased since the trade conflict began.

Source: CPB World Trade Monitor

Source: Ministry of Commerce of the People’s Republic of China

But there are downsides: the same success is not achieved with respect to the United States in 2019.

Source: United States Census Bureau

In that year, the tariffs increases have resulted in an accelerating slide of China’s sales to the US. Since, as we have seen, prices have not dropped, these are reductions in volume. Is a reduced domestic growth the other downside? Perhaps, if we factor increasing pessimism from Chinese consumers and investors. Measuring these, and even more, attributing what is owed to the trade conflict and what may be due to an economic model running out of steam, is very hard. What is certain is that growth is now under 6 %.

The debate on who gets hurt the most and on price increases for US customers rebounded again at the end of 2019, as new and across the board tariff increases were to be confirmed. Particularly at issue were consumer electronics and especially the smartphone industry, whose products are mainly assembled in China, and the auto industry.

This debate is – perhaps temporarily – put to rest, since the outline of a “Phase 1” trade deal has been announced on December 15, rescinding the implementation of new tariffs and cutting back on some of those already in place.

On the Chinese side, tariff retaliation remained sectoral. Aerospace and electronic components have been spared – these are vital value chain industries with a high degree of global integration. It is soybeans and other agricultural products that have been heavily taxed, or simply purchased elsewhere. These moves targeted America’s mid-West states, often swing states in elections, which are essential to Donald Trump. Particularly striking was Beijing’s dance on soybeans – basically, a USD 15 billion a year business for American farmers in China. Beijing clobbered these in 2018, to the delight of Argentina and other alternate suppliers. Notably, the Trump administration spent an estimated USD 26 billion over two years in subsidies to farmers – and did not lose the mid-term elections in these swing states.In August 2019, China reversed its tactics. After a new Trump salvo of tariff increases, China announced it would resume purchases of soybeans and pork from the US.

It is debatable that this is a gift – pork imports are a necessity because of the swine flu epidemics raging in the country, and soybeans purchases so far have been much lower than in any previous year except 2018, when they were halted. China evidently understands the soybeans import business is seasonal, happening each year in the fall, and therefore not a bargaining tool for the entire year: nonetheless, it could be, so to speak, a trump card before the November 11, 2020 presidential elections…

For the first ten months of 2019 YoY, the US trade deficit with China is down by USD 50 billion.

But the Trump administration also won. For the first ten months of 2019 YoY, the US trade deficit with China is down by USD 50 billion. It is down by 16,9% YoY in Q3. Needless to say, this has been achieved without damage to growth (at 2,1% in Q3 2019), to jobs (unemployment is at its lowest since 1969) or to the consumer price index (which at the end of September stood at 2,1% versus 1,8% a year before). Politically, it is impossible to blame the Trump tariffs for damage to the economy, and this is a source of strength both on the domestic political front and against China.

However, there is also a downside for the US. Trade diversion has occurred, in different ways. Some favor China. A complete exemption of duties for single packages valued under USD 800 is used massively by China’s exporters and e-commerce companies, who ship in bulk to Canada and Mexico and redistribute from there. And just like the Japan of the 1980s installed “screwdriver factories”, assembling final products on the Mexican border to the United States, the upsurge in FDI into countries such as Vietnam and Malaysia is not only from foreign companies leaving China: Chinese companies are also shifting final assembly lines elsewhere as staging grounds for their sales to America.

And who else won?

Third countries indeed can benefit on both sides. According to the Nomura Research Institute, US import substitution has benefitted Vietnam, Taiwan and South Korea for electronic products; Malaysia for semiconductors; and South Korea and Mexico on motor vehicle parts. China’s import substitution has led to beneficiaries in copper (Chile); soybeans (Argentina, Brazil, Chile and Canada); gold (Singapore, Hong Kong and South Africa); natural gas (Malaysia, Australia); and aircraft (France and Germany).

The most striking example, one that runs completely contrary to recent media coverage about a Germany trapped between two economic giants, is that of German exports. While their growth towards China has markedly slowed down in 2019, they have surged towards the US (+5,3% YoY in Q2, +7,6% YoY in Q3 2019). Machinery and electronics figure prominently. In general, EU exports to the US are rising – in part driven by US growth, in part helped by the decline of the euro. It is no wonder that the Trump administration is tempted to target Europeans on trade.

Conclusion

Early analysis and estimates tended to exaggerate the harm from the trade conflict to the US economy, and to underestimate the damage to China’s. As tariff escalation occurred, this damage became more evident. In terms of direct bilateral tariff increases, it is even harder to identify damage to third economies – and, on the contrary, one can find windfall benefits that occur with displacements of value chain and staging of final export locations. The increased demand from the US economy picks up the slack from Chinese demand – although East Asian exporters to China such as South Korea may well suffer more than others. It is only by invoking uncertainty, or more accurately angst, fueled by misplaced talk of war, that one can position the US-China trade conflict as a key factor in the global economic slowdown. Much more likely, the end of an extremely long expansionary cycle, or fear of that ending, is the right explanation.

As we shall see in part 4 of this blog, the same judgment does not hold true if one considers that targeted tech export denials and the ban on some suppliers for critical supplies, escalate into a wider decoupling. The disruption would be on a wider scale, although there too one will need to disentangle benefits and losses for each party.