What does a trade war “win” look like?

President Trump’s decision on Sunday to extend the March 1st deadline for a trade deal between the US and China was interpreted favourably by investors as an indication that progress was being made on the discordant trade negotiations which have whipsawed global equity markets over the last several months. But to redress the full list of US grievances against China would require no less than a complete reversal of Chinese trade and industrial policies and for President Xi to relinquish his dream of a Chinese Century. With that in mind, what does a realistic trade war “win” look like to both factions, and should investors to expect a lasting resolution to this dispute between the two preeminent superpowers?

The list of US grievances is long and ranges from the burgeoning US-China trade deficit to intellectual property theft and industrial policies that subsidise Chinese companies in strategic industries. Despite revising its ambitious Made in China 2025 strategic plan due to pressure from the US, Chinese leadership has made few concessions (or admissions) to address allegations of IP theft and cyber espionage, forced technology transfers, and market-distorting subsidies and other types of government support. For President Xi, “winning” the trade war is straightforward – the lifting of punitive US tariffs on Chinese imports without substantively compromising on structural reforms that would alter China’s centralised development model nor inhibit the advance of its national technology champions.

For President Trump, who seems to adopt a zero-sum mercantilist approach to trade, a “win” is not so clear-cut. The trade hardliners in the Trump Administration are unlikely to be satisfied with a deal that only addresses trade deficit reduction without structural reforms to China’s trade practices. So far China has agreed to dramatically increase purchases of US goods, strengthen intellectual property rights protection and phase out certain domestic vehicle subsidies, but has resisted more meaningful reforms demanded by the US. The economic and political risks of a protracted trade war, especially with re-election on the horizon in 2020, may encourage Trump to accept a less comprehensive trade deal – a “mini deal” that addresses deficit reduction but leaves open further negotiations and sanctions.

But even a “mini deal” that focuses on reducing the US’ trade deficit with China may be unrealistic and fail to reduce the US’ overall trade deficit. The US has demanded that China take action to reduce the trade deficit by $200 billion by 2020 and eliminate the trade imbalance entirely by 2024. China has subsequently offered to go on a six-year, $1 trillion buying spree of US goods to reduce the bilateral trade deficit to zero by 2024. A cursory overview of the existing US-China trade relationship suggests such a deficit-reduction program is unlikely if not impossible.

Firstly, we need to understand the extreme imbalance of trade between China and the US. In 2017, the US imported $505 billion of goods from China while only exporting $130 billion to its trade partner. The trade deficit for 2018 is even greater and on track to exceed $400 billion. A $200 billion reduction to the trade deficit would require either the US to reduce its imports from China by 40%, or more likely China to more than double its purchases of US goods. Eliminating the trade deficit by 2024 would require China to more than quadruple its imports from the US in six years, assuming the US does not further increase its imports from China.

This begs the question – how does China source an additional $400 billion of imports from the US? Any shift in bilateral trade balances of this magnitude will have significant flow-on impacts to global trade.

Take the recent pledges by China to increase its purchases of US agricultural and energy products, predominantly soybeans, crude oil and LNG. China imported over $80 billion of agricultural goods in 2017 and $145 billion of crude oil[1]. If China decided to neglect its other trade partners and source all its agricultural and crude imports from the US, it would only reduce its trade surplus with the US by less than $140 billion, as the current US crude oil export run-rate of 2.4 million bpd[2]is only worth $57 billion at the average 2018 WTI price. In any case, such reliance on a strategic rival for imports of strategic resources would never fly politically in China.

China has also offered to buy an additional $200 billion of US semiconductors over the next six years, which is over $30 billion a year and five times the current level of semiconductor imports from the US[3]. Such an increase in semiconductor imports seems highly fanciful even if US semi companies were to relocate production from third countries to China (that would be akin to simply rearranging the deck chairs). US companies are also unlikely to accept this offer as not only would reworking global supply chains be extremely costly, it would also increase their dependence on China at a time when they are trying to lessen their dependence.

Even if the US and China agree on an actionable framework to eliminate their bilateral trade imbalance by 2024, such a deal would have no impact on the US’ overall trade deficit to the world. Fundamentally, the US trade deficit is caused by the country’s low savings rate rather than any malicious trade practices employed by China. Recall from macroeconomics 101 that a country’s savings equals its investments in equilibrium; a deficit of savings vs investment results in a capital account surplus and thus a current account deficit. In fact, China’s current account surplus has fallen close to zero in 2018, which indicates that it is in fact a net importer from the rest of the world. President Trump’s deficit-funded tax cut and spending increases will further reduce the US savings level and drive greater current account deficits (with China or the rest of the world).

A trade deal between the US and China is likely to be symbolic at best. China is unlikely to capitulate (or follow through) on matters it considers to be of national importance and minor concessions to lift the US tariffs could be considered a win for President Xi who has years if not decades to achieve his “Chinese Dream”. President Trump on the other hand needs a “win” to sell to voters ahead of the 2020 Presidential Election. A compromise deal that purports to drastically reduce or eliminate the US-China trade imbalance may temporarily calm the markets, but investors ignore the underlying tensions between the US and China at their own risk.

[1]https://atlas.media.mit.edu/en/profile/country/chn/

[2]https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCREXUS2&f=M

[3]https://www.wsj.com/articles/china-seeks-to-lure-u-s-with-pledges-to-boost-chip-and-other-purchases-11550151263?ns=prod/accounts-wsj

DH5_2155Daniel Wu is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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