April 18, 2018

Trade wars are not like ordinary wars. They don’t start with a formal declaration of war, or with an informal one like the bombing of Pearl Harbor. They get under way slowly, with tit-for-tat threats which escalate step by step.

The Trump Administration got the ball rolling by placing tariffs on USD $50 billion of Chinese exports to the US, and when China retaliated with tariffs on USD $50 billion of US exports to China, The Donald threatened to tariff another USD $100 billion of Chinese goods. From simple tariffs the opposing parties can move up to import quotas and administrative controls and competitive devaluations and other economic weapons. Before you know it, the tit-for-tat retaliatory measures will have set in motion a collapse in global trade volumes. (Fun fact: the Smoot-Hawley tariff of 1930 was designed to reduce US imports, but other countries’ retaliation caused US exports to fall by 66% within three years, and Mr Smoot and Mr Hawley were both voted out of Congress.)

The various threats and counter-threats of a trade war have sent US equity markets into repeated panics, albeit only on a company-specific and sector-specific basis so far. The US economy is so large and diversified, with exports accounting for less than 10% of GDP, so a full-blown trade war would have limited effect on the economy as a whole. This is why China’s counter-measures have targeted key sectors with outsized political pull, such as agriculture.

Whether 2018 will see another trade collapse depends on the decisions of two men – Xi Jinping and Donald Trump. But in both the US and China there are powerful interest groups arguing against a trade war.

In the US, most of the Republican Party holds a philosophical commitment to free enterprise and free trade. In addition, many Republican representatives have been forcefully reminded by their farming constituencies that the Chinese tariffs on agricultural products such as pork, soybeans, and sorghum are damaging and unnecessary. The November 2018 midterm elections offer an outstanding opportunity for voters to remind politicians of their priorities. Votes will be cast for the entire 435 seats in the United States House of Representatives along with 35 of the 100 seats in the United States Senate.

The Democratic Party is naturally opposed to anything The Donald might do, but its opposition to tariffs is compromised by the fact that many of its labour union constituencies favour tariffs as a means of preserving jobs in their industries. Nonetheless there may be majorities in both House and Senate for legislation to limit the President’s unilateral power to impose tariffs. In this case, The Donald could tweet to the American public that his righteous efforts had been thwarted by Congressional cowardice and stupidity.

The Donald has claimed that tariff wars are “easy to win”, on the grounds that in 2017 the US imported USD $505 billion worth of Chinese products but China only imported USD $130 billion worth of US products. The President also wants to end Chinese “theft” of US intellectual property, and to restrict the size and number of Chinese acquisitions of US businesses.

But China possesses several important weapons which the US does not have. The first is its complete control of all news media within China, which allows it to present the trade war in the way that suits it best. The second is the ability to devalue its currency, because the exchange rate is fixed daily, rather than being allowed to float freely. Another weapon is the government’s power to cut off, with the stroke of a pen, the very lucrative flow of Chinese tourists and students to the US. An additional weapon is the Chinese government’s wide administrative powers, which allow it to influence, on a company by company basis, the activities and profitability of all US companies operating in China, from Apple on down. Readers may remember the concerted campaigns which were mounted against Japanese and South Korean companies when the actions of the Japanese and South Korean governments displeased the Chinese government. In addition, the government can use its new cybersecurity law to restrict US companies’ operations or to impose additional obligations.

The Chinese government’s biggest weapon is the USD $1.2 trillion-plus of US government debt which it owns. If China made it known that it was selling down its holdings, the likely consequences would include a run on the US dollar and confusion in US capital markets. The US Federal Reserve would probably be forced to intervene by buying the bonds which the Chinese were selling. This is of course the nuclear option, and the relevant Chinese authorities have been careful to state that China’s foreign reserves will continue to be prudently managed. But, like a nuclear weapon, everyone knows that it might be used one day.

On the Chinese side, there are forces in favour of a negotiated settlement, and forces against one. The Politburo understands the US far better than President Trump or Congress understands China. They know that the US business community does not want a trade war. They are well aware that The Donald embarked on his tariff crusade purely for domestic political purposes, and that Trump’s voters mostly think that tariffs will protect American jobs. Accordingly, they may have guessed that if they give him the appearance of a victory, he will tweet about it for a few days then wander off to another of his pet projects.

The Politburo also knows that the Chinese economy is far less dependent on exports than it used to be a decade ago, because the main driver of GDP growth is now the consumer sector. Even USD $150 billion of tariffs would not seriously damage either the USD $19 trillion US economy or China’s USD $13 trillion economy.

The difficulty is that the Chinese authorities have chosen to present the trade war in the state media as a matter of national pride, in the same category as China’s nuclear deterrent, its five thousand years of culture, its “rebel province” of Taiwan, and its sovereignty over the South China Sea. This positioning is a response to the US decision to use tariffs to target China’s leadership ambitions in high tech industries – the “Made in China 2025” program. Trump’s threat of a trade war against China’s high tech industries simply reinforces the Politburo’s belief that the US is trying to box it in, therefore China needs to control its technological future. It is certain that Xi Jinping will not be giving The Donald everything he is asking for on technology and intellectual property.

Trade wars are like ordinary wars in that they can be fought at varying levels of intensity, ranging from propaganda barrages like the Cold War, to small insurgencies and guerrilla wars, through conventional armies and navies and air forces, right up to nuclear strikes. The intensity of the trade war will determine the amount of collateral damage which is suffered by third parties – such as Australia, Japan, South Korea, or Vietnam – who get caught in the crossfire.

Over the next few months we will find out at what level this trade war is going to be fought. It is of course possible that the US and China will kiss and make up, and everyone will live happily ever after. Call us cynical, but we will keep our portfolios prepared for the worst.


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