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The Importance of China

Despite all the brouhaha over the US-China dispute, our analysis suggests it is likely to have minimal influence on the global economy.

That said, we believe that the Americans have good reason to be unhappy. According to the United States Census Bureau, the Chinese sold $393bn more to the US than they bought from it in the 12 months to the end of July 2018(1). To put this into perspective, that’s almost the equivalent to the entire annual output of the world’s 29th largest economy, Norway(2).

After much preamble, President Trump’s administration responded by initiating a series of new trade tariffs in July 2018. By late September, US tariffs were put into effect exclusively on Chinese goods imported to the US worth $250bn. China reciprocated with $110bn-worth applied exclusively to US imports(3). While substantial amounts at face value, they are relatively insignificant for both economies as exports make up a small part of Chinese and US economic growth.

There is also a fair amount of bravado mixed in with these numbers. Among the 6,000 products that the Americans have targeted, there are nearly 1,000 on the proposed list that the US doesn’t import from China(4); it would appear that everything was thrown in to get the total up to a media-friendly sound-bite total of $250bn.

The situation going into the latter part of 2018 was one in which the majority of US imports into China had been tagged for extra tariffs, while only around half of the Chinese imports into the US had been included. So the Americans still have more options than the Chinese at least as far as tariff imposition is concerned.

The Chinese could devalue their currency, the yuan, in order to counteract the effect of US tariffs. Indeed, Chinese authorities allowed the yuan to fall a significant 8% against the dollar between April and August in 2018.

This served two purposes. Firstly, it brought the yuan down to below “fair value”, i.e. what it would be worth if it were a free-floating currency that rose and fell according to market-led supply and demand. Secondly, it provided a form of domestic economic stimulus by making Chinese exports cheaper to overseas customers.

Chinese puzzle

While some, especially in the US, might worry that significant reductions like this could be repeated, we see the sharp 8% drop as a one-off. This is because the Chinese authorities are facing contradictory problems: slowing growth which benefits from a lower value to the yuan, and too much debt having built up which would be better controlled by measures that would push the value of the yuan up.

Chinese policymakers have the long-term strategy of steering the country’s economy away from export-led business built on manufacturing and infrastructure, to one that is predicated on domestic consumption. Over the coming years as this economic rebalancing develops, new companies and industries will take time to become established before growth can recover more towards its previously high levels. In short, that means that economic growth will slow over the medium term before it can pick up again.

At the same time, Chinese authorities are clamping down on the huge debt burden that has developed. It stands at around $34,000bn(5) and, despite government counter-actions, rose by 14% in 2017 leaving it two-and-a-half times the size of the country’s entire annual economy(6).

If financial policy is too accommodative (e.g. by keeping interest rates too low and thereby encouraging more borrowing), then borrowing would be more likely to increase. This would heighten the risk of a financial crash in China sometime in the future when people can no longer afford to borrow and everyone wants their money back at the same time.

The problem for the Chinese is that policy-makers have pledged to keep domestic growth at “around 6.5%” for 2018, as stated by President Xi Jinping and rubber stamped by the Communist Party. To achieve this target, stimulus measures such as authorities pumping cash into the financial system(7) are likely to be needed.

With China having pledged not to devalue the yuan and having to keep borrowing curtailed, it would appear that the country’s leaders have to find other ways to stimulate economic growth.

Indeed, the Chinese central bank, the People’s Bank of China (PBOC), is one of a very few major central banks currently providing financial stimulus through its interest rate and asset purchase activities. Another tool that the PBOC used in October 2018 was to reduce the reserve requirements of commercial banks by one percentage point to 14.5%. What this means is that for every 14.5 yuan that a commercial bank holds, it can make loans to the value of 100 yuan. With more money available to borrowers, interest rates are pushed down as lenders compete for customers. So this move alone has the double-whammy of increasing the availability of credit and making it cheaper, which increases spending and stimulates economic growth.

Behind the noise

While all this might be the case, we feel that the implications on global growth of the US-China dispute will be minimal.

Chinese exports to the US account for less than 3.5% of China’s economy, while US exports to China add up to around 0.6% of the US economy. Taking into account the consequences of all the trade disputes currently underway across the world, the Organisation for Economic Cooperation and Development (OECD) has lowered its global economic growth forecast from 3.8% to 3.7% in 2018, and from 3.9% to 3.7% in 2019(8). This is a modest adjustment and still leaves the global economy growing at a respectable pace.

Digging further into these numbers we can see that imports of services from China into the US have yet to be included in President Trump’s trade sanctions. At the same time, around only a third of Chinese goods imports have been affected and the tariffs have been started at relatively low levels of 10% to 25%, as opposed to the media reports of 30% to 60% to which tariffs could be raised in the future(9).

That’s not to say that we do not see some focused negative implications. American consumers would be likely to experience a one-off increase in prices brought about by tariffs applied to imports.

The implications for Chinese employment might appear to be more substantial: a reduction of $50bn in exports to the US could wipe out more than 700,000 jobs in China(10). At first glance that seems shocking until one notes that China added 13 million jobs in 2017. So even after this hit, a 12 million increase in employment is still healthy.

View a short video where Markus Stadlmann, Chief Investment Officer, Wealth discusses the Chinese economy in 2019.

While China might have exhausted most of its tariff-based retaliation, it still has non-tariff barriers to maintain or deploy. For example, China signed up to the World Trade Organisation in 2000, promising that by 2010 foreign capital would have free access to Chinese financial, retail, energy and transportation industries. Most of these sectors remain largely off limits to foreign investors. Meanwhile, a number of trade deals that China has struck involve the divulgence of intellectual property, effectively giving Chinese industry an instant and, some might say, unearned leg-up.

There are two points to be noted here. Firstly that the US has only instigated a relatively small selection of trade sanctions. The second is that China can find ways to reciprocate if it so chooses.

The likely implications

The knock-on effects to China’s much smaller suppliers could be severe. The providers of components and minerals to China, such as Taiwan and Australia respectively, are watching nervously. For example, of the 100 largest China-based companies that export to the US, 35 are entirely Taiwanese owned. Taiwan’s trade surplus with China accounts for 13.9% of the former’s annual economic output(11).

As concerns over trade tensions rise, the demand for perceived “havens” in which to place money increases.

The dollar is seen by many as the most dependable currency in the world. Therefore, when in doubt, investors often transfer cash or assets into dollar-denominated investments. That pushes the demand for the dollar up, driving its value up relative to other currencies. As explained, we don’t expect that to happen this year.

On top of that, interest rates in the US are being raised steadily by the country’s central bank, the Fed. That means that there is an increasing return for holding the dollar which also drives up demand. A caveat to add here is that, if economic growth slows in 2019, the pattern of rising interest rates could be curtailed, putting a halt to sustained rises in the value of the dollar.

Finally, the US economy has been performing well, with company profits benefiting from the recent tax cuts, making US assets more attractive, once again driving up the demand for and value of the dollar to date.

These factors have combined to send the value of the dollar up by 15% since September 2014. As well as counteracting the inflationary hit from import tariffs, this can also reduce the effect of the tariffs from the Chinese perspective; a higher value to the dollar effectively makes imports into the US cheaper, helping to maintain demand.

1. Source: www.census.gov/foreign-trade/balance/c5700.htm, accessed October 2018.
2. Norwegian nominal gross domestic product in 2017 was $399bn, World Bank website, accessed October 2018.
3. Source: CIO Insight Call - “Trade wars: Getting heated or just hot air?”, Lloyds Bank plc, September 2018.
4. Source: CIO Insight Call - “Trade wars: Getting heated or just hot air?”, Lloyds Bank plc, September 2018.
5. Source: “China’s debt bomb”, Bloomberg, 17 September 2018, and “China’s debt threat”, Financial Times 25 July 2018 in which it refers to Chinese total
debt is referred to as 300% of gross domestic product which was more than $12,000bn in 2017 according to The World Bank online data resource
accessed in October 2018.
6. Source: “China’s debt bomb”, Bloomberg, 17 September 2018.
7. “The People’s Bank of China skipped its regular open market operations [for the week-ended Friday 20th July], bringing total injections into the country’s
interbank market for the week to 540bn yuan ($79bn), the largest net weekly injection since February”, from “China’s money rates fall as c.bank boosts
liquidity with eye on trade war”, Reuters, 20th July 2018.
8. Source: September 2018 Economic Outlook, OECD, September 2018.
9. Source: CIO Insight Call - “Trade wars: Getting heated or just hot air?”, Lloyds Bank plc, September 2018
10. Source: “…the average Chinese manufacturing worker generates about $70,000 in GDP/year” so a contraction of $50bn could wipe out more than
700,000 jobs, $50bn ÷ $70,000 = 714,285. Taken from “Trade War: Economic Impact, Market Reactions And Policy Responses”, AlpineMacro, 10 August
2018.
11. Source: “Trade war and EM woes”, AlpineMacro, 27 June 2018
.

Important Information

Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at January 2019.

Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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