Monday, June 17, 2019

"Don't Say We Didn't Warn You"

"Don't Say We Didn't Warn You"
by Jim Rickards

"The phrase "Don't say we didn't warn you" may be a cliché in English but the Chinese equivalent is anything but. The Chinese used this phrase in 1962 just before they went to war with India. They used it again in 1979 just before they went to war with Vietnam. And they just used it for only the third time in over 50 years against the United States. The context, of course, was the U.S.-China trade war. Events are moving so quickly in this war that it's hard to keep up with the news. The threat was used in the context of an ominous warning about China's ability to retaliate against U.S. tariffs on Chinese exports that have been imposed by the Trump administration. 

As I’ve explained before, China cannot match the U.S. tariff for tariff for the simple reason that the U.S. imports far more from China than they import from the U.S., so they simply run out of room to put on tariffs. China is already there. Trump can still tariff another $200 billion of Chinese goods (and has threatened to do so) and China has nothing left to tariff. For China to keep fighting the trade war, they need an asymmetric response; they need to fight the trade war with something other than tariffs.

China has many nontariff responses including dumping Treasury notes, cutting off exports of rare earths, restricting U.S. foreign direct investment in China and diverting import orders to competing suppliers in Europe and South America, among other tactics. 

Now, dumping Treasury notes, as I’ve also explained before, is not a viable option. China holds over $1.2 trillion of U.S. Treasury securities. Some analysts say China can dump those Treasuries on world markets and drive up U.S. interest rates. This will also drive up mortgage rates, damage the U.S. housing market and possibly drive the U.S. economy into a recession. Some call this China’s “nuclear option” when it comes to fighting a financial war with Trump.

But the nuclear option is a dud. If China did sell some of their Treasuries, they would hurt themselves because any increase in interest rates would reduce the market value of what they have left. Also, there would be plenty of buyers around if China became a seller. Those Treasuries would be bought up by U.S. banks or even the Fed itself. If China pursued an extreme version of this Treasury dumping, the U.S. president could stop it with a single phone call to the Treasury.

That’s because the U.S. controls the digital ledger that records ownership of all Treasury securities. We could simply freeze the Chinese bond accounts in place and that would be the end of that. So don’t worry when you hear about China dumping U.S. Treasuries. China is stuck with them. It has no nuclear option in the Treasury market.

China’s threat to cut off exports of rare earths is also problematic. To remind you, rare earths are metallic elements than can be used in pure form or combined to produce critical components for electronics and automobiles. They are not "rare" but they are found in small concentrations, which makes them expensive and difficult to produce in large quantities. China is the source of almost all rare earths used in the world today. The reasons China will not resort to an export ban are that substitute rare earth production from other countries could be brought online easily and retaliation by the U.S. would be swift and fierce. Once China loses the rare earth export market, they will not get it back and they know it.

Reports indicate the Pentagon is already taking steps to line up alternate sources of supply. The U.S. military may even place some orders for rare earth exports from countries other than China just to test the alternatives and blunt the threat from China in advance.  It may be difficult to know if China will or will not actually cut off rare earth exports. It is not difficult to know where this is all headed. The trade wars are rapidly escalating in unexpected ways. Let's hope the struggle is confined to trade and does not spill over into a shooting war as it did in the cases of Vietnam and India in the past. 

But unfortunately, history does not offer much comfort on this front. Below, I show you why the Chinese economy is in trouble, even without fallout from the trade war. And can China escape the “middle income trap”? Read on."
"The Crumbling Chinese Economy"
By Jim Rickards

"A lot of the criticism of Trump's trade war tactics with China is based on a misunderstanding of the dynamics of global trade and global supply chains. When the U.S. imports goods from China and then imposes a tariff, the analysts simply multiple the quantity of goods by the size of the tariff and proclaim on happy talk TV that the "cost" of the tariffs to U.S. consumers will be the result of that multiplication. 

But this method of analysis is badly flawed in several ways. The first problem is that the tariffs aren’t necessarily passed along to consumers, especially in a world of low inflation. Tariff costs may be absorbed by the importers (resulting in lower margins) or pushed back to the suppliers (resulting in reduced profits) and not passed to consumers. The actual result is likely to be some combination of all three effects, but the impact on consumers is still far less than the talking heads estimate. 

The second and more serious problem for China is that U.S. importers will change the source of their imports from China to another jurisdiction that does not suffer from high U.S. tariffs. Costco, for example, which faces stiff competition from Amazon and Wal-Mart, is already taking steps in this direction. 

Vietnam is a likely source for manufactured goods currently produced by China. According to China’s state-run Securities Times newspaper, Q1 2019 foreign investment in Vietnam rise 86%, with Chinese investment responsible for almost half of that figure. Malaysia and Indonesia are also emerging as alternatives to China.

From China’s perspective, the problem with this kind of resourcing is that once the U.S. importers abandon China, they will not come back. The loss is likely permanent. This is one of the strongest levers the U.S. holds in the U.S.-China trade war and one reason why China prefers a solution that will end the war quickly. It is, however, taking steps to prepare for a long trade war if necessary.

For example, China is digging in for a long struggle in which it rejects U.S. claims as an infringement of China’s “core interests.” Beijing has pivoted from talk about trade to discussion of territorial issues such as Taiwan and the South China Sea. China also rejects U.S. efforts to alter the behavior of China’s state-owned enterprises, SOEs, that compete in the private sector but are government owned, controlled and subsidized. 

Having said that, ending the trade war soon is definitely in China’s interests for the reasons I just described. That’s another reason why China is wary of cutting off exports of rare earths to the U.S. and its allies like Japan and South Korea. China is currently responsible for 90% of global production, which theoretically makes them a very potent trade war weapon. 

If the U.S. can get rare earths from nations other than China, it negates China’s current advantages. There could be major manufacturing disruption in the short run before new production from new sources comes on line. But over time, Western powers can replace rare earths purchased from China.

China cannot really afford a major economic setback. My view is that a crisis in China is inevitable based on China’s growth model, the international financial climate and excessive debt. I believe a countdown to crisis has already begun.

China has hit a wall that development economists refer to as the “middle income trap.” This happens to developing economies when they have exhausted the easy growth potential moving from low income to middle income and then face the far more difficult task of moving from middle income to high income. The move to high-income status requires far more than simple assembly-style jobs staffed by rural dwellers moving to the cities. It requires the creation and adoption of high-value-added products enabled by high technology.

China has not shown much capacity for developing high technology on its own, but it has been quite effective at stealing such technology from trading partners and applying it through its own system of state-owned enterprises and “national champions” such as Huawei in the telecommunications sector. 

Unfortunately for China, this growth by theft has run its course. The U.S. and its allies, such as Canada and the EU, are taking strict steps to limit further theft and are holding China to account for its theft so far by imposing punitive tariffs and banning Chinese companies from participation in critical technology rollouts such as 5G mobile phones. Last December’s arrest of Meng Wanzhou, Huawei’s chief financial officer and daughter of the company’s founder, is one powerful indication of the changing times. Canadian authorities arrested her at Vancouver airport at the request of the U.S. 

At the same time, China is facing the consequences of excessive debt. Economies can grow through consumption, investment, government spending and net exports. The “Chinese miracle” has been mostly a matter of investment and net exports, with minimal spending by consumers. The investment component was thinly disguised government spending — many of the companies conducting investment in large infrastructure projects were backed directly or indirectly by the government through the banks.

This investment was debt-financed. China is so heavily indebted that it is now at the point where more debt does not produce growth. Adding additional debt today slows the economy and calls into question China’s ability to service its existing debt.

China’s other lifelines were net exports and large current account surpluses. These were driven by cheap labor, government subsidies and a manipulated currency. These drivers of growth are also disappearing due to demographics that reduce China’s labor force. As mentioned, China is facing competition by even cheaper labor from Vietnam, Malaysia and Indonesia. Trade surpluses are also being hurt by the trade wars and tariffs imposed by the U.S.

Meanwhile, the debt overhang is growing worse. China’s creditworthiness has now been called into question by international banks and direct foreign investors. Of course, the single most important factor right now is the continuation and expansion of the U.S.-China trade war. 

The big issues including limits on U.S. investment in China, forced technology transfers to China and theft of intellectual property have not been resolved, and won’t anytime soon. In the meantime, China’s export-driven economy will continue to suffer. Given these economic, trade war and political head winds, weakness in China is only getting worse. And China’s leadership can only hope the damage can be limited before the people begin to question its legitimacy.  That is Beijing’s greatest fear."

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