At the G20 summit on 1 December, China and the US agreed on a temporary trade-war truce. The US agreed to leave tariffs on USD 200 billion worth of Chinese exports to the US at the 10% rate for 90 days to give more time for negotiation, i.e. the US tariff rate will not rise to 25% on 1 January 2019, as previously announced. China, in turn, agreed to boost its purchases of agricultural, industrial and energy goods from the US to reduce its trade surplus with the US and to open up its markets further.
However, the threat of higher tariffs on China remains: Should the two sides fail to reach an agreement in the 90-day period, the 10% tariffs will be raised to 25%.
The short-term impact
The truce has led to a relief rally in global markets. It is hard to see any near-term resolutions to the fundamental differences between China and the US, as these span economics, political ideology and national security. In addition, the United States is wrapping up its national security review of automotive imports, and this will likely result in a renewed threat of tariffs or quotas on European imports.
For China, the relief rally might see a rebound in industries hit hard by the trade war since June this year, including electronics and related equipment, automobiles and computers. The financials sector and large-cap companies could also gain on improved sentiment. But Mr. Xi’s promise to open up the Chinese internet market further could hurt sentiment in Chinese IT and internet-related stocks.
The truce should also be positive for the renminbi in the short term, though the uncertainty of renewed tariffs should cap any significant upside. We now expect the CNY-USD cross rate to range between 6.85 and 6.95 through early 2019 when the possibility of more portfolio inflows, due to the addition of more Chinese stocks to the MSCI EM Index and the inclusion of Chinese government and policy bonds in the Bloomberg/Barclays Aggregate Bond Index, may boost the renminbi. The market estimates that more than USD 200 billion could flow into China following these indices’ addition of Chinese assets.
What do the negotiations involve?
The next 90 days should see intense Sino-US negotiations focusing on the list of 140-odd demands that the US Treasury presented to China in the summer. There is some low-hanging fruit, as China had already indicated that it could meet 40% of the demands swiftly (presumably on Chinese imports of US products and market access issues). But the US will most likely push China on the other 40% that China said could be addressed over time (likely on the issues like joint ventures and forced technology transfer). China has also said that it would not budge on the remaining 20% (which is likely about Beijing’s industrial and technology policies).
China’s attitude towards negotiation seems to have softened recently. At the Shanghai Imports Expo early last month, President Xi vowed to tighten up on IP protection regulations and to sharply increase the penalty on violations. To address the complaints about unfair state support of Chinese industries, Beijing has recently started working on an action plan for state-owned enterprise (SOE) reforms that is in line with the OECD’s framework of competitive neutrality.
US pressure may have played a role in changing China’s attitude. But China may also finally be realising that better protection of IP, reforming the SOEs and stopping forced technology transfer is increasingly in its own interest. Given the rapid growth of home-grown IP products, enhancing IP protection and making the SOEs more competitive would certainly be helpful to promote local innovation and facilitate China’s aim to become a technological powerhouse by 2020. So there seems to be more hope that China and US may find some common ground in their negotiations on these thorny issues.
Risks have changed, not gone
However, these potential positive developments will not be enough to end the trade war, which in fact reflects the economic and political ideological differences between the two countries as well as their national security concerns. The tariff ceasefire will only move the trade war impact from the macroeconomic level (in terms of market volatility) to the microeconomic level (in the technology sector).
Through its sanctions, first on ZTE and now on Fujian Jinhua (a state-funded Chinese memory chip start-up which is being accused by Washington of stealing trade secrets from US firm, Micron Technologies), Washington has shown its ability to shut down major Chinese companies swiftly and effectively. This threatens China’s entire semiconductor ambition and puts its leading telecommunications companies, notably Huawei, at risk.
The US incentive to shut down Huawei is strong, as it is the leading competitor in 5G technology. China could respond by employing the ‘nuclear options’ – hitting US companies operating in China via regulatory and other invisible trade barriers. The trade-war truce does not eliminate this risk; it may provide temporary relief for financial markets but does not end the war for economic and technological dominance.
The US is also intensifying its efforts to tighten control over Chinese firms’ access to sensitive US technologies. Most importantly, the Foreign Investment Risk Review and Modernization Act (FIRRMA) was enacted in mid-October. The Act expands and strengthens the remit of the Committee on Foreign Investment in the US, a Treasury-chaired inter-agency committee that reviews and approves foreign direct investment in US companies from a national security perspective. The Treasury Department has only just begun to write the implementation rules for FIRRMA, so we can expect an increasingly forceful oversight regime in the future for Chinese investment in US companies in technology and other sectors.
Congress also recently tightened up the US export control regime, with a focus on limiting access to sensitive technologies by foreign firms and governments.
What else can China do?
Since external uncertainty is likely to linger, Beijing will probably continue to focus on fighting the trade war from within – i.e. to reflate the domestic economy. There are still many policy options it can employ, including but not limited to:
- Injecting more liquidity via the lending facilities (medium-term lending (MFL), pledged supplementary lending (PSL) etc.) and cuts in the reserve requirement ratio (RRR) and even the benchmark interest rate
- Un-clogging the monetary transmission mechanism (where banks are still not keen to lend the funds injected by the People’s Bank of China (PBoC) into the inter-bank market), by lowering the banks’ risk preference by expanding the collateral for, and cutting the interest rates of, the lending facilities
- Employing administrative directives to set bank lending targets for the non-state sector and small and medium-sized enterprises (already starting)
- Increasing infrastructure spending by allowing local governments to tap the capital market for funding via special purpose bonds (already happening)
- Easing fiscal policy via 1) more individual tax cuts, 2) more tax rebates for exporters, 3) subsidies for consumer-goods sales, 4) cutting the companies’ cost burden, such as value-added tax or mandatory social security contributions, and 5) offering tax incentives for passenger car purchases and/or tightening up emission standards to boost the replacement of old cars
- Easing restrictions on the property market
- Relaxing the new asset management regulations to stabilise shadow bank activities and, thus, aggregate financing growth
- Allowing renminbi depreciation as warranted by market forces, with the PBoC only intervening to slow the rate of decline
What’s next for the US?
The trade truce can be viewed as a win-win for the various camps within the Trump administration. National Economic Council Director Kudlow and Treasury Secretary Mnuchin have been most sensitive to the negative economic and market consequences of tariffs, and will be relieved that further escalation in the trade war has been delayed, leaving time for additional negotiations. US Trade Representative Lighthizer, Commerce Secretary Ross, and National Trade Council Director Navarro will see the 90-day truce period as sufficiently short to keep the threat of tariffs hanging over Chinese negotiators.
The 90-day negotiating period also reveals some learning within the administration, or at least the greater influence of Lighthizer, Ross and Navarro in these negotiations compared with the summer discussions with European Commission President Jean-Claude Juncker. The framework that emerged from those summer discussions delayed US tariffs but did not specify a time-line for completing negotiations. This has created a view among the administration’s trade hawks that European officials are slow-walking negotiations.
President Trump has also shown frustration with what he views as the slow pace of negotiations with the EU.
That President Trump was willing to agree to a short-term truce suggests a perception that tariffs are incentivising China to consider adjusting its IP protection and technology transfer practices. Whether this perception is misplaced remains to be seen. There is also nothing in the G20 denouement to suggest that the President is backing away from his view that tariffs are a valuable bargaining chip in trade negotiations. Still, there is likely some relief that China provided sufficient flexibility in Buenos Aires to allow the administration to delay raising the tariff rate on 1 January.
The threat of further escalation in the trade war has likely been weighing on the US equity market, which the President views as the most important indicator of the success of his economic policies. In addition, if not President Trump, then at least his economic advisors are aware that a number of economic indicators have shown weakness as of late, and early readings on the fourth quarter suggest a slowing of GDP growth to around a 2.5% annualised rate. A 1 January escalation of the trade war would have increased the odds that the loss in economic momentum would have carried over into 2019.
One tariff threat wanes, another waxes
Finally, the truce with China provides breathing room for the Commerce Department to conclude in short order its review of the national security threats posed by automobile imports under Section 232 of the Trade Expansion Act. The review and any recommendations are scheduled for completion no later than mid-February, but there are indications that the work is nearing an end.
The Commerce Department is likely to conclude that automobile imports weaken the US industrial base and therefore pose a national security threat, and is thus likely to recommend a mix of tariffs and quotas. European vehicles may only receive a temporary exemption from these measures, setting up time-constrained negotiations aimed at wringing concessions from the EU.
A crucial issue in these negotiations, however, is that the specific demands of the US in terms of trade in vehicles have not so far been made clear.
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