From a US perspective, the potential for tensions over Sino-US trade looks real. Late 2017 saw the release of US strategy documents on national security, defence and trade, which for the first time identified China as a strategic competitor and disavowed America’s long-standing policy of constructive engagement.
Our base case remains that there should be no full-scale Sino-US trade war . But even friction could have a long-term impact on global trade, investment flows and the political power balance in Asia-Pacific. The short-term effects would likely be unevenly distributed across global markets. The impact on China may be far less than US President Trump expects, but the collateral damage to Asia’s regional economies could be significant and would have asset allocation implications for the region’s financial markets.
A stubborn trade deficit with China
The pressure point of Sino-US trade friction lies in the persistent trade deficit that the US has with China. It is more than five times larger than the deficit with Mexico. Furthermore, China’s trade surplus with the US has climbed to record highs, while its surplus with the rest of the world has fallen (see Exhibit 1).
Exhibit 1: China’s trade balance, data series in 12-month rolling sum
Source: CEIC, BNP Paribas Asset Management Asia, as of 21/02/2018
President Trump thus believes a tough trade stance on China is justified. Things now seem to be moving in that direction. After imposing import duties of 30% and 20% on solar panels and washing machines, respectively, in late January, the US Commerce Department proposed in mid-February to impose high tariffs or quotas on US imports of steel and aluminium, China being the world’s largest producer of both commodities.
The collateral damage of Sino-US trade friction
Financial markets see these moves as evidence of Mr. Trump’s protectionist policy . However, gross trade data can be misleading because over one third of China’s exports, including those to the US, are goods that China has added value to, but that were mainly produced in other Asian countries.
This means that rising US protectionism, as manifested in Sino-US trade friction, could hurt economies that supply parts and components to China. The potential collateral damage can be estimated by stripping out the added-value portion of China’s gross exports and reassigning it back to its source countries to assess their ultimate export exposure to the US.
The point is clear: An escalation of US trade protectionism would be quite damaging to most of Asia’s export-oriented economies, with six of the top-10 most-exposed countries being Asian (see Exhibit 2). The damage to China is somewhat limited.
From an asset allocation perspective, ceteris paribus, it would appear that China would be the least-affected Asian market should trade frictions increase.
A market study  also finds that in the Asian countries that are the most exposed to the US, the industries that could be hit hardest are
- textiles, leather and footwear in Vietnam
- computers and electronics in Taiwan and Malaysia
- chemicals and petroleum products from Singapore.
Exhibit 2: Final export exposure to the US compared to direct exports to the US (2016)
Note*: Exports that cater to US domestic demand, excl. goods that are re-exported from the US to third markets. Source: UN Comtrade, Eurostat, OECD-WTO TiVa database, IMF, national statistics, CEIC, Nomura, BNP Paribas Asset Management Asia, as of 21/02/2018
The US’s strategic calculations
The US does not seem to be bluffing. In 2017, trade policy was subordinated to the goal of gaining China’s help on the North Korean crisis and passing a tax cut bill. Now, with the North Korean crisis risk stabilising and the tax bill in place, tough trade policy has taken priority on Mr. Trump’s political agenda.
Mr. Trump and many US officials seem to think that China still depends heavily on foreign trade for growth and that it has such a fragile financial system that pressure from the US could force China to cave in to its demands.
In my view, they have overestimated the US ability to force China’s hand and their understanding of China’s economic structure is outdated. Since 2009, the contribution of net exports to China’s GDP growth has largely been zero or negative (see Exhibit 3). This suggests that its economy has already shifted from export-led to domestic-led growth.
Exhibit 3: Growth contribution of China’s GDP components
Note: net exports = auxiliary tool for growth, and it has not been contributing to growth in recent years. Source: CEIC, BNP Paribas Asset Management Asia, as of 21/02/2018
The reality of China
Market research suggests that a permanent 10% fall in China’s exports to the US would cut Chinese GDP by about 0.3 percentage points. This is material, but can easily be offset by domestic infrastructure spending and/or an increase in exports to other markets under the Belt & Road initiative.
Furthermore, the power of China’s domestic innovation to generate growth has improved significantly. Its industrial upgrading process under the “Made in China 2025” policy has been backed by hundreds of billions of dollars in government venture-capital funds in addition to traditional subsidies.
So do foreign investors, faced with an opaque system with onerous regulations and lack of market access, still want to pour money into China?
China’s foreign direct investment (FDI) rose by almost 10% to USD 144 billion in 2017, according to the UN, while the total amount of global FDI fell by 16% to USD 1.52 trillion. The chances are that as long as China remains the world’s fastest-growing major economy, the lure of its market size and momentum, together with progress on economic reform, will outweigh complaints about an uneven playing field and the fear of technological leakage.
In the short term, a persistent US campaign of economic pressure on China would bolster the view that the US has embarked on a long-term fight to reduce its trade deficit, possibly using a weak US dollar as a tool.
US Treasury Secretary Steven Mnuchin raised exactly this fear in late January by commenting on the benefits of a weak dollar. Although senior US officials hastily reaffirmed a strong dollar policy afterwards, the market has grown sceptical. Cutting the trade deficit is now a stated policy goal. Research from a US think-tank shows that cutting the US current account deficit from 4% to 2%-3% of US GDP would require a 10% depreciation of the US dollar real exchange rate.
Over the longer term, both China and the US seem to be striving to on-shore the globalised production chains developed over the past three decades. China is doing this through import substitution to minimise the foreign share of its industrial base.
The US is applying America-first policies. Even a partial success of these initiatives could be damaging.
- The breaking-up of the global supply chains will likely raise inflation by reversing the disinflationary forces of globalisation.
- Secondly, I would argue, cross-border production chains are a force for peace and stability as they raise the stakes should armed conflicts break out. Reverting back to domestic production raises the possibility that major countries would try to settle their differences by force. It may be too early to be alarmed, but the possibility is worrying.
Complications for Asian currencies
In broad terms, Asian currencies would face depreciation pressure as trade slows and local policymakers act to protect growth. However, if the US dollar remains weak despite the expected US interest-rate increases, it could mitigate the risks of protectionism for Asian currencies and could even allow Asian central banks to hold off on raising interest rates.
The relative strength of these two forces is unknown. Much depends on the direction the US dollar takes. This, in turn, depends on whether the Federal Reserve raises US rates by more, or faster, than currently expected by the markets.
: “Chi Time: Trump and China and the Potential Surprises”, as of 05/01/2017
: Mr. Trump has until mid-April this year under US trade law to decide on the steel and aluminium tariff and quota proposals.
: The Impact of US Trade Protectionism Centring on China”, Asia Special Report, Nomura, 23/03/2017.