As the trade war situation has now escalated we now see this as a key political shock. We expect China to retaliate vigorously to any fresh US import tariffs and see the likely battle ground as Foreign Exchange. China’s probable response would be to slash the exchange rate putting enormous pressure on a wide variety of countries and resulting in a major hike in the dollar. An FX War would certainly be damaging for stocks, perhaps bonds too, says Charles Dumas, Chief Economist at TS Lombard. You can view a video here.
It has become increasingly clear that President Trump intends to continue the trade war at least through to the US Mid-term elections on November 6th. It is unlikely that any settlement of the disputed issues would add many US manufacturing jobs.
Both the original tariff impositions and the current threats to place tariffs on a further $200 billion of US imports from China – maybe at 10%, maybe at 25% – appear to be based on the US assumption that China’s position is weak. It is certainly true that China imports less from the US than it sends the other way – that is what the argument is all about. But the political will, and ability, of China’s leadership to retaliate is clear, as detailed by my colleague Jonathan Fenby in last week’s China Watch. So what will China do?
Foreign exchange is the likely battle ground. After its temporary peak in March, 2015, following round two of Abenomics and the ECB’s QE, the dollar stayed strong until early 2017, but then fell a real 9% until April this year, when trade-war talk really started. Since then it has bounced 7%. The Chinese yuan, having peaked in April 2015, fell nearly 10% in real terms until the summer of 2016. Then it appreciated almost to its earlier peak by April this year. But the threat of trade war has cut it by 8% in real terms (6% to mid-July in the chart, and 2% more since then). The yuan is also down 8% against the dollar since the end of March, from the high 6.20s to the low 6.80s.
If the US imposes 25%, or even 10%, tariffs on $200 billion of Chinese imports at the end of this month, or early next, the Chinese authorities will use the weapons available to them. In the short term, this may include inhibitions of service trade, and tougher conditions for US companies operating in China, but the most obvious step would be to slash the exchange rate. Any such move would put enormous pressure on a wide variety of countries – Japan, Korea, the EA and Australia as well as emerging markets. They could well follow suit. The result: a major hike in the dollar, probably dwarfing that of the past few months. As my colleague Jon Harrison put it in yesterday’s EM Watch, EM FX rates may well need to price in 25% US tariffs on $500 billion of imports from China, not just 10% on $200 billion, let alone the current relatively small imposts.
Clearly, the US could counter-escalate if the US Treasury were to find China to be a currency manipulator. But that might simply boost the dollar some more.
If this grisly scenario does emerge, the yuan depreciation could be hastened by the desire to ensure any capital outflows occur mostly after it, not before. We have a chart that shows a rough measure of net capital flows, by subtracting from the change in reserves the current-account and FDI balances (the so-called ‘basic balance’). It includes valuation effects in the reserves from changes in (for example) the €/$ rate, so it exaggerates somewhat the outflows during the crisis from mid-2014 to early 2016, when the euro (as well as the yen) was falling.
The appetite for withdrawing money from China is plain enough and easily understood, but has been curbed since 2016 by tough capital controls in an improving economic environment. With the current account veering towards balance or even deficit even before any trade-war effects have been registered, and FDI quite possibly another source of net deficit, a revival of capital outflows would hit the reserves, currently $3.1 trillion: they are already down from $4 trillion in mid-2014 as 2015-16 capital outflows far exceeded the surplus on current account and FDI.
A soaring dollar could turn the trade war into self-harm rather immediately, causing major turbulence in financial markets, hurting both stocks and perhaps also bonds. The tariffs would threaten higher inflation and reduced confidence, though a rising dollar would lower some US costs. Amongst other things, the Fed could treat dollar appreciation as quite sufficient tightening of monetary conditions; even the September rate hike that now seems a certainty might re-open attacks on the Fed’s independence. After a long, hot summer, investors may have to put up with equally intense heat of a different sort soon.
The longer-term consequences of this trade war could include the breakdown of the world economy into regional blocs, with the China-centred bloc probably the largest. We will be examining this prospect in an LSR View in September, once we have seen how much of its current threats the US Administration chooses to implement. An important part of the analysis will concern the ambivalence of the Europeans, and their relative political impotence.
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