The US government wants the Chinese to respect US intellectual property and a lower bilateral trade deficit.
Unleashing a trade war isn’t likely to bring these goals closer, in fact it could very well result in the opposite.
It risks doing great damage to the US and world economy and denies the considerable progress China has actually already made.
For investors, there are few if any upsides here, and quite a few downsides.
The Trump government, which has already imposed 25% tariffs on $50B of Chinese imports (as well as on steel and aluminium, and solar panels), is threatening to greatly escalate the trade war.
First slapping tariffs (10%-25%) on another $200B of Chinese exports to the US, possibly followed by another round on basically the rest of Chinese exports to the US, some $267B.
Sometimes, the cure is worse than the disease, and this definitely runs the risk of being an example of that. The question we ask is what is the US government trying to achieve?
Well, China is a trade cheat and they “robbed US jobs and intellectual property.” There is indeed something in that, but much of this is in the past.
There are a number of ways the Chinese got hold of US intellectual property
- Acquisitions of US companies
- Forced joint ventures
- Intellectual espionage and cyber theft
- Hiring returning overseas workers (or even Americans)
While all of this has been going on, opinions differ on how important that is today, and if so what the US can effectively even do about it. We see three opinions:
- There is very little the US can do about this
- China has cleared up much of its act
- The trade war is going to make things worse, not better
There is some truth in all three of these, in our view. In fact, of the different avenues for the Chinese to get hold of US intellectual property, the US has only good defenses against Chinese acquisitions, and this is indeed what the US government has been shoring up.
The Committee on Foreign Investment in the U.S., or CFIUS, has been beefed up, blocking (technically, advising to block) the acquisition of Qualcomm by Broadcom, for instance. Or, from Bloomberg:
But it’s not easy to see what effective measures can stave off any of the other avenues China has for acquiring US intellectual property. We’re not sure starting a trade war will achieve that and in fact, this could make things considerably worse.
It’s an explicit Chinese policy goal to become more economically independent, more especially in high tech. This is what the dreaded China 2025 program is all about, as it happens.
The trade war will only speed this up, and legitimize the Chinese government efforts to frustrate US companies in the Chinese markets, support its own companies and it could very well make them even less respectful with regards to US intellectual property.
We already argued a couple of months ago that the lesson from the ZTE saga for China was likely to be to speed up decreasing the reliance on foreign technology, they are likely to double down developing their own stuff.
The fact is also that China has build an enormous scientific and engineering community, as well as some formidable domestic companies so its dependence on US tech has lessened already. Here is Teresa Barger, co-founder and CEO of emerging markets activist fund Cartica Management (CNBC):
The truth is, China no longer needs these joint-venture rules in many industries, with several sectors and companies already competitive with their counterparts in the United States. In fact, in April 2018 China agreed to ease its rules on foreign auto companies operating in China, a clear signal that the quality of Chinese cars, including autonomous and electric vehicles, is rapidly increasing. It also just announced that foreigners would no longer need specific permissions to invest; they would just be prohibited from investing in a “negative list” of industries.
And the efforts of moving up the technology ladder (our emphasis):
The early results show this plan is paying off and China is already emerging as a global leader in AI, renewable energy and electric vehicles, among other sectors. This technological advancement is tied to the recent trade talks in that China is increasingly incentivized to protect its own IP rather than trying to steal foreign IP. We are reaching the critical crossover point in China where the return on IP theft is falling toward zero and the return on IP protection may soon rise above zero. The reality is that many of the Trump administration’s articulated demands are things that China is already doing, albeit at a somewhat slower pace.
Barger isn’t the only one pointing out this progress, here is William Weightman with a survey in The Diplomat:
However, over the past decade, China has become increasingly innovative and has demonstrated a serious resolve to enforce an effective IPR regime. Indeed, as Chinese firms focus on global expansion abroad and high-tech innovation at home, they have increasingly demanded effective IP protections from the government. In fact, many of the concerns raised by foreign companies operating in China have been addressed by legal reforms and new enforcement mechanisms.
So we come away with the conclusions that yes, China did steal US IP, but things have improved significantly in this respect, and starting a trade war isn’t going to improve the situation but will achieve exactly the opposite result (and at considerable cost to the US economy).
Apart from the theft of US IP, the President is also consistently hammering that big bilateral trade deficit the US has with China, and a second aim seems to be to reduce this. From CNBC
His stated objective is to reduce the size of the U.S–China trade deficitfrom an estimated $370 billion to $200 billion by 2020.
There are really numerous problems with this:
- China isn’t much of a trade cheat anymore
- The real situation is much more complex
- Bilateral trade deficits are meaningless
- The result will be counterproductive
- The collateral damage to the US will be considerable
Again, China used to be a trade cheat, but that has greatly diminished:
The current $370 billion deficit estimate does not account for value-added. When looking at the value-added content of Chinese exports, the U.S. deficit with China is actually only half of what it seems. And if we then add back the U.S. surplus in “invisibles” and how much money the United States brings back from investments in China, the U.S.–China deficit shrinks from 2 percent of U.S. GDP to 0.8 percent, a report from Oxford Economics revealed.
If that is too abstract, here is a terrific example:
In the case of the Apple iPhone, this means that China’s exports balance accounts for the full $500 iPhone value, when China adds only approximately $15 to $30 of the value to the phone. Most of the iPhone value accretes to Samsung in Korea ($150) and to Apple — the brand owner and engineer.
Since there is a good deal of US value added in much of Chinese exports to the US, slapping tariffs on these will hit the US in multiple ways:
- If these are producer goods or intermediary goods (as were much of the first $50B batch of goods under tariffs already), it hobbles US producers as it increases their cost. They will have to raise prices (which raises inflation and could trigger more Fed rate hikes) or seek alternatives.
- Insofar as the Chinese exports contain US value added, it hobbles US producers as these product will now become more expensive in the US so fewer will be bought.
- Insofar as the products are consumer goods, US inflation will rise which could lead to a more aggressive Fed and real wages will fall.
- The dollar is likely to strengthen as a result of the uncertainty created by the trade war
- Chinese retaliatory measures will inflict further damage.
Even now there is already considerable damage, but there is more to come, from Yahoo:
The Trump administration is expected to enact tariffs on an additional $200 billion worth of Chinese imports to the US. Some companies say they will have to immediately lay off employees to absorb the cost. Others warn they may have to shut down completely.
The whole concept of bilateral trade deficit is economically meaningless and not really amenable to policy. Here is Steven Roach (Economist):
“The tariff war is really a foil,” Roach told CNBC, saying that the U.S. had bilateral deficits with 102 countries around the world. Instead, he called it a “multilateral problem” that’s due in a large part to Americans not saving. “When you don’t save and you want to grow, you import surplus savings from abroad, you run massive current account and trade deficits to attract the capital,” Roach said, claiming that was something that “any basic macroeconomics class will teach its students.” “Apparently the president or his advisors, several of them unfortunately went to Yale, don’t either remember or didn’t do well in their macroeconomics classes,” Roach added
Indeed, even if one would be able to reduce it, a bigger trade deficit with some other region will show up elsewhere as long as the US saves less than it invests.
We have written earlier about the curious trade views of the US government seems to hold (here), and wondered how they could persist in the face of basic facts and economics. Well, here is a clue, from Esquire:
“Several times [chief economic adviser Gary] Cohn just asked the president, ‘Why do you have these views [on trade]?’ ‘I just do,’ Trump replied. ‘I’ve had these views for 30 years.’ ‘That doesn’t mean they’re right,’ Cohn said. ‘I had the view for 15 years I could play professional football. It doesn’t mean I was right.'”
China integrating with the rest of the world
Unleashing a trade war on Chine could just simply speed up the Chinese efforts to become more dependent on their large and growing domestic market, and speed up the integration with other parts of the world. From Asia Times:
a report released on Thursday by the American Chemistry Council detailed how tariffs will accelerate Asian economic integration, to the detriment of US firms. China has recently committed to eliminating or reducing trade barriers on more than 8,500 goods imported from trading partners in the Asia-Pacific region, the report noted, which will significantly reduce costs of inter-Asia-Pacific business.
The Chinese have already been investing billions all over the world where they have build infrastructure and markets, and their Belt and Road initiative has been unleashed in 2015. From
According to the Belt and Road Action Plan released in 2015, the initiative will encompass land routes (the “Belt”) and maritime routes (the “Road”) with the goal of improving trade relationships in the region primarily through infrastructure investments. The aim of the $900 billion scheme, as China explained recently, is to kindle a “new era of globalization”, a golden age of commerce that will benefit all. Beijing says it will ultimately lend as much as $8 trillion for infrastructure in 68 countries. That adds up to as much as 65% of the global population and a third of global GDP, according to the global consultancy McKinsey.
The US is absent from this and one of the first measures the new US government took was to step out of the TPP, the Asian trade pact without China, leaving the field to the Chinese.
From CLSA Economist:
“It may well have the perverse reaction of accelerating China’s attempts to move up the supply curve … to become self-sufficient (IN) more and more high-tech products. And it will certainly encourage China in its moves to build more and more political and economic spheres of influence,” he told CNBC’s Akiko Fujita at the 2018 CLSA Investors’ Forum in Hong Kong.
Meanwhile, it’s pretty difficult for investors to deal with all of this. There is hardly any economic upside from a trade escalation, and much downside. But it depends on the whim of the government, and that hasn’t been the easiest of lodestars to follow.
It isn’t even clear what the US government is trying to achieve, whether that is achievable, or (what we suspect) it will be even counterproductive with respect to the stated goals, respect for US IP and a reduction of the US-Chinese trade deficit.
What we do know is that the fallout can be large, in terms of rising US inflation, a more aggressive Fed, a higher dollar, putting more pressure on emerging markets, frayed international institutions and relations, frayed supply chains, job losses, real wage declines. Take your pick.
Lots of companies will see their earnings affected. Apple (AAPL) is in the fire line from two sides (US tariffs on Chinese exports and Chinese retaliation) as is much of the network sector.