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How can we have trade war when US-China 'trade deficit' is disappearing?

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"There is room for compromise but the path to an agreement could be long and tenuous while it is likely that the issues of income inequality and populism may intensify in the next global downturn rather than going away." - Prashant Bhayani.

MUCH ink has been spilt on the topic of trade tension. But the simplistic response that "trade wars are not good, everyone loses" is not all that helpful to analysing the root causes of the current situation. Furthermore, neither is a trade surplus useful as a barometer of competitiveness.

Firstly, it is important to remember that trade tensions have been going on for many decades. The recent steel and aluminium one-off tariffs by the US have been occurring between the US, Europe and Asia for many decades, and have not been material in their impact on overall global GDP.

But the rhetoric is building to a new crescendo with the current renegotiations of Nafta, additional US$50 billion tariffs proposed by the US against China, and escalating tension around intellectual property.

So why now? Despite the remarkable growth in global trade and wealth, there has also been a concomitant increase in income inequality globally. For example, the top 1 per cent income earners in the US have doubled their share of the national income to more than 22 per cent since the 1950s.

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Asia is not immune as well from the increase in income inequality. Many of the gains have benefitted college educated workers disproportionately, increasing income disparities.

Finally, multi-lateral organisations like the WTO have not been as effective at levelling the playing field, with China and other emerging countries entrance, especially on the opaque, non-tariff barriers to trade.

So how can governments address this while still increasing the total size of the economic pie?

Firstly, it is clear that a number of developing countries including China need to further liberalise their trade policies. For example, the simple average of China's tariffs on traded US goods are estimated nearly three times higher than the tariffs the US applies to Chinese goods.

US President Donald Trump tweeted, "When a car is sent to the United States from China, there is a tariff to be paid of 2.5%. When a car is sent to China from the United States, there is a tariff to be paid of 25%."

But this is normal for any country at a developing stage, but given China's emergence, it has the ability to lower tariffs and to open up incrementally.

This is in-line with Chinese President Xi Jinping's reform agenda to bring down protection for excess capacity industries, spur competition in China, and reduce the economy's reliance on government support via implicitly guarantees on debt.

The big question is can it happen fast enough given the challenges of managing that in the social context of China's economy?

But the even more contentious issues are the non-tariff barriers to trade. This is when countries require joint venture partners in selected industries, technology transfer, and enact policy barriers to impede foreign companies.

In China, this is of particular focus given the "Made in China 2025" plans. Importantly, China recently agreed to liberalise, allowing majority foreign ownership in the financial sector, lower auto tariffs over time, and increase protection of intellectual property. Clearly on the intellectual property, the proof will be in the pudding.

Intriguingly, that has been more of a concern as both the US and Europe are now utilising similar policies allegedly used by the foreign governments. For instance, the recent Broadcom takeover of Qualcomm was put on hold for national security reasons by the Committee on Foreign Investment in the United States (CFIUS), an interagency committee.

Presently, the Trump administration is looking to broaden the powers of CFIUS. Europe, Australia and other countries are also acting to review Chinese investment in sensitive industries. Hence, the battle for a level playing field continues but there are risks of creating a trade war.

In addition, while reciprocal trade is good in principle, trade surplus is an imprecise and poor measure of a country's competitive position, since trade deficit or surplus only accounts for goods produced in one country and sold to another, and does not include the sale of goods and services that are simultaneously locally produced and sold.

A good example is Apple in China. Apple produced and sold more than 300 million iPhones in China, more than double the sales in the US with US$48 billion in 2016. Amazingly, the "official" trade statistics show just US$1 million of imports into China of US phones in the same year.

Similarly for GM, China is its largest market by car sales, largely via joint venture sales in China. Ironically, the sales of US subsidiaries in China are the fastest growing area of trade between the US and China, and at the same time completely invisible in trade statistics.

The sales of US subsidiaries in China have exploded, growing at an estimated annual pace of 18 per cent from 2009 to 2015. It is estimated that if the subsidiary sales of US subsidiaries in China is added in, the trade deficit evaporates astonishingly from US$367 billion in 2015 to just US$30 billion. It could even be in surplus at present times. Yes, surplus!

But this does not solve the income inequality and populist political issues as the profits from Apple iPhone profits largely accrue to workers with college degrees and shareholders. In conclusion, trade balances don't account for the foreign direct investment channel (US subsidiaries in China).

So how do we assess the likelihood of a full-blown trade war? Of course, that risk should not be dismissed. But little attention has been given to the US and South Korea agreeing in principle to a new trade agreement and a key milestone to monitor will be the Nafta negotiations ahead of US-China negotiations this year.

While it is true that China's economy is more dependent on exports to the US, the overall sales balance including the China subsidiary sales of US multinationals could almost be in balance. While the US economy is less dependent on exports, the US stock market could react more negatively than the US economy to any trade war as more than 40 per cent of sales are international in nature.

This could also keep a noticeable check on the extent of a trade war especially before mid-term elections in November in the US. Simultaneously, as China gradually liberalises while the US and Europe push for more open and reciprocal trade, it can result in a healthier and more balanced global economy.

The time to do it is definitely now as we are experiencing synchronised global growth. Incidentally, it is unprecedented in recent times to have this level of populism when growth is robust.

There is room for compromise but the path to an agreement could be long and tenuous while it is likely that the issues of income inequality and populism may intensify in the next global downturn rather than going away.

  • The writer is chief investment officer, Asia, BNP Paribas Wealth Management
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