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Let's Catch Mice
Year end review of US-China relations
The US-China relationship is complex, but often description of the interaction between the two states is reduced to binary terms. We win, they lose. Good versus evil. Globalist versus nativists. So much of the dialogue, debate and reporting on US-China relations degrades rapidly into a tribal chant paying fealty to a world view. Rarely do we get information and often we just get angry. For those of us focused on business objectives such absolutes and emotions add no value. What we need is a description of nuance, the shades of gray, and analysis of deeper trends some of which we will tease out in this piece.
Let’s start with the basic premise of warfare. A war is more than a battle. Much like a game of chess, long-term strategies are involved. And although it seems like this trade war has been hot for a while, it is still early in this latest standoff. New battle lines have been drawn. Positions taken, pain inflicted and suffering endured. But it is premature to count casualties and more useful to consider underlying trends that indicate where we are headed as these will reveal the probable outcomes.
One clear trend is a fundamental change in attitude in the US. Namely, a few years ago consensus opinion in Washington and New York held that engagement with China would have positive effects, enhancing free trade, improving market access, creating a more pluralistic liberal society. As these objectives failed to materialize and market access was increasingly constrained, a growing number of political and business leaders began to say—though not always publicly—that it was time to reset the terms of trade.
Trump did so by flipping the table. And the new dynamics have changed Republican and Democrat alike. Regardless of who wins the 2020 election, China will face negotiators that emphasize reciprocity, a level playing field, non-tariff trade barriers…. Those who posit that this feisty confrontational and aggressive attitude goes away when Trump does are misguided.
The shift to view the US-China relationship as competitive has invigorated the US to defend its interests. Actions taken by the current US administration, however ill-conceived or haphazardly enacted, have put pep in the US step where many will say: “At least we are standing up for ourselves, fighting back rather than fantasizing”.
Conversely, as Weijian Shan noted in a recent Foreign Affairs article: “To be sure, the trade war has exacted a severe psychological toll on the Chinese economy.” While it is common to see claims that China is in a stronger position, momentum is building around a narrative in China that significant and irreversible errors were made over the past decade when policies drifted away from liberalization toward supporting state and quasi-state companies. Business and political leaders are beginning to wonder if China has economic policies that can support growth.
In China, the private sector, including international and local companies, has been hit hard by the trade war and this is at least partially due to policies to constrain private companies. The trade war is culling the weak, but it is also bringing to light the limits of state-directed capitalism as well as the ramifications of recent ill-conceived policies to retard the growth of private companies.
Outside of the plutocrats that Beijing knights to dominate a sector (e.g. Alibaba, Tencent…), private companies—the main engine of job growth, innovation and profit—continue to suffer from a lack of policy support and an unlevel playing field. Disruption in the trade relationship has brought the weaknesses of this sector into stark relief.
A general malaise gnaws at the business community. And a distraught disposition belies the seemingly robust macroeconomic indicators. Psychologically, it feels like a recession when 5% growth is less than half of what most people remember as normal.
People are beginning to realize that the guiding principles for the past decade, the so-called path to the China Dream, is riddled with inconsistencies. Within many business and political communities there is growing consensus that the economic policies are ineffective. The Party has lost the plotline so succinctly articulated by Deng: Let’s just catch mice. Pompoms at military parades are a quaint distraction while the anxious crowd awaits practical economic policies that drive growth and improve living standards.
The pace of growth masks the structural shift from manufacturing and investment to consumption and services, a wrenching change for many that are ill-equipped to develop the products and services to meet demand. In a relative sense, markets are more competitive and job opportunities less attractive. In real terms—with food, education and healthcare inflation running well ahead of wage inflation—the world doesn’t look so rosy. Rather than prepare for battle, lots of people talk of stocking up for winter, which admittedly for many will feel like a vacation in a well-stocked chateau given the enormous gains of the past few decades and the relative deprivation in their youth.
The belief that Americans bear the brunt of the war is misguided. Everyone is hurt in this conflict. Misery is shared because the US tariffs focus primarily on inputs, not finished goods. As such, most negotiations over the past 18 months have distributed the cost increases as follows: currency depreciation absorbs 30%, suppliers another 30%, buyers 20-30%, and consumers 20-30%. There is no direct 1:1 correlation between tariff rates and consumer prices.
The net effect, significant in a macro and aggregate sense, is negligible and difficult to see for US consumers who enjoy a robust job market, rising wages and more take-home pay due to tax relief. An amorphous 5-10% increase at the till doesn’t register. In some cases, the price/value function has been distorted due to changes in quality or frills but not price. We are buying lesser quality or quantity at the same prices. Our coloring books may have 80 pages rather than 100.
Moreover, savvy companies have leveraged asymmetric information to their gain. The trade war has benefitted US distributors, brand owners and importers that have managed to increase profits by taking the opportunity to raise prices more than costs. In the latest earnings season, more than 75% of S&P500 companies reported positive earnings “surprises”. In 4Q2019 we expect more of the same.
Contrary to popular opinion in the US press, not only has the trade war hurt manufacturers in China it is also negatively impacting consumers. Apart from currency depreciation which will drive structural inflation, the Chinese consumer faces rapid inflation in food prices where the trade war has intensified an acute problem. Food inflation is running at more than 10% which is well above wage inflation of 6-8%. Pork prices, severely impacted by shocks to domestic supply, would not have increased by 70% at retail prices and 140% at wholesale prices if the US was supplying China. 70% increases in retail prices make consumers sit up and listen, but the increase in wholesale prices make businesses wonder how much longer they can stay solvent.
In January 2019, the New York Timesarticle “A Tiny Screw Shows Why iPhones Won’t Be ‘Assembled in U.S.A.’” presented a typical misrepresentation by positing that the US does not have a supply chain to support manufacturing hence Apple must produce in China. While such logic appears sound, the prime factor driving Apple’s decision to produce in China is market access and proximity to customers. Apple is not solely attracted to a deep electronics supply chain. They need to capture demand. In many product categories, China is an important market for Apple. Conversely, Samsung, a firm with only 1% market share in China, has successfully moved all handset production to Vietnam.
Apple is a lightning rod for the static in the US-China relationship. If they were to move production out of China now, they would be burned at the stake. In a sense, the New York Times is right: Apple is screwed. Put politely, they are fastened to a web of interconnected interests and constraints. As is anyone that wants to continue to work the US-China trade lanes.
It is hard to say just where negotiations will settle, but settle they will. We continue to believe that an informed and mature cadre of negotiators on both sides of the table will, notwithstanding the inane and high-pitched rhetoric, come up with a solution so that we can all get back to work. Enough already with throwing dishware around the kitchen!