This guest commentary was written by Daniel Lacalle.
In recent weeks we have read a lot about the so-called trade war. However, this is better described as a negotiation between the largest consumer and the largest supplier with important political and even moral ramifications. This is also a dispute between two economic models.
Nobody wins in a trade war, and tariffs are always a bad idea, but let’s not forget that they are just a weapon.
Why right now?
For many years China has been allowed to maintain a mercantilist dictatorship and protectionist model under the excuse that its high growth made it attractive.
Shortly before the US launched its set of tariffs, the Chinese government accelerated two dangerous policies that we cannot ignore: intensifying capital controls , limiting the outflow of dollars from the country, and increasing the list of banned companies and sites, two measures that proved that the Chinese government was unlikely to open its economy, rather the opposite. These measures intensified in the last year and a half. Two other factors show China’s decision to halt the opening of its system. The “Made In China 2025 Plan” and the removal of the two-term limit on the presidency, effectively allowing Xi Jinping to remain in power for life.
Between 2004 and 2018, the United States filed 41 complaints against China at the World Trade Organization, focused on 27 different areas. The vast majority of these WTO resolutions are not enforced (“Paper Compliance: How China Implements WTO Decisions.” The previous strategy of looking the other way and expecting the Chinese economy to open up little by little met the reality of increased interventionism.
A senior official of the US Administration explained to me several months ago that there were two opposing opinions in the White House. The first claimed that starting a trade war would sink the US dollar, make US bond yields soar and throw the economy into a recession. The second estimated that the risk to the US economy was small and manageable. These were proven right with the US 10-year bond at 2.13%, its demand (bid-to-cover) comfortably doubling supply despite the end of the Federal Reserve purchases, and the dollar (DXY Index) at a conveniently strong level, adding very solid employment level, wages, and economic growth. The US dollar strengthened its position as the world reserve currency at 88% share of transactions while the yuan was only 4%, according to the BIS.
Meanwhile, the proponents of a “gold-backed” yuan faced the reality of a Chinese central bank that injected and increased the money supply in a more aggressive way than the US Federal Reserve. China is not following sound money policies. The PBOC is copying the same policies of the Fed and BOJ by the book. It is not even remotely close to a gold standard, as gold reserves are less than 0.25% of M2 money supply.
The gold-backed-yuan mirage faded with two consecutive devaluations, a currency that is used in less than 4% of global transactions and an extremely aggressive monetary policy.
Many have mentioned that China could sell its US treasury holdings or threaten with its rare earth supply, essential for the manufacture of technological equipment.
China is not the largest holder of US bonds in the world, not even close. It’s the US. In fact, China has already reduced part of its holdings in US bonds and yields fell.
No, China could not weaponize its US debt holdings because it would run out of reserves and sink the economy and the yuan with it (read this excellent analysis ). China’s FX reserves have fallen by 21% from the highs and the vast majority of them cannot be used.
The only solution for China would be to eliminate its capital control and let the yuan float, but then it could face a huge devaluation that would lead the country to a spiral of bankruptcies which may, in turn, lead to more yuan printing, a yuan that is not used worldwide and with diminishing demand. Recession or financial crisis.
What about rare earths?
In a magnificent article called ” The False Monopoly “, the authors debunk the myth of the alleged US dependence on China, but there is an additional factor. None of the Chinese miners in this sector generate returns above the cost of capital. Either they are loss-making or losing relative to working capital costs. We know this because they already tried both blanks in the past and they did not work.
The confidence of the hawks in the United States administration was strengthened by the evidence that “the Chinese currency is not even wanted by the Chinese” given the evidence of capital outflows and a huge percentage of loans backed by copper and other commodities. China’s dependence on the US dollar turned out to be double: via FX reserves and via commodities. Their vast reserves are much smaller and less accessible than many thought.
The technological battle
There is a fourth factor added to the high trade surplus, capital controls, and lack of legal security and property rights. The technology battle.
70% of the software used in China is pirated from the US. The negative impact for the North American economy, only in the area of intellectual property, is $600 billion (“China: Effect of Intellectual Property Infringement and Indigenous Innovation Policies on the US Economy “) a larger figure than the trade surplus that China has with the US.
It is not just a battle for control of technology, but security. The American technological giants are private companies and most of their leaders are critical of the White House Administration. The technological giants in China are either government-owned, semi-state owned or concessions to members of the communist party.
The wrongly-called trade war is much more than tariffs. There are many additional forms of protectionism, and capital controls, restrictions on currency, lack of separation of powers and respect for intellectual property are also forms of protectionism.
The United States has discovered the Achilles heel of China. The same one Japan had in the 80s when it seemed that it was going to invade the world. Its dependence on the US dollar to maintain its large domestic imbalances, a very fragile house of cards of excess capacity, real estate bubble and unproductive spending.
Does the United States have anything to lose? A lot, but much less than China. According to Oxford Economics, the impact on US GDP of a total and prolonged trade war would be between 50% and 70% higher in China than in the US, and we have to add the domino effect of bankruptcies in China Global fund flows move to the US and out of emerging economies.
The strength of the United States is to have a safer, open economy where currency remains a global reserve, not because of military power, but because the rest of the currencies fall into the trap of carrying out the same monetary imbalances as the US but without its free market, openness and real demand for currency.
China’s Achilles heel has been to try to be a reserve currency whilst maintaining capital controls and increasing state intervention, playing to be the US without its dynamism, openness and free market. Its only card was a debt-fueled high-growth economy. Chinese officials knew it was impossible, but thought that being the “engine of world growth” would allow them to get away with it. They have met with a customer, the United States, which is the only one that supports its huge trade surplus ( China has a trade deficit with most of its other partners), and that does not depend so much on exports. The US exports less than 12% of its GDP.
The United States knows that this war has important negative internal economic consequences. Tariffs are not a solution, only a weapon, because if China does not begin to open its real economy, the problem will be greater in the long term.
China and its citizens would greatly benefit from eliminating barriers. Moreover, if it does and truly becomes a reserve currency by merit, it will be excellent for the US because the perverse incentive of the central banks will be counterbalanced. But China seems to prefer to fall into the same monetary, legal and commercial errors rather than reduce control. And that is a big problem, as tariffs serve as a justification to perpetuate dictatorial mercantilism, not to reduce it.
Protectionism is not solved with more protectionism, but when the opponent does not seek trade as a tool of mutual progress, but as a Trojan horse to take control, we find ourselves with much more than a trade war. A fight between two models of society.
The United States and China will find a form of agreement, but it cannot come from closing our eyes to the totalitarian risks of the Chinese system. Both China and the US know that this battle is not to see who wins, but who loses less, and who drops the weapons first.
This is a Hedgeye Guest Contributor note written by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the most recent Escape from the Central Bank Trap.