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New Year predictions #1 – King Don v the Dragon

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Patrick Kelliher

As Yoggi Berra may have said, predictions are always difficult, particularly about the future, but to start they year, I thought I would highlight a few scenarios which may or may not arise in 2017, but which are worth considering.

The first follows on from the election of Donald Trump on a protectionist platform. While he has flitted between Democrats and Republicans, and flip-flopped between a wide range of opinions, one of the few things Trump has been consistent about is his aversion to free trade and his belief that other countries are getting the upper hand on the US on trade.

So while many commentators expect Trump to renege on promises he made during the election, I don’t think he will pull back from imposing protectionist measures. Already, car makers like Ford are feeling the brunt of his “bully pulpit” when it comes to moving jobs to Mexico. For what it’s worth I think he will build his wall on the southern border, even if it is a fence in places, and I wouldn’t be surprised if he gets Mexicans to pay for it by imposing a toll on crossings.

However, I think the key protectionist battle will be with China. To my mind, if he has to have any credibility with the blue-collar voters who handed him the White House, he will need to make some attempt at imposing tariffs on China. One problem he faces is that the US is already imposing stiff tariffs of up to 266% on steel [1], so there is no “quick win” to be had on this front.

Trump could seek to impose broader tariffs on the basis that China is manipulating its’ currency. To be fair, China is manipulating its currency but while in the past they may have been trying to keep the Yuan low to encourage exports, they are currently struggling to prevent it falling while they wrestle with capital outflows. This nuance might be lost on Trump and the US Congress, which in 2011 proposed tariffs on imports from countries with undervalued currencies, with China firmly in mind. The bill passed the Senate but did not go any further [2]. It is likely that Barack Obama may have vetoed the bill for fear of starting a trade war, but President Trump will have no such fears. I wouldn’t be surprised if the bill is dusted down and used to impose tariffs on Chinese imports.

Don’t expect China to take this sitting down. Disruption to exports would undermine the Chinese economy. This in turn could burst the debt bubble which has been building over recent years, leading to a sharp recession which could undermine the authority of the Chinese Communist Party. Faced with such a prospect, I would expect the Chinese leadership to play fast and hard to force the US to relent.

Retaliatory tariffs and other trade barriers would be imposed on US export to China such as airplanes and agricultural produce. Intellectual property (IP) laws may be applied less rigorously for US firms’ IP. US firms which have operations in China may find themselves bogged down with more frequent inspections, disrupting their supply chains. The disruption may extend to outsourced operations – for instance, disrupting the operations of Foxconn could cripple Apple who use it to make its iPhones. Whether President Trump would be upset about this is moot – he clearly feels too many US firms have outsourced jobs to China – but the disruption will damage economic growth both in the US and globally, as will the wider downturn in trade caused by tit-for-tat trade barriers.

Another front in the confrontation between the Trump administration and China could be financial markets. China hold US$1.22trn of US Treasury bills and bonds [3]. It could seek to destabilise the US financial system by selling a large part of these, pushing up T-Bond yields and hence US mortgage rates. The US Federal Reserve could offset this by expanding QE but whether it would is another matter. Higher T-Bond yields will push up yields and depress bond values elsewhere. This may also harm equity markets which are likely to suffer from trade disruption and its’ economic consequences. A Chinese sell-off may also push down the US dollar, perversely making it ever harder for Chinese exporters and reducing the value of dollar assets held by China, but as noted the Chinese authorities may view the confrontation with Trump as one where they cannot afford to be seen to back down.

One could draw an analogy with the Cold War and possibly the game of chicken that was the Cuban missile crisis. I don’t think the confrontation will come as close to outright war as in 1962 but I wouldn’t be surprised if there were flashpoints between US and Chinese ships and aircraft in the South China Sea and the Western Pacific, adding to market jitters.

China’s trump card (if you’ll forgive the pun) may be minerals such as Neodymium and Dysprosium. China accounts for the bulk of global production of these rare earth elements which are critical in electronics and other manufacturing. I would not be surprised if China suspended exports of these to the US, crippling US firms who would have to pay over the odds for alternative supplies or halt production altogether. There is a precedent for this: China is reputed to have suspended rare earth minerals to Japan in 2010 during a flare up in their dispute over the Senkaku/Diaoyu islands which had Japanese firms scrambling for alternative supplies [4]. Although China was subsequently found to be in breach of WTO rules over restrictions on rare earth export [5], I wouldn’t be surprised if they used this economic weapon again.

In summary, I believe Trump may feel politically bound to start a scrap with China. It will be bloody, and the global economy will suffer as a result, but in the end my money is on China…oh, and on mining firms with interests in rare earths…

[1] http://www.wsj.com/articles/u-s-imposes-266-duty-on-some-chinese-steel-imports-1456878180  

[2] https://en.wikipedia.org/wiki/Currency_Exchange_Rate_Oversight_Reform_Act_of_2011  

[3] Though it has been selling these holdings down as part of its campaign to support the Yuan – see https://www.bloomberg.com/news/articles/2016-09-16/china-s-holdings-of-treasuries-fall-to-lowest-level-since-2013  

[4] Though this is disputed – see http://www.eastasiaforum.org/2013/08/18/did-china-really-ban-rare-earth-metals-exports-to-japan/   

[5] http://www.japantimes.co.jp/news/2014/03/26/business/japan-u-s-eu-win-rare-earth-dispute-with-china/#.WG_woencvIU

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