Originally published on Marc to Market.
When William Gibson would say, "the future is already here, it is just not evenly distributed," he was referring to how wealth and location determine one's access to technological advances (the future). Yet it equally can apply to the U.S.-Chinese relationship.
In a recent article in the Wall Street Journal, former Treasury Secretary Henry Paulson seemed to express the views of many. If neither the U.S. nor China changes their course, an "iron curtain may soon descend." Pssst...the future has happened.
It can be debated when the Rubicon was crossed. Perhaps it was when Chinese officials thought a deal had been struck with Treasury Secretary Steven Mnuchin to buy more U.S. goods to reduce its bilateral surplus with the U.S., only for President Trump to torpedo the agreement. That taught China that power does not lie with the U.S. Treasury. Chinese officials also took that to mean that issue was not really the bilateral imbalance, but part of a larger attempt to stymie China's rise. The Rubicon has been crossed.
Trump's speech a couple of months ago should have left no doubt about what’s happening: "When I came we were heading in a certain direction that was going to allow China to be bigger than us in a very short period of time. That is not going to happen anymore."
Vice President Pence was crystal clear in a recent speech. China was trying to shape the world in ways that are contrary to the U.S. values and interests. Past administrations that sought to integrate China into the U.S.-led order, like Paulson, in effect were co-conspirators to the violations of the rules to the detriment of America. Pence claimed China was interfering with domestic policies. This is a strong claim.
It is not exactly clear what the vice president meant, but China, like several countries, responded to U.S. tariffs with retaliatory levies aimed at products from areas in which Trump drew support, like agriculture. Pence may have also been referring to the op-ed ad that China took in a local paper a few weeks ago. In any event, the claim is China wants to harm us and subvert of goals. It is not a strategic partner, rather it’s a rival and adversary.
U.S. Secretary of State Pompeo was on message when he recently said "the trade war with China against the U.S. has been going on for years. Here's what's different in this administration. We are determined to win it." And many think to win it, China must change its behavior in fundamental ways in addition to abandoning the "Made in China 2025" initiative. Even then, many will not be satisfied until China liberalizes politically. Paulson, who plays down ideological differences, blames the failure to sustain and extend the previous reform momentum on the "tightening grip" of the Chinese Communist Party.
Let's be frank. Even before Trump's election, some Chinese officials thought the U.S. was trying to contain the PRC's rise. It may or may not have been the case previously, but there can be little mistake now. The U.S. is not just preparing for a fissure, it is fostering one.
NAFTA 2.0 is not much different than NAFTA 1.0 other than some of the measures agreed to in the Trans-Pacific Partnership negotiations and a few domestic content changes. It also contained two other modifications, which mean very little for Canada and Mexico, but are significant as a template for future agreements. The first is about intervention in the foreign exchange market and making it transparent and rare. The second is the gem. It essentially says having trade agreements with non-market economies can end the bilateral deal with the U.S. "Non-market economies" is diplomatic-speak for China.
It can force countries who want privileged access to the U..S market to limit their trade with countries it judges unfit. Paulson fears the U.S. will be isolated because few will want to be locked out of the rapid growth that China continues to enjoy, even if not as fast as it was a few years ago. This seems to be an expression of defeatism among many of globalist camp.
It will take several years for the blocs to take form and solidify. There is no need for linear projections. China's economy is slowing, and its demographic challenge is looming, not to mention the precarious financial system. Paulson recognizes that the challenge China poses is one of the few issues that unite the polarized American society and elites. Yet, he did not recognize the opportunity for the U.S to lead a broad coalition in forcing China to implement what it committed to when joining the WTO in late 2001.
The U.S. forced Britain and France to back down in the Suez Crisis in 1956. They both took different lessons from the experience. France learned the U.S. could not be trusted to further French interests. It later pulled out of joint NATO command. Britain took a different lesson. It understood that the U.S. had the upper hand, and Britain should stay close to it. What kind of lesson will China take from this recent experience?
Chinese officials have said to me, not in so many words, that they will not allow the U.S. to treat it like the U.S. treated Japan, whose rise in the 1970s and 1980s, was also regarded as a threat to American hegemony by some of the same people who are leading the charge against China. No matter how much yen appreciation Japan accepted, it was never satiated U.S. demands. Some observers blame the "lost decades" on the massive deflationary forces unleashed by the appreciation of the yen.
The lesson China may take from U.S. actions and the acceptance that other countries have started to not be as receptive to Chinese investment (Australia rejected a $13 bln bid for a power company by a Hong Kong-China consortium this week) is to turn inward. Rather than jettison "Made in China 2025," it may put it on steroids, which is to say expand and deepen the import substitution strategy and reduce the external sector as a share of GDP.
There will be fewer goods and services flowing between the world's two largest economies. It does not necessarily mean less capital flows, and that is an important point. For example, the largest U.S. asset managers who track international benchmarks will have to hold Chinese bonds and/or stocks, just as they do Russian bonds/stocks. On the other hand, the depth, liquidity and security of the U.S. Treasury are second to none. Despite the rhetoric about exorbitant privilege, the fact of the matter is that the U.S. pays a premium that is at multi-year if not record highs against most of the G10 sovereigns including Germany.
China initially appeared content to bide its time and President Xi Jinping is positioned to outlast Trump. It tried offering concessions to ease the bilateral imbalance. These were ultimately rebuffed. The rhetoric on both sides has become more hostile. China has few friends in the U.S. Environmentalists, labor, human rights activists and businesses are frustrated with the discrimination, and nationalists (Trump's self-identification) are vocally critical. Antipathy toward China is one of the few bipartisan issues in America, where the electorate and officials are exceptionally polarized. Democrats, who were often criticized by Republicans for being "soft on Communism" after the Kennedy-Johnson era, are not going to be similarly vulnerable in this new cold war.
This means that Chinese officials cannot in anyway count on the changes of the U.S. electoral cycle to dial back the confrontation. While many in the U.S. see a contradiction between China modernizing the economy and an archaic political system, China sees U.S. government as unstable.
Consider that the U.S. impeached one president who lied about a having slept with a consenting woman while electing another man president who appeared to have bragged about taking advantage of other women. Or consider that U.S. political elite sponsored a multilateral system of free mobility of goods and capital, but in one election in which the winner did not receive a majority of the popular vote, the strategy has been turned on its head. The vagaries of America's electoral system and the gerrymandering that helps preserve it is not a stable foundation upon which China's development strategy can reliably depend.
The situation is likely to get worse in the period ahead. It seems unlikely that China will make concessions the U.S. is looking for later this month when Trump and Xi meet. Trump then is likely to begin the formal process of putting tariffs on the remainder of Chinese goods. That process will take a couple of months and could be halted or modified before implementation, but in the meantime, it is consistent with the maximum pressure tactics the Art of the Deal requires. Moreover, on Jan. 1, the 10 percent tariff on $200 bln of Chinese goods will be raised to 25 percent.
The Federal Reserve's projections suggest three hikes between now and the middle of next year. The market is not as sanguine and has discounted nearly two hikes. China is likely to ease monetary policy. It does not have to cut interest rates. It could reduce required reserves, which are still among the highest in the world, for example. The 170 bp premium China offered over the U.S. to borrow for 10 years at the start of the year is now less than 35 bp. Already the U.S. pays a premium over China to borrow for two years.
Wider rate differentials are likely to continue to underpin the dollar broadly, and the risk is that it rises above CNY7.0. Although Chinese officials had previously suggested that it did not want the dollar to rise above it, economic conditions change. There is nothing sacred about CNY7.0. A push above there probably will coincide with the euro's range ($1.13-$1.18) breaking to the downside.