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China dropped out of the headlines in the second half of 2016 as fears of a hard economic landing receded. But the nation was catapulted back into the spotlight over the course of Donald Trump’s election trail.
His antagonistic stance threatens the country’s prospects at a time when China’s economy is becoming more consumer-oriented, so how strong is the investment case for exposure to China in 2017?
Western markets separate Trump’s fiscal plan from his trade policies, argues Ed Smith, Rathbones’ asset allocation strategist.
There seems to be an assumption that Trump is going to cap taxes and spend on infrastructure, but that ‘his protectionism is just campaign rhetoric that is not going to come to pass. But we think that doesn’t seem quite right’.
Smith says Trump wrongly believes he can pay for his fiscal spending though his trade policy, which includes ‘reshoring’ jobs from overseas and protectionist moves.
Trump thinks such policies will double the rate of growth in the US economy and therefore double tax revenue, replenishing US Treasury coffers.
China is a big target for Trump: it’s the country he refers to most fervently and frequently. Two of his loudest election promises were that he would label China a ‘currency manipulator’ and slap a 45 per cent tariff on Chinese exports to the US.
Trump’s accusation is that China’s government is artificially weakening its currency against the dollar to make its exports more competitive, at the expense of manufacturing jobs in the US.
In fact, being branded a currency manipulator is not an insult – in contrast to many other things he has said – but a technical term.
But there are no recent precedents for it: the last time the US designated another country a currency manipulator was more than two decades ago in the early 1990s (it was China under fire then too).
US law states that once the Treasury secretary declares a country a currency manipulator, ‘enhanced bilateral engagement’ with the offending country begins. If after one year the country has failed to adopt appropriate policies, a penalty kicks in.
The first part of that penalty involves a halt to the US Overseas Private Investment Corporation (Opic) doing business with the offending country.
However, such a move seems irrelevant in the case of China, given that Congress passed a law prohibiting Opic from working there back in 1989, after the killings in Tiananmen Square.
Another element of the penalty involves the Treasury secretary instructing the International Monetary Fund (IMF) to keep a close eye on China. However, the IMF already monitors the Chinese currency, and it has recently said that the currency is reasonably valued.
The US Treasury publishes a report every six months that includes a ‘watch list’ of countries that could become manipulators and require close surveillance. Currently, China is on the watch list, as are Japan, Korea, Taiwan, Germany and Switzerland.
‘The bottom line is that it’s going to be very easy for Trump to fulfil this pledge, but it will have zero concrete impact on China,’ says Andy Rothman, investment strategist at Matthews Asia and former head of the macroeconomics and domestic policy office at the US embassy in Beijing.
‘I think Chinese officials are well aware of the law and understand that being branded a currency manipulator has no concrete implications for them.’
Contrary to what most people believe, pegging a currency to the US dollar does not violate any IMF or World Trade Organisation (WTO) rules, adds Rothman.
A few years ago around 60 countries pegged their currency to the dollar. Furthermore, China can point out that over the past decade the renminbi has appreciated by more than 45 per cent in real terms against the dollar.
TIT-FOR-TAT TRADE TARIFFS
Another policy on Trump’s list is a 45 per cent tax on Chinese imports. ‘A lot of US company CEOs are probably calling Trump already to discourage him from doing this,’ says Rothman.
‘China is a fantastic market for US airplane manufacturers and soybean producers, and for many other companies’.
Imposing the 45 per cent tariff would be bad for both US businesses and consumers, because it might increase the price of many products in Walmart by around 10 per cent.
Moreover, since China joined the WTO in 2001, US exports to China have risen by more than 600 per cent. In comparison, US exports to the rest of the world are up by just 80 per cent.
Instead of putting a high tax on all Chinese imports, Trump could tax specific products such as steel. However, we know from history that such a tactic doesn’t work well.
Former president George W Bush put a tax on steel from China, but all that happened then was that steel imports from China declined, only to be replaced by imports from Brazil.
Similarly, in 2009 president Barack Obama put a tariff on tyre imports from China. As a result prices rose, and China’s share of the US market went to Mexico, Thailand and Indonesia. In the end, the tariff didn’t help US tyre company workers.
On top of that, China retaliated by putting a high tax on US chicken feet. Americans eat a lot of chicken, but they don’t eat the feet, so it was easy money for US poultry companies to ship all those feet to China, where they are in high demand.
When China retaliated against the tax on tyres by blocking US chicken feet, US poultry producers lost $1 billion (£825 million). A few years later the US and China agreed to drop their tariffs.
Chinese manufacturing would be hit in a trade war, but overseas trade isn’t as big a part of the Chinese growth story as it once was, says Smith.
There are other countries in the Asia Pacific region, such as Vietnam, Malaysia and South Korea, where trade in terms of manufacturing exports to the US is a bigger component of GDP than it is in China.
Although China is in Trump’s sights, it is better placed than some of these other countries to weather a trade war. China has a current account surplus and reserves that cover about 18 months of exports, so it can survive a big trading setback.
China is no longer an export-led economy. This year will be the fifth consecutive year in which the services and consumer element of the economy is worth more than the manufacturing and construction part.
Rothman says: ‘I estimate that only 10 per cent of all the goods produced by Chinese factories get exported. 90 per cent of what comes out of Chinese factories (by value) is consumed in China. Only 18 per cent of China’s exports go to the US. It’s a significant market, but not the majority. China will manage.’
CAUTION WARRANTED WHEN INVESTING
Andrew Parry, head of equities at Hermes, says: ‘Trump is less a politician than an owner of assets and properties. He will always consider the consequences of his policies on his property empire, and a trade war with China is not good for US business. So the realpolitik is that they’ll find a way to rub along.’
Parry concedes that there could be a ‘big event’ where China challenges the US – over Taiwan, for instance – but he believes this could be in five weeks’ time, or it could be 50 years down the line.
In recent years, the Chinese government has been trying to transform the economy from one based on manufacturing and exports into one driven by domestic consumer demand.
Innovation in areas such as IT, healthcare and consumer goods means Chinese companies are challenging global leaders, and this could be a key driver of growth in the years ahead.
However, given that the Chinese authorities have a big influence on how the country’s sectors and companies are run, there are variable levels of corporate governance and limited transparency, which can make it difficult for investors to have real confidence in what they’re investing in.
Patrick Connolly, certified financial planner at Chase de Vere, says: ‘There are particular concerns over the Chinese banking system. Ownership is mostly controlled by the state, and banks have very high levels of bad debt.
‘This situation needs very careful managing, as there are genuine fears that the banking system could implode at some point.’
Smith concedes that political uncertainty warrants caution when investing in emerging markets. But he says this is unfortunate, because for the first time in six years, emerging market GDP growth is accelerating relative to developed market GDP, and equity markets usually follow.
He adds: ‘But if there are question marks over global trade due to Trump and the anti-globalisation sentiment that is building up steam across Europe, there will be question marks over emerging markets’ earnings growth too.’
Smith does not buy into the idea that China will suffer a hard landing, though. ‘We think China has already landed,’ he comments. The growth rate has already halved according to official measures.
Looking beyond Chinese official statistics, which put growth at around 6.5 to 7 per cent, Smith’s best guess is that China’s annual growth rate lies somewhere between 2.5 and 4.5 per cent, and that it will stay within that range for the next 10 years.
He says: ‘The Chinese slowdown is already largely behind us, and the world didn’t fall off a cliff. China still exists, and people are still spending money.’
This article was originally published in Money Observer: http://www.moneyobserver.com/our-analysis/why-china-isnt-too-bothered-trumps-threats