Posts Tagged ‘Trade War’

Authored by James Rickards

 

China is a relatively open economy; therefore it is subject to the impossible trinity.

China has also been attempting to do the impossible in recent years with predictable results.

Beginning in 2008 China pegged its exchange rate to the U.S. dollar. China also had an open capital account to allow the free exchange of yuan for dollars, and China preferred an independent monetary policy.

The problem is that the Impossible Trinity says you can’t have all three. This model has been validated several times since 2008 as China has stumbled through a series of currency and monetary reversals.

For example, China’s attempted the impossible beginning in 2008 with a peg to the dollar around 6.80. This ended abruptly in June 2010 when China broke the currency peg and allowed it to rise from 6.82 to 6.05 by January 2014 — a 10% appreciation.

This exchange rate revaluation was partly in response to bitter complaints by U.S. Treasury Secretary Geithner about China’s “currency manipulation” through an artificially low peg to the dollar in the 2008 – 2010 period.

After 2013, China reversed course and pursued a steady devaluation of the yuan from 6.05 in January 2014 to 6.95 by December 2016. At the end of 2016, the Chinese yuan was back where it was when the U.S. was screaming “currency manipulation.”

Only now there was a new figure to point the finger at China. The new American critic was no longer the quiet Tim Geithner, but the bombastic Donald Trump.

Trump had threatened to label China a currency manipulator throughout his campaign from June 2015 to Election Day on November 8, 2016. Once Trump was elected, China engaged in a policy of currency war appeasement.

China actually propped up its currency with a soft peg. The trading range was especially tight in the first half of 2017, right around 6.85.

In contrast to the 2008 – 2010 peg, China avoided the impossible trinity this time by partially closing the capital account and by raising rates alongside the Fed, thereby abandoning its independent monetary policy.

This was also in contrast to China’s behavior when it first faced the failure of its efforts to beat impossible trinity. In 2015, China dodged the impossible trinity not by closing the capital account, but by breaking the currency peg.

In August 2015, China engineered a sudden shock devaluation of the yuan. The dollar gained 3% against the yuan in two days as China devalued.

The results were disastrous.

U.S. stocks fell 11% in a few weeks. There was a real threat of global financial contagion and a full-blown liquidity crisis. A crisis was averted by Fed jawboning, and a decision to put off the “liftoff” in U.S. interest rates from September 2015 to the following December.

China conducted another devaluation from November to December 2015. This time China did not execute a sneak attack, but did the devaluation in baby steps. This was stealth devaluation.

The results were just as disastrous as the prior August. U.S. stocks fell 11% from January 1, 2016 to February 10. 2016. Again, a greater crisis was averted only by a Fed decision to delay planned U.S. interest rate hikes in March and June 2016.

The impact these two prior devaluations had on the exchange rate is shown in the chart below.

Major moves in the dollar/yuan cross exchange rate (USD/CNY) have had powerful impacts on global markets. The August 2015 surprise yuan devaluation sent U.S. stocks reeling. Another slower devaluation did the same in early 2016. A stronger yuan in 2017 coincided with the Trump stock rally. A new devaluation is now underway and U.S. stocks may suffer again.

 

China cannot keep the capital account closed without damaging badly needed capital inflows. Who will invest in China if you can’t get your money out?

China also cannot maintain high interest rates because the interest costs will bankrupt insolvent state owned enterprises and lead to an increase in unemployment, which is socially destabilizing.

China cannot maintain a strong yuan because that damages exports, hurts export-related jobs, and causes deflation to be imported through lower import prices. An artificially inflated currency also drains the foreign exchange reserves needed to maintain the peg.

Since the impossible trinity really is impossible in the long-run, and since China’s current solutions are non-sustainable, what can China do to solve its policy trilemma?

The most obvious course, and the one likely to be implemented, is a maxi-devaluation of the yuan to around the 7.95 level or lower.

This would stop capital outflows because those outflows are driven by devaluation fears. Once the devaluation happens, there is no longer any urgency about getting money out of China. In fact, new money should start to flow in to take advantage of much lower local currency prices.

There are early signs that this policy of devaluation is already being put into place. The yuan has dropped sharply in the past month from 6.45 to 6.62. This resembles the stealth devaluation of late 2015, but is somewhat more aggressive.

The geopolitical situation is also ripe for a Chinese devaluation policy. Once the National Party Congress is over in late October, President Xi will have secured his political ambitions and will no longer find it necessary to avoid rocking the boat.

 

China’s President Xi Jinping awaits appointment to a second term at the 19th National Congress of the Communist Party of China, starting October 18. His reappointment is a foregone conclusion.

China has clearly failed to have much impact on North Korea’s nuclear weapons ambitions. As war between North Korea and the U.S. draws closer, neither China nor the U.S. will have as much incentive to cooperate with each other on bilateral trade and currency issues.

Both Trump and Xi are readying a “gloves off” approach to a trade war and renewed currency war. A maxi-devaluation of the yuan is Xi’s most potent weapon.

Finally, China’s internal contradictions are catching up with it. China has to confront an insolvent banking system, a real estate bubble, and a $1 trillion wealth management product Ponzi scheme that is starting to fall apart.

A much weaker yuan would give China some policy space in terms of using its reserves to paper over some of these problems.

Less dramatic devaluations of the yuan led to U.S. stock market crashes. What does a new maxi-devaluation portend for U.S. stocks?

We might have an answer soon enough.

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In an unexpectedly strong diplomatic escalation, one day after China agreed to vote alongside the US (and Russia) during Monday’s United National Security Council vote in passing the watered down North Korea sanctions, the US warned that if China were to violate or fail to comply with the newly imposed sanctions against Kim’s regime, it could cut off Beijing’s access to both the US financial system as well as the “international dollar system.”

Speaking at CNBC’s Delivering Alpha conference on Tuesday, Steven Mnuchin said that China had agreed to “historic” North Korean sanctions during Monday’s United Nations vote. “We worked very closely with the U.N. I’m very pleased with the resolution that was just passed. This is some of the strongest items. We now have more tools in our toolbox, and we will continue to use them and put additional sanctions on North Korea until they stop this behavior.”

In response, Andrew Ross Sorkin countered that “we haven’t been able to move the needle on China, which seems to be the real mover on this, in terms of being able to apply the real pressure. What do you think the issue is? What is the problem?”

 

The stunner was revealed in Mnuchin’s answer: “I think we have absolutely moved the needle on China. I think what they agreed to yesterday was historic. I’d also say I put sanctions on a major Chinese bank. That’s the first time that’s ever been done. And if China doesn’t follow these sanctions, we will put additional sanctions on them and prevent them from accessing the U.S. and international dollar system. And that’s quite meaningful.”

And to underscore his point, the Treasury Secretary also said that “in North Korea, economic warfare works. I made it clear that the President was strongly considering and we sent a message that anybody that wanted to trade with North Korea, we would consider them not trading with us. We can put on economic sanctions to stop people trading.”

In other words, to force compliance with the North Korean sanctions, Mnuchin threatened Beijing with not only trade war, but also a lock out from the dollar system, i.e. SWIFT, something the US did back in 2014 and 2015 when it blocked off several Russian banks as relations between the US and Russia imploded.

Of course, whether the US would be willing to go so far as to use the nuclear option, and pull the dollar plug on its biggest trade partner, in the process immediately unleashing an economic depression domestically and globally is a different matter. So far Washington has been reluctant to impose economic sanctions on China over concerns of possible retaliatory measures from Beijing and the potentially catastrophic consequences for the global economy. Washington runs a $350 billion annual trade deficit with Beijing, while the PBOC also holds over $1 trillion in US debt.

Ironically, the biggest hurdle to the implementation of the just passed sanctions may be the president himself. “We think it’s just another very small step, not a big deal,” Trump told reporters at the start of a meeting with Malaysian Prime Minister Najib Razak. “I don’t know if it has any impact, but certainly it was nice to get a 15-to-nothing vote, but those sanctions are nothing compared to what ultimately will have to happen,” said Trump who has vowed not to allow North Korea to develop a nuclear ballistic missile capable of hitting the United States.

Separately, at a hearing of the House Foreign Affairs Committee on Tuesday, Republican Chairman Ed Royce said the U.S. should target major Chinese banks, including Agricultural Bank of China Ltd. and China Merchants Bank Co., for aiding Kim’s regime. Russia also came in for criticism. Assistant Treasury Secretary Marshall Billingslea said in prepared remarks to the committee that North Korean bank representatives “operate in Russia in flagrant disregard of the very resolutions adopted by Russia at the UN.”

While China and Russia supported the latest UN sanctions, officials made clear they were troubled by Haley’s comments in the Security Council that the U.S. would act alone if Kim’s regime didn’t stop testing missiles and bombs. They emphasized the world body’s resolution also emphasized the importance of resolving the crisis through negotiations. “The Chinese side will never allow conflict or war on the peninsula,” Foreign Ministry spokesman Geng Shuang said in a statement on Tuesday.

In a soundbite late on Tuesday, Japan’s Nikkei quoted prime minister Shinzo Abe who said that “in the end, [the North Korean] problems should be solved through diplomatic dialogue,” adding that Japan will “work together with the international community to apply maximum pressure, so that North Korea commits to perfect, verifiable and irreversible denuclearization.” For Japan to engage with the regime, he stressed it would have to be “on the condition that North Korea commits to” this complete denuclearization.”

Which, of course, won’t happen: “sanctions of any kind are useless and ineffective,” Russian President Vladimir Putin told reporters earlier this month at a summit in Xiamen, China. “They’ll eat grass, but they won’t abandon their [nuclear] program unless they feel secure.”

Predictably, North Korea’s Foreign Ministry slammed the sanctions saying it “condemns in the strongest terms and categorically rejects” the United Nations adding more sanctions, North Korea’s state-run KCNA reported on Wednesday morning. Instead, North Korea warned it “will redouble efforts to increase its strength” as it seeks to establish “practical equilibrium” with U.S.

And so, not only is the entire geopolitical circle jerk back at square one, but the ball is again back in North Korea’s court, while the decision on whether or not to launch another ICBM really depends on whether China will give it the quiet go ahead; a China which responds notoriously poorly to being threatened in the global financial arena, like for example when the US threatens to kick it out of the global dollar system…

Roughly at the same time as China’s infamous snub of Obama‘s arrival at Hangzhou for the G-20 summit, when the G-20 host nation’s delegation first made sure there was no staircase for Obama to exit the plane and descend on the red carpet; forcing the president of the world’s most powerful nation to use an emergency exit…

… followed by a shouting match by a Chinese official who unleashed on the US Press corps and national security advisor Susan Rice, blocking them from crossing a blue rope holding back press and saying “This is our country. This is our airport”, Chinese officials had no such problems greeting Russian president Vladimir Putin with full honors, whose arrival – on the red carpet – took place without a glitch.

 The favor was returned: according to RT, Putin brought a box of Russian ice-cream as a gift to Chinese leader Xi Jinping:  “I promised you I’d bring some ice-cream,” Putin said. “I’ve brought for you a box of it as a gift.” Xi Jinping is a real fan of Russian ice-cream. “Thank you very much for the gift, for the tasty ice-cream. In my every trip to Russia I always ask to buy Russian ice-cream. And then, at home, we eat it,” the Chinese leader said.

“You have the best cream, and it makes it so tasty. I like it very much. Thank you for this courtesy,” he added.

* * *

Having brought no ice cream of his own, and his embarrassing arrival in China making front page news over the weekend, Obama quickly tried to talk down the embarrassing incident, saying the tensions were the result of different approaches to the media, as well as the sheer scale of the US operation when he travels, according to AFP. Obama pivoted away from the snub, instead accusing China of once again showing little respect for human rights: “Washington stands up for press freedom and human rights and – whatever the fallout – does not leave our values and ideals behind when we take these trips” he said.

“It can cause some friction. The seams are showing a little more than usual in terms of some of the negotiations and jostling that takes place behind the scenes,” Obama told reporters on Sunday.

The justification continued: “Part of it is we also have a much bigger footprint than a lot of other countries. And we’ve got a lot of planes, a lot of helicopters, a lot of cars, a lot of guys. You know, if you’re a host country, sometimes it may feel a little bit much.

Obama said it was not the first time Washington’s differences with Beijing had erupted during a visit, and that clashing values were also on display in his discussions with Xi.

Obama concluded by expressing hope the world would quickly move on and forget China’s snub of Obama on his last official visit to the country: “And so I wouldn’t over-crank the significance of it,” he said.

“None of this detracts from the broader scope of the relationship (with China),” he told a news conference. “The bilateral discussions that we had yesterday were extremely productive and continue to point to big areas of cooperation.”

* * *

Obama’s “explanation” aside, China took the initiative to continue piling its critisim of the US, when Chinese President Xi Jinping said at the open of a two-day G-20 summit that the global economy is being threatened by rising protectionism and risks from highly leveraged financial markets. He was referring to recent US trade war escalations, and Washington’s recent response to Chinese dumping with duties on cold-rolled steel as high as 522%. As for highly leveraged financial markets, pretty much anyone could be at fault there.

His warning on Sunday followed bilateral talks with Barack Obama that the U.S. president described as “extremely productive”, but which failed to bring both sides closer on thornier topics such as tensions in the South China Sea.

In addition to the previously leaked communique details, which as reorted last night will call for more fiscal and monetary stimulus, observers expect G20 leaders to mount a defense of free trade and globalization and warn against isolationism, eyeing Britain’s vote in June to exit the
European Union and before the U.S. presidential election in November. The global economy has arrived “at a crucial juncture”, Xi said, in the face of sluggish demand, volatile financial markets and feeble trade and investment.

“Growth drivers from the previous round of technological progress are gradually fading, while a new round of technological and industrial revolution has yet to gain momentum,” he said.

Xi also called on G20 countries to match their words with actions. “We should turn the G20 group into an action team, instead of a talk shop,” he said. Considering that the G-20 has been equated with the UN in terms of efficiency, we hope Xi isn’t holding his breath.

* * *

Meanwhile, some of the G20 leaders have begun drawing battle lines in disputes over issues ranging from trade and investment to tax policy and industrial overcapacity, suggesting there was far less smiling by world leaders going on behind the scenes.

According to Reuters, Xi held talks with Australian Prime Minister Malcolm Turnbull and told him he hoped Australia would continue to provide a fair, transparent and predictable policy environment for foreign investors. China was angered when Australia blocked the A$10 billion ($7.7 billion) sale of the country’s biggest energy grid to Chinese bidders last month.

China has accused Australia of bowing to protectionist sentiment in blocking the bid for Ausgrid, as well as an earlier one by a China-led consortium to buy cattle company Kidman & Co. Beijing has also criticized Australia, a staunch U.S. ally, for running surveillance flights over disputed islands in the South China Sea.

Meanwhile, European Commission President Jean-Claude Juncker shot back at China saying the G-20 host nation must set up a mechanism to address its problem of industrial overcapacity, adding it was “unacceptable” the European steel industry had lost so many jobs in recent years. “Overcapacity is a global problem but there is a particular Chinese element,” he told a news conference.

* * *

Britain’s future after its departure from the European Union was also subject to discussion. Obama reassured Prime Minister May that Britain’s closest political, commercial and military ally would stand by her, tentatively backing off his infamous line that Brexit would leave the UK “in the back of the queue.”  However, Obama did not shrink away from his stance that Brexit was a mistake and that London would not be able to jump the queue to arrange a bilateral trade deal.

Juncker said that if Britain wanted access to the European Union’s common market, it needed to respect the rules of the common market. Turnbull, meanwhile, said Australia wanted an early free trade agreement with Britain so markets could remain open between them when Britain formally left the European trading bloc.

* * *

Snubbed or not, Obama held talks with Xi on Saturday that ran late into the night focusing mostly on the recent geopolitical tensions surrounding the disputed islands. He urged Beijing to uphold its legal obligations in the disputed waters of the South China Sea, and stressed U.S. commitments to its regional allies. Xi responded by saying China would continue to safeguard its sovereignty and maritime rights in the South China Sea. But China is keen to keep the summit focused on economic issues and to prevent other disputes from overshadowing it.

According to a “fact sheet” on China-U.S. relations issued on Sunday, the two sides agreed on a range of issues, including avoiding competitive currency devaluations and not limiting deal opportunities for foreign information and communication technology providers.

Obama, in the last five months of his presidency, is using the visit to put a final stamp on his signature policy shift toward the Pacific, setting the tone for his White House successor, who will be elected in November and take office on Jan. 20. Judging by this weekend’s incidents, Chinese opinion of the highest US political institutions has never been lower.

Perhaps just as bizarre as the now infamous Obama snub, however, was China’s decision to convert parts of the city of Hangzhou, with its 9 million people, into a virtual ghost town as China sought to ensure that the G20 summit stays incident-free.