Why the US-China trade war is not about jobs – Part I

Buenos Aires, Argentina

Donald Trump continued to do his favourite thing this week…hanging out on Twitter. We’re supposed to believe he has the Chinese on the run in trade negotiations.

But look around wherever you are right now, Dear Reader. Whether you’re at home…in your place of work…dining out…at a store. It’s likely that 90% of the things around you were made in China, or at least have some component that came from that huge country. That’s not going to change any time soon.

The US-China trade discussions are still up in the air. Unfortunately, too much of what’s going on gets reported through the Twitter account of the current US President.

There was a time when such important and sensitive issues were dealt with in a confidential manner. And for good reasons. The arrangements for trade between the world’s two biggest economies are a big deal.

Any statements about the negotiations – or even credible rumours – move markets. This is destructive. Instead, it should work something like this:

  • US and Chinese governments make a very dull joint statement that they are reviewing their trade arrangements
  • Everyone forgets about it
  • US and China make a joint statement, months or years later, about what they’ve agreed (or not)
  • Life moves on

In any case, the current process is what it is. The outcome will be whatever it will be.

In the meantime, it’s time to remind ourselves how things got to where they are. Also, what are the US government’s real motivations for stirring things up? I’ll explain why I don’t believe that it’s really about American jobs.

So here we go…

First of all, this is what all the fuss is about – America’s trade deficit with China…

Source: Quartz

Let’s take a look at how and why this happened…

  • China became communist in 1949. Unsurprisingly, its people suffered decades of social upheaval, persecution and economic failure.
  • In the late 1970s, around 90% of the population lived in extreme poverty. In December 1978, China’s leader Deng Xiaoping started the first economic reforms, slowly moving towards a more open and market-based economy.
  • The economy didn’t really start to take off until the early 2000s. My parents visited China in 1987, and it was still dirt poor. My first visit was in 1998, and it was still all bicycles and dust.

China starts to boom…and things get more complex

  • In the year 2000, China’s GDP was just $1.2 trillion, which was only 12% of the USA’s. Using a purchasing power parity (PPP) basis, China’s economy was 36% the size of the USA’s. Using PPP adjusts for local prices, and hence can be thought of as a volume-based measure of economic size.
  • By 2013, the size of China’s economy matched that of the US, in PPP (volume) terms.
  • In 2018, at current exchange rates, China’s GDP reached $13.6 trillion, a more than eleven-fold increase since year 2000. By comparison, the US economy doubled over the same 18 years. By this measure, the Chinese economy is now two-thirds the size of the US economy.
  • On a PPP (volume) basis, China’s economy is already 25% larger than the US (although the Chinese population is 4.2 times as large).
  • Although China still has a one-party political system, it’s clear that it has a predominantly capitalist economy these days. For example, there are more billionaires in China than in the US (see here). This is what’s referred to as “socialism with Chinese characteristics”.
  • The Chinese growth miracle (a.k.a. abandoning communism and adopting capitalism) mainly came from becoming the world’s factory for manufactured goods (at least, so far). China could and can produce huge volumes at low prices.
  • This had two effects. A lot of low-tech manufacturing, based in high cost countries, moved to China. At the same time, a lot of new, high-tech products were manufactured in China by foreign corporations. This allowed them to be sold globally for huge profit margins. The perfect example of this was Apple. The iPod was launched in 2001, the iPhone was launched in 2007. Both were/are made in China (and never in the US or other developed countries).
  • The flood of low-priced products was great for global consumers, as many things became more affordable. For example, the prices of clothes and toys plummeted, which was a great benefit for families with children.
  • But this embedded a deflationary effect in the consumer price inflation statistics in Western countries. In turn, the Federal Reserve and other central banks set interest rates too low. This caused the mid-2000s financial boom, speculative commodity bubble and multiple housing bubbles. The global financial crisis was the consequence.
  • Along the way, China continued to enjoy large trade surpluses with the rest of the world. Especially with the world’s largest consumer country, the US.
  • The flood of (mainly) dollars into China caused the country’s foreign exchange reserves to rocket between year 2000 and 2014. From a peak of around $4 trillion, they are now close to $3.1 trillion.

China’s foreign exchange reserves

  • Despite some periodic grumbling in the US about China having an undervalued currency, no one especially cared. Just so long as China was pumping a lot of those dollars back into US treasury bonds. In December 2000, the Chinese government owned just $60 billion of treasuries. Holdings peaked above $1.2 trillion during the period from 2013 to 2015.

Source: US Department of the Treasury, OfWealth

  • That meant America’s trade deficit with China was largely recycled into the US and used to fund the US government budget deficit. Dollars out, dollars back in.
  • As such, the Chinese government funded a vast amount of US government spending on pensions, welfare, healthcare and the military…plus all the rest.
  • However, China’s current holdings of US treasury bonds, at $1.1 billion are practically unchanged since 2010. (Although this is still 8.8% of the total tradable stock of treasuries of $13.4 trillion, not owned by the Fed.)
  • Effectively, China stopped recycling dollar inflows back to the US government after 2010 (except to renew maturing bonds). This is despite China’s ongoing and substantial trade surpluses since 2010. (Meanwhile, the Fed filled the gap by printing trillions to buy bonds, via quantitative easing, or QE.)

Sources: World Bank (WIT), OfWealth

  • Despite these surpluses, China’s total foreign exchange reserves have also flatlined since 2011.

In summary: Since 2011, China has continued to enjoy large trade surpluses. However, both total foreign exchange reserves and holdings of US treasury bonds have flatlined.

This begs a couple of questions:

First, where did all the rest of the money go?

Second, what are the real reasons that the US government has chosen now to attempt to address its trade deficit with China.

If President Trump is to be believed, it’s all about jobs…or rather, lost jobs. But the evidence says otherwise.

More to come…

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.