Pieces in the puzzle

Just as the fall of the Berlin Wall in 1989 kick started the wave of globalisation, so the Russian invasion of Ukraine threatens to throw the process into reverse. Whereas its rise was initially a slow process which only seeped into the wider consciousness around the turn of the century, the reversal of globalisation is likely to take the form of a screeching U-turn as the west reassesses its security and economic needs. Whether or not the fighting in Ukraine quickly comes to an end, it is clear that Russia under its current government will remain an untrustworthy geopolitical partner which will require governments to reassess their political alliances. This in turn will have consequences for the shape of the global economy.

Assessing China’s position

The role of China will be particularly fascinating. Prior to 2008 it was hoped that China would align more closely with the west as rising prosperity convinced the government that opening up the economy would be in its best interests. That has proved a forlorn hope. An ever stronger China has continued to plough its own political and economic furrow with ambitions of usurping the US to become the dominant Asian power. It is ultimately likely to achieve that goal one way or another. At issue is the timing and the extent to which this transition occurs peacefully or otherwise.

It was therefore particularly interesting to hear suggestions that Russia has asked China for financial and logistical support for its invasion of Ukraine which further complicate the geopolitical mix. Whether China will agree to do this remains unclear. Last month, Russia and China extended the 2001 Sino-Russian Treaty of Friendship for another five years which commits China to support Russia “in its policies on the issue of defending the national unity and territorial integrity of the Russian Federation.” It also states that “when a situation arises in which one of the contracting parties deems that peace is being threatened and undermined or its security interests are involved or when it is confronted with the threat of aggression, the contracting parties shall immediately hold contacts and consultations in order to eliminate such threats.” Clearly, the ties between the two are very strong although it is questionable whether China expected Russia to launch its invasion which runs counter to its interests.

A particularly interesting article by Hu Wei, vice-chairman of the Public Policy Research Centre of the Counsellor’s Office of the State Council, suggests that China’s alignment with Russia could cause more problems than it solves. The thrust of the text is that if the conflict were to spiral, with NATO becoming involved, Russia cannot win by military means which would raise US influence on the global stage and leave China more isolated. He suggests that “China cannot be tied to Putin and needs to be cut off as soon as possible … Being in the same boat with Putin will impact China should he lose power. Unless Putin can secure victory with China’s backing, a prospect which looks bleak at the moment, China does not have the clout to back Russia.” It is important to stress that this does not reflect government policy and the fact that it was submitted to the Chinese-language edition of the US-China Perception Monitor and translated into English suggests it was designed for a western audience.

The official Chinese position views the world in zero-sum terms: What is good for the US must be bad for China (although the Trump administration was guilty of the same mindset). It does not have to be this way and rather than issuing threats about how the US would react – wielding the big stick would likely prove counterproductive, especially since China is aware of the consequences – a better approach may be to highlight the benefits of the cooperation which China claims to value. Whilst we should not expect China to publicly oppose Russia’s actions, at the UN or elsewhere, it has more potential than any other external force to act as a restraining influence.  

China is also aware that it runs significant reputational risk if it aligns itself with Russia and has more to lose than to gain if the west does decide to loosen economic ties. Moreover, Russia’s actions will cause problems for one of China’s signature economic policies – the Belt and Road Initiative. The BRI is designed to create a land route across central Asia, linking China to consumer markets in western Europe and raw material producers across Europe and Asia. War in eastern Europe will disrupt the supply of commodities to China and elsewhere, particularly in the event of a protracted conflict. It is thus in China’s economic interests that the war in Ukraine is swiftly resolved.

Big questions for Europe

From a European perspective, the western alliance has come together far more quickly and in a more unified fashion than we have seen for many years. The EU’s actions are a reminder that it has its roots in a project designed to ensure that the continent would not revisit the ravages of the first half of the twentieth century – a point that was lost on large parts of the UK electorate during the Brexit referendum. With the spectre of conflict once again at the EU’s border, the nature of the union is likely to change. The commitment to raising defence spending will mean more expansionary fiscal policies across Europe. During the Cold War, European economies routinely spent around 3% of GDP on defence. Recent figures suggest that this has slipped to around 1.5%. In order to boost outlays will mean either higher taxes or an increase in debt issuance (and this is before we discuss the costs of dealing with the refugee crisis).

In addition the rush to diversify away from Russian energy sources will impact on living standards for many years to come as the relative cost of energy remains elevated. This may also have implications for the EU’s green agenda. Whilst there are increased incentives to diversify away from hydrocarbon fuels, it will be difficult to make the sudden switch to renewables. Consequently, many EU countries may be forced to extend the lifetime of coal-fired power stations, rather than using gas as a transition fuel until such times as renewable sources come online.

Across the continent, governments are likely to be far more engaged in economic management than has been the case for many years, which they will justify on national security grounds. As this post from the Breugel think tank pointed out, the private sector may have responsibility for the generation and distribution of energy but has no responsibility for ensuring security of supply nor for ensuring that consumers have access to energy. The private sector may also be unwilling to carry the costs of replenishing supplies at current prices, for fear of huge losses in the event that oil and gas prices fall. All of this suggests that significant fiscal intervention may be required to guarantee energy supply.

Europe has perhaps been too complacent about the risks emerging from the geopolitical sphere in recent years, partly because it has had to cope with the aftershocks of the Greek debt crisis and Brexit. However, it has acted remarkably swiftly in the last three weeks as latest events highlight that the time for complacency is over. In the wake of the 2008 crash, hopes were expressed that we could return to the old world order. The pandemic and the war in Ukraine suggest that we are likely to return to a geopolitical order more reminiscent of 1985 than 2005.

Trump, tariffs and beyond

As the world now knows, Donald Trump followed through on last weekend’s tweet promising to raise tariff rates on USD200 bn of Chinese imports from 10% to 25%. The fact that some of the heat appeared to go out of the tariff wars towards the end of last year suggested that both sides realised there was nothing to be gained from continually ramping up the rhetoric. After all, nobody ever won a tariff war. But once again Trump has upended conventional wisdom and those who continue to underestimate him should now be fully aware that he means to push forward with his ‘America First’ agenda, irrespective of how damaging it might appear at first sight.

We need to view Trump’s actions in a domestic context. Simply put, they can be seen as the opening shot in his 2020 re-election campaign and his strong-arm tactics are broadly popular at home. The US also has a point about technological expropriation and the requirement for the Chinese to open up their domestic markets in a reciprocal manner, in line with their WTO commitments. But we also have to view this from the Chinese perspective which sees itself as reasserting its rightful place on the world stage after two centuries of political and economic humiliation by the west. Finding a resolution that accommodates both sides will not be easy.

Market reaction to Trump’s actions has been somewhat muted. Admittedly, US equities fell 2.2% during the course of last week but that is not a huge decline and only puts the S&P500 back where it was a month ago. One interpretation is that markets are clinging to the belief that a resolution to the tariff war will somehow materialise within the next couple of weeks. After all, only goods leaving China after the Thursday midnight deadline will be subject to the new tariffs – those currently in transit will not – so if a deal can be brokered within the two weeks it takes for goods to make the journey by sea, the impact of the latest tariff spat will be limited.

That may be a very complacent view. Indeed, recent events might just prove to be another shot in the long war against globalisation from which there are no economic winners. Consider first the tariffs themselves. They are in effect a tax on imports and the one thing we do know about product taxes is that they are borne by the end-consumer. Companies that import certain items from China will now have to pay 25% more for them (although the impact so far has been partially offset by dollar appreciation). Households consuming those Chinese goods on the list will face a similar problem. But as this paper by Pablo Fajgelbaum and his co-authors point out, the direct impacts of last year’s tariff hikes cost the US economy just USD69 billion (0.3% of GDP). And once we account for the substitution away from Chinese imports towards domestic alternatives and the gains from higher prices received by US producers, the total impact is a mere USD7.8bn, or 0.04% of GDP.

But this is to underestimate the longer-term damage that an escalation of tariff wars could inflict on the global economy. Unfortunately, the recent actions might encourage the Trump administration to believe that tariff wars are indeed “good and easy to win” as the President said in March 2018 which (a) reduces the chances that the US will offer any concessions to the Chinese in the current dispute and (b) encourage the US to target European exporters, where German auto manufacturers are widely concerned that they will be the next in the line of fire.

With regard to point (a), we do not know how the Chinese will respond. Given that the US imports more from China than it exports, China’s direct ability to engage in a tit-for-tat tariff escalation is limited. It could, of course, levy additional duties on US agricultural products. But more damagingly it could target the US tech sector. China is less dependent than the rest of the world on Amazon, Apple and Google given the local dominance of Tencent, Huawei, Baidu and Alibaba. The Chinese companies start from the advantage of a bigger domestic market and are already formidable competitors in third markets. In a phrase reminiscent of the thinking during the Brexit referendum campaign, the likes of Apple need China more than the Chinese need them.

Also we should not overlook the fact China is the biggest buyer of US Treasury debt. Whilst it is unlikely to sell its current holdings, a buyers strike may push up US interest rates and thus have the opposite effect to what Trump wants (he has, after all, called for the Fed to lower interest rates). However, it is widely believed that the Chinese have no incentive to exacerbate the trade dispute in the short-term – particularly since the Communist Party wants to sell a rosy view ahead of the 70^th anniversary of the People’s Republic in October and the party’s centenary in 2021. But if there is no quick fix or if they are forced to make too many concessions, the Chinese will not easily forgive or forget.

With regard to point (b) there is a relatively easy fix. The EU could adopt a policy of pre-emptive tariff equalisation by reducing the tariffs on auto imports from the US from the current 10% to the rate of 2.5% which the US levies on EU imports. But the wider concern is that the US will become a less reliable ally than has been the case over the past 80 years. Europe and the US have common international interests and cooperation has led to better outcomes for both sides. This would be put at risk in the event of policy divergence. For example, one of the biggest issues rising up the policy agenda are environmental concerns which require international cooperation – no single economy can fix things on its own.

The current environment is increasingly one of mutual suspicion which does not bode well for finding global solutions to global problems. There is also a risk that local issues could become flashpoints for bigger problems, as we experienced during the Cold War. For example, China regards the region bordering the South China Sea as its own sphere of influence and is increasingly less tolerant of US interference in the region. The US does not see it the same way. But having dominated the geopolitical arena since 1945, the US may be forced to cede some control and the manner in which it does so will have a great bearing on the history of the 21^st century. The tariff wars could turn out to be a Gavrilo Princip moment. Or they may simply be a Cuban missile experience. Either way, there is a lot more at stake than import taxes.

Some thoughts on China

It has been an interesting week on the China front following the news that the US is to impose a tariff of 10% on $200bn of Chinese imports with effect from next week. The timing of a series of discussions this week on Chinese economic prospects with some experts in the field thus proved fortuitous, and whilst they reinforced the little I do know, they also served to put the subject in a wider context.

To start with the trade issues, the primary reason for US action against China can be traced to the strategic plan unveiled in 2015, Made in China 2025, which intends to place China at the forefront of technological advancement and which was described by the US Council on Foreign Relations as a “real existential threat to U.S. technological leadership.” More problematic for the US, and indeed many other western nations, is that China is seeking self-sufficiency via technological substitution i.e. switching foreign technologies for those developed at home, which would shut the US FAANG industries out of one of the world’s largest consumer and business markets. Not only is there a growing belief that Made in China 2025 violates WTO rules by setting targets for self-sufficiency, but there is a real concern that China is seeking to achieve its goal of technological supremacy by expropriating western technology via fair(ish) means (forced technological transfers in return for permission to operate in China) or foul (espionage).

The view from non-Chinese Asia is that US actions to clamp down against technological expropriation are understandable, but the way the US has handled the situation leaves a lot to be desired. The US would be in a better position to get China to take heed of its position if it had all its allies onside first – after all, the technology transfer issue is common to all western nations – but it has instead succeeded in antagonising the EU and Canada by threatening trade sanctions against them. Failure to present a united front may thus undermine US efforts to force China to the negotiating table. Equally, however, there is a view that China perhaps ought to recognise that it has been one of the main beneficiaries of its accession to the WTO, and that it can afford to be more magnanimous rather than pursue its goal of simply “making China great again.”

Another question that was raised in this week’s discussions is the extent to which China can afford to retaliate in any trade war. It is well known that the US imports more from China than China does from the US, and as a result the trade sanctions will initially hurt the Chinese most. Due to this factor alone, China will struggle to match the US in a tit-for-tat escalation. But there is a more fundamental political problem. Next year marks the 70^th anniversary of the foundation of the People’s Republic of China, which will be marked with great fanfare, and in 2021 the Chinese Communist Party will celebrate its centenary. The Chinese authorities have no desire to spoil the party by creating additional economic difficulties. Indeed, it is arguably in their short-term interests that the world economy remains strong so as not to damage export prospects which would risk spoiling the party.

Moreover, as I noted earlier this year, simulation analysis conducted by Bloomberg Economics suggests that the optimal economic response is for China not to respond to the US actions. The rationale for this is that whilst China will take a hit, it will suffer even more if the trade war escalates, since this threatens to spill over into other important Chinese export markets, depressing global trade and making life even more difficult for China.

Having grown rich and powerful on the back of an export- and investment-driven growth model, China is attempting to redress the balance by developing a more consumption-driven economy. But there are some clouds on the horizon. One is that demographics are turning against China. The population aged 15-64 peaked in 2015 and within a decade it will have declined back to levels prevailing at the turn of the century. Japan hit peak labour force in 1995. But at the time, its GDP per head in per capita terms was around $43,000 – more than three time current levels in China (~$12,000). This is not to say that per capita incomes will not increase further. As the chart shows, real per capita incomes in Japan have continued to rise even though working age population is falling – it just becomes much harder. Moreover, the Chinese economy is heavily indebted, with the non-financial sector operating under a debt burden equivalent to 250% of GDP – about the same size as in the US, but with more unfavourable demographics and lower incomes, and much larger than other developing markets (Brazil is at 150% and Russia 80%).

One way to boost incomes, of course, is through technological innovation – hence the Made in China 2025 programme, which is where we came in. But what exactly is the underlying motivation for the policy? One argument is that the primary objective of Chinese leaders down the ages has been simply to feed its vast population. It is thus not interested in the rest of the world for any other reason than as a means to keep the show on the road. This has been made relatively easy in recent decades by the industrialisation and urbanisation programme which has allowed China to put labour to use in higher value added activities, thereby boosting incomes. But this process may be about to become more difficult, which is where the politics starts to get tricky.  Historically, China has relied on strong leaders at such times who can marshal the economy’s resources and if Xi Jinping is anything, he is a strong leader. Accordingly, we perhaps ought to view the recent push to restore China to its rightful position at the top table as an attempt to give the country a unity of purpose at a time when economic conditions may be turning less favourable.

I do not pretend to be a Chinese expert but I found some of these thought-provoking ideas very interesting. As a parting shot, it is notable that China is led by a strong populist leader, in much the same way as the US, and both have similar goals for their country (and indeed for themselves). It is thus ironic that the US and Chinese leadership should find themselves on opposite sides of the negotiating table when in fact they have much in common.

China crisis

The announcement that the US government plans to impose tariffs of 25% on $50 bn of goods imported from China has set the cat amongst the pigeons, with equity markets turning sharply lower and safe havens such as gold gaining ground. But whilst this may look like a simple application of economic nationalism, led by a president who clearly has no appreciation of the damage that he may be about to unleash, it is worth considering the underlying US grievances. First and foremost, the Administration believes that China has gained from the unfair expropriation of US intellectual property and that some form of recompense is required. But this is not only a US problem: Many western governments are beginning to worry about the asymmetries which their companies face in doing business in China – the US is simply the first to take action.

Three weeks ago The Economist, which has long been a cheerleader for global free trade, expressed reservations about the direction in which China is heading. In its view, “the China of Xi Jinping is a great mercantilist dragon under strict Communist Party control, using the power of its vast markets to cow and co-opt capitalist rivals, to bend and break the rules-based order.” The article went on to point out that “Chinese markets are opened only after they have ceased to matter” whilst regulators “take away computers filled with priceless intellectual property and global client lists.” A week later, the Financial Times ran a story headed “Backlash grows over Chinese deals for Germany’s corporate jewels” following the news that Geely has acquired a 10% stake in Daimler which has raised fears that Daimler’s know-how in the field of electronic vehicles will filter back to China without appropriate compensation.

Industrial espionage is not new, of course, and we should remember that some of the earliest examples of such activity involved the transfer of Chinese technological advantages into western hands. For example, in the 1800s China had a monopoly on tea growing until a British botanist, acting on behalf of the East India Company, smuggled tea plants and seeds to India and established an industry whose output eventually eclipsed that of China. But this does not assuage current western concerns that the heavy-handed techniques employed by the Chinese are backed by the government. Whilst western companies have long been required to hand over technological secrets before being allowed to conduct business in the Chinese market, the fear is now that many of China’s major foreign acquisitions have been funded by state-backed institutions. Indeed, the FT reports that the message conveyed by the Geely chairman to the German media, that the company wanted to cooperate with Daimler, was not the one he gave to his home audience which was that the action was designed to “support the growth of the Chinese auto industry” and “serve our national interests.”

Seen in these terms, it is hardly a surprise that the US feels that it needs to take some form of action. But despite Trump’s rhetoric to the contrary, it is hard to believe that the US really wants to embark on a major trade war. The fact that China responded with tariffs on only $3bn of imports from the US suggests that it is not willing to escalate the problem either. In the grand scheme of things, the US actions will have next to zero impact on Chinese GDP. A 25% tariff on $50bn of exports amounts to a total hit of $12.5bn which is insignificant in a Chinese economy whose output is valued at $12 trillion. But it is what comes next that matters.

In assessing the outcomes, I am indebted to some modelling analysis conducted by Bloomberg analysts using the NiGEM global macro model. In its first scenario, Bloomberg assumed that the $50 bn figure becomes a US revenue target to reflect the estimated damage done to the economy by intellectual property theft. But the impact of such an outcome, which is four times more significant than what we believe likely to happen, only costs 0.2% of Chinese GDP by 2020. Bloomberg thus concluded that China would be better off not retaliating because the economic losses resulting from inflation generated by higher import tariffs would exceed this amount. In a second simulation exercise, Bloomberg tried to assess the impact of a 45% tariff on all Chinese imports – a figure that Trump happened to mention on the campaign trail. This resulted in a 0.7% hit to GDP by 2020 which they concluded would “not be disastrous.”

But the real problem comes when the tariff war goes global and pulls in countries other than China. An across-the-board rise of 10% in US import tariffs which is met with a similar response by all the US’s trading partners results in a 0.5% drop in Chinese output but a 0.9% drop for the US. This highlights the self-defeating nature of tariff wars and results from the fact, as Bloomberg pointed out, “the tariffs affect 100% of US trade, but for China and other countries, [they] only impact bilateral trade with the US.”

On the surface, the optimal Chinese response to higher tariffs which in aggregate terms amount to little more than a gnat’s bite, would be to ignore them. Since it continues to grow faster than the US it will – in the not-too-distant future – overtake the US as the world’s largest economy and will be in a position to retaliate more effectively. In any case, there are other ways to respond. China is also the largest holder of US Treasury securities (chart). It could thus tweak the tail of the US by selling Treasuries and put upward pressure on US longer-term interest rates.

But this issue is about more than just economics. This is a tale of two alpha economies demonstrating their political muscle, which runs the risk of miscalculation. Unlike Japan in the 1980s, when the US tried to exert pressure using similar tactics, China is a much more potent economic and political rival. It is also not politically allied with the US in the way that Japan was. I have never subscribed to the idea that China and the US are doomed to fall into the Thucydides Trap. But this is a time for cool heads and as I noted in late-2016, it is at times like these that we will miss the rationality of an Obama.

We live in troubled times

More than 30 years after the Thatcher government adopted a policy of systematic indifference to the fate of British manufacturing, it comes as no real surprise that the future of the UK steel industry once more hangs in the balance. Nine years after Tata Steel bought the remnants of the industry from Corus, the company ended up losing significant amounts of money by holding onto the Port Talbot plant in the face of a massive glut of global output, triggered largely by Chinese overcapacity.The whole issue is a microcosm of the economic problems facing the UK today and raises a number of uncomfortable questions for the future of the British manufacturing sector in general, and steel in particular. First off, how much support is the government prepared to give to an industry which is potentially of critical national importance? Second, to what extent can we rely on free markets to generate the kind of outcomes which are socially acceptable? And third, to what extent can China be relied upon to play by the rules of the international trade game?