economic disengagement from china: macroeconomic costs …economic disengagement from china:...

ALL RIGHTS RESERVED, MACROLENS LLC NOVEMBER 8. 2018

1

Economic Disengagement from China: Macroeconomic Costs and Benefits

The costs to the U.S. economy of disengagement with China are unlikely to be macroeconomically significant. Given potentially large positive externalities and the political

popularity of the strategy, the Trump Administration has little reason to change tack.

“To understand the actual world as it is, not as we should wish it to be, is the beginning of wisdom.” -Bertrand Russell Overwrought assessments of the costs of economic disengagement from China perhaps suffer from a perception problem. Disengagement entails a significant deadweight loss relative to an alternate in which China marketizes, democratizes, and the U.S. and China establish a harmonious co-hegemony for the betterment of mankind. Dual-track development of new technologies with the two largest economic units on the planet failing to embrace their comparative advantages is a depressing outcome relative to what might have been in a nirvanic alternate reality. But here in the actual world as it is, China is not marketizing nor democratizing. It is becoming more centrally planned and sternly authoritarian. The cost of disengagement must be considered relative to a realistic alternative in which China continues to engage in central planning that has an increasingly distortive effect on the global economy, continues to utilize intellectual property theft and non-tariff barriers to hinder competition in its market, and continues to use the fruits of its trade surpluses for expansionist endeavors.


2

While the disengagement scenario is sub-optimal, so too was the status quo ante. The comparison must be between two realistic potential states of the world – status quo ante vs. trade war and disengagement. We conclude that the strategy of disengagement will prove beneficial to the U.S. economy and ultimately even to equity market valuations. A lack of engagement facilitates disengagement The U.S. and China are very large economies. They are also very closed economies. In fact, they are two of the least trade-dependent economies in the developed world (Figure 1). While the costs of disengagement will large in absolute terms, they are relatively insignificant. A larger body can throw a heavy punch, but it can also absorb much more force in return. According to Bloomberg:

China ranks 59th out of 62 countries evaluated by the OECD in terms of openness to foreign direct investment. Almost half of companies surveyed in June by the European Chamber of Commerce in China said they missed out on business opportunities due to regulatory barriers or market access restrictions, and they expected obstacles to increase during the next five years.1

Remember, the reason we’re in this spat with China is largely because it remains a heavily closed economy. It’s easier to disengage from an economy that didn’t really let you freely integrate with it in the first place. Exhibit 1: Gross Trade / GDP

Source: OECD. U.S. (26.5%) and China (37.1%) highlighted in red. Luxembourg (413.5%) omitted for scale.

0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

Unite

d St

ates

Japa

nCo

lom

bia

Chin

aIn

done

siaIn

dia

Austr

alia

Russ

iaTu

rkey

New Ze

aland

Chile

OECD

- Av

erag

eIta

lyIsr

ael

Unite

d Ki

ngdo

mSo

uth

Afric

aGr

eece

Fran

ceSp

ainCa

nada

Costa

Rica

Norw

ayFin

land

Mex

icoKo

rea

Portu

gal

Germ

any

Euro

pean

Uni

onSw

eden

Euro

area

Icelan

dPo

land

Austr

iaDe

nmar

kLa

tvia

Switz

erlan

dSlo

veni

aLit

huan

iaNe

ther

lands

Esto

nia

Czec

h Re

publ

icBe

lgium

Hung

ary

Slova

k Rep

ublic

Irelan

d

Gross Trade / GDP (2016)


3

Framework and Assumptions We’ll assess the economic costs to the U.S. from several angles:

• Increased cost of imports from China • Decreased exports to China • Threats to multinational corporate activities in China • Fallout from a likely RMB devaluation and potential financial contagion

And as we dive into some numbers, we’ll make the following assumptions:

• The U.S. proceeds to a 25% tariff on all U.S. imports from China over the next 9-12 months

• China retaliates with tariffs on U.S. imports and impediments to the activities of U.S. multinationals in China

• No significant U.S. tariffs on other trading partners remain in place. • The China disengagement policy gradually becomes multilateral in nature

Tariffs on Imports Could be Equivalent to a 40bp Consumption Tax Hike This is the most potentially problematic source of dislocation to the U.S. economy, primarily because of the effect an increase in PCE inflation could have on Fed policy. Simple math sets an upper bound of ~90 basis points for the resultant increase in the level of the PCE price index over time. 25% tariff x $506bn in imports from China = $127bn, relative to total annual U.S. personal consumption of just over $14T. Of course, the effect will be mitigated in several ways:

• supply chains will exit China to get around the tariff • the Chinese will absorb some of the tariff to protect market share (they’ve already

increased export tax rebates for many products from 1 to 5%) • tariff avoidance measure both legal and illegal (transshipping) • substitute products will be found where available

We will set aside the potential for RMB depreciation to offset the tariffs, given the possibility that RMB depreciation might simply bring higher tariff rates. In appendix 1 we’ve broken down U.S. imports from China as finely as seemed necessary in order to make an estimate of the effective consumer “tax increase” likely to result from the imposition of 25% tariffs on all China imports. We assume a 2% offset from China export tax


4

rebate increases to calculate the effective increase in tariff from current levels (which are generally not zero) to 25%. It’s also important to keep in mind that these are not global tariffs. A tariff against only China presents ample opportunity for demand to switch to alternative providers and for supply chains to move to lower-tariff domains. Therefore, we make further assumptions regarding goods which are commoditized or for which the U.S. relies on China only for a small percentage of total imports (suggesting abundant alternative sources of supply to which U.S. demand can shift). We also assume that low value-added products are likely to realize a high degree of supply-chain movement. And while supply chains can’t move instantly, we further assume that producers intending to move production facilities will temporarily absorb the tariff to protect market share in the interim. For products which are higher-value added and for which there is a significant reliance on China for sourcing we simply assume the additional incremental tariff will be paid fully by U.S. consumers. We reach an estimate of a $59.7bn “consumption tax increase” resulting from the imposition of full 25% tariffs, which equites to 42 basis points of total personal consumption expenditure. Given the gradual imposition of tariffs, we think that year-on-year PCE inflation could be “goosed” by around 20 basis points for the next 18-24 months. Given that the Fed will have little ability to tease out the one-off price effect, this could tip the balance on for a 25bp rate hike at some point, a marginal negative for U.S. asset markets. China’s Retaliatory Tariffs on U.S. Exports to China Will Have Little Effect U.S. exports to China in 2017 totaled $106bn, or 0.6% of GDP. Why so little? Because China generally imports only what they need from the U.S. Agriculture ($16bn in exports to China) is a prime example. Commodities are a highly ineffective means of Chinese retaliation. Commodities are generally fungible. China will shift its soybean demand to Brazil. Brazilian bean prices will increase a bit relative to U.S. prices which will motivate some of Brazil’s customers to shift demand to the U.S. On top of that, the Administration has earmarked $6bn in subsidies to help farmers hurt by Chinese retaliation and has expressed willingness to go up to $12bn if necessary (the


5

Agricultural Dept. budget allows for up to $30bn without the need to go to Congress). The dislocation to U.S. farmers will be prove to be minimal. Like commodities, chemicals ($16bn exported to China in 2017) are also largely fungible and susceptible to transshipment. Aircraft exports to China at $16.3bn in 2017, are similar. The production of large passenger aircraft is essentially a global duopoly). If China shifts demand to Airbus, someone else will either have to wait interminably for Airbus to fill their orders or shift their demand to Boeing. The U.S. exports $17.1bn in computer and electronics products to China, primarily semiconductors and instrumentation equipment that is highly specialized. For the most part China needs this stuff and can’t get it elsewhere. (As of 2015 China met only 9% of its semiconductor needs internally). Auto exports to China are significant at $10bn despite the existence of a 25% tariff (recently reduced to 15%). These exports will be put at risk, but for perspective Big Three revenues in 2017 totaled $385bn. Machinery exports of $9.3bn will similarly be put at risk. Throw in the rest of U.S. exports to china and it still only adds up to macroeconomic chump change. In sum, it’s a stretch to get to a .2 or .3 hit to U.S. GDP over 1-2 years from reduced exports to China. Threats to China-Sourced Corporate Revenues U.S. multinational corporates doing business in China have revenues at risk of increased tariff and non-tariff barriers, and they have assets at risk of forfeiture in an extreme outcome. The bulk of China-sourced corporate revenue results not from export activities, but from activities that take place solely within China. GM makes cars in China that is sells in China. Apple makes phones in China that it sells in China. Such activities, while unaffected by Chinese retaliatory tariffs, could be subject to increased non-tariff barriers or even consumer boycotts. Fortunately, if these China-based activities were brought to a complete halt tomorrow the direct effect on the U.S. economy would be close to nil. Of course, the effect on Apple or GM stock would be significant, undoubtedly with some magnitude of knock-on effect to the market more broadly. But it’s very hard to get to numbers that would have a sustained market-wide effect. While hard data is unavailable because not all firms report China-specific revenues, estimates are in the range of $300bn per year in China sourced non-export revenue. Here is a list of 33 China-vulnerable companies that break out revenue by geographical areas including “Greater China,” ”China including Taiwan,” “China


6

including Hong Kong,” and “Asia Pacific including China.” This covers over half of the estimated total China-sourced revenue.

Source: FactSet, Bloomberg, Morgan Stanley The data above overstates the problem by including some non-China revenue and it’s also highly unlikely that China-sourced revenues would be completely wiped out. But even if they were, we’re basically talking about a semiconductor sector problem. Starbucks, Corning, Apple, Tiffany, Tesla – these companies can certainly withstand 15-20% of their earnings stream being put at risk without entering crisis.


7

Yes, these stocks will get hit (and probably have already started to discount these risks). But this is by no means a bear-market catalyst. $300bn in China-sourced revenue is less than 2% of total annual U.S. business sales. It’s just not systemically relevant. Furthermore, even the semiconductor sector is probably only losing out relative to the “happy alternate reality” in which China marketizes. In the real world of the status quo ante, those profits were going to prove ephemeral anyway. From the most recent “Trends in Trade” report from the U.S. – China Economic and Security Review Commission:

the U.S. Department of Commerce’s International Trade Administration forecasts China’s semiconductor consumption to continue double-digit growth for years to come, making for positive near-term prospects for U.S. exports. However, the report also notes that “China has accelerated implementation of its strategy to develop a completely domestic [ICT] supply chain”; this strategy and the market access barriers it entails for foreign firms cast doubt on the long-term prospects for U.S. semiconductor exports to China2

Sadly, this has been a recurring theme for foreign multinationals doing business in China. Whos’ Afraid of an RMB Devaluation? Lastly, let’s consider the effects on the U.S. of feedback from China, which will struggle mightily with the new geopolitical reality. An RMB devaluation to USDCNY 7.50 or above is a strong likelihood in the next 6-9 months, and a more extreme tail scenario cannot be ruled out. While some-degree of short-term market disturbance is inevitable while the RMB is making its adjustment, several factors mitigate against a sustained negative effect on U.S. economic growth and asset market performance.

• Markets have already begun to price in China’s gradual economic isolation • Unlike 2015, the coming RMB devaluation will result from China-specific stress • The Fed has room to not only react, but over-react

While the market is only gradually coming around to the idea that U.S.-China economic disengagement is the new normal, the deeper we get into the process the less susceptible the rest of the world will be to RMB devaluation. The reaction function to RMB depreciation is probably already altered, in that corporate decisions to move supply chains in response to the shifting geopolitical landscape are unlikely now to be affected by near-term currency moves.


8

And if the RMB is depreciating because China is being cut out of the U.S. market (and potentially others as the “coalition of the willing” is built) then RMB devaluation will not be as big a threat as it has in the past to other countries that compete with China for U.S. and European market share. As it is, China’s competitors are gaining a big advantage as a result of the U.S. imposition of China-specific tariffs. Secondly, and critically, unlike 2015 the next RMB devaluation episode will be China centric. I know 2015 seemed China-centric, but it really wasn’t. The correlation between the 2015/16 RMB volatility and weakness in EM, credit and equities was more spurious than causal. China’s extreme credit and real estate bubbles have left it intensely vulnerable to liquidity tightening imposed on it though its heavily-managed exchange rate. China’s had a classic “impossible trinity” problem in 2015, in which the 25% rally in the Dollar necessitated an unsustainable tightening of monetary policy. The move to increased “RMB flexibility” in August of 2015 was an attempt to loosen that constraint on domestic monetary policy, DXY Index

But the 25% rally in the Dollar that was ultimate source of the problem. To wit: Would China have “devalued” in August 2015 if the Dollar hadn’t just rallied 25%? Probably not. Would EM have sold off in response to a 25% rally in the Dollar even if China had not “devalued” in 2015? Probably so.


9

Did everything turn around in 2016 because of something China did? Of course not. It was the Fed tossing the 2016 “dots” out the window and stepping back from the deflationary abyss. That there is no 25% Dollar rally to deal with this time. What we’re dealing with is that China mistimed its “this time it’s for real” deleveraging policy to coincide with a Fed tightening campaign and a generational shift in the geopolitical landscape that badly disadvantages them. It’s not a Fed / Dollar problem (yet, at least). It’s just a China problem. Which means that while EM assets will react negatively, that reaction is likely to be an over-reaction this time around, as broad deflation pressures are lacking. The Fed’s reaction though is likely to be similar (100bps came out of 2-year ahead fed Funds expectations in early 2016, about what’s in the curve now), though less necessary this time around. A quick move to 7.50-8.0 on USDCNY will create a lot of volatility in risk assets, EM in particular. But we’re not on the cusp of a deflationary spiral as we were in early 2016 and China is simply not integrated enough into the global economy to take us there singlehandedly. The Fed drives that train, and any outsized volatility in the RMB is likely to push them aggressively into reflation mode. Risk assets will take that trade and run with it. The Plus Side: Externalities As we compare the economic disengagement scenario not to a fantastic “happy alternative reality,” but to the status quo ante, which entailed sub-optimalities all its own, we can see that there are still costs to be born. And as many of those costs fall on corporate America, we can expect continued complaints and lobbying from that sector. But we should also consider the benefits of reducing the negative externalities which result from:

• Decreased capital allocation globally resulting from the presence of a large non-market player

• The societal costs of having to compete with 1.4bn workers with no political rights

• The geopolitical threat posed by an authoritarian regime which controls 18% of the world’s population


10

• Providing China with USD to fund predatory and expansionist and policies such as the Belt & Road

The best argument I’ve heard in support of the status quo ante is that we shouldn’t worry about “China taking over,” because centrally planned systems always implode upon their own inefficiencies eventually anyway. I have a lot of sympathy for this view. However, we must appreciate the Chinese government’s unparalleled ability to extract resources from its 1.4bn citizens who lack any semblance of political rights. And we should take seriously China’s stated designs on expanding that pool of extractable natural and human resources via geopolitical adventurism. Yes, China is highly likely to suffer a financial crisis of its own making a in the not-too-distant future. But will they then change course or merely redouble their efforts to marshal the productive resources of their oppressed citizenry in pursuit of political ends? If we continue to accommodate China’s wealth accumulation we will anyway before long be facing the reality of a hegemonic competitor controlling the world’s largest economy and holding sway over much of the emerging world. Given China’s lack of liberalization, that is simply not a comfortable long-term outlook for U.S. investment. While confronting China does entail some near-term costs, they appear manageable. Markets will ultimately reflect that those costs are more than offset by the beneficial effects of having U.S. policymakers on both sides of the ideological divide finally dealing with the actual world as it is, and no longer basing policy on the world as we all should wish it to be. Notes 1. Bloomberg news, “Xi's Swipes at Trump Show China Standing Its Ground in Trade War,”

November 4, 2018 2. U.S.-China Economic and Security Review Commission, “Trends in Trade: U.S.-China Goods

Trade 2012-2017.” July 19.2018


11

Appendix 1: Estimates of “Import Tax” Flow-through to PCE

economic disengagement from china: macroeconomic costs …economic disengagement from china:...

Documents