World Markets Thinking Turns to the Obvious: China is NEVER Going to Willingly Change Their Trade Policy, Because the Status Quo Favors China.

Global equity markets have tumbled on reports that China has backtracked on a possible US-Sino trade agreement. According to a variety of private and government sources, the scale and scope of revisions made by China to a previously agreed framework was so large, encompassing virtually EVERY point in a 150 page document, that it seems obvious a deal may be dead and further negotiations are pointless.

It was, perhaps, too optimistic for investors to assume that Chinese policy-makers would willingly accept a reduction in the present one-sided trade relationship agreements that greatly favor China at the expense of trading partners. Most global trade frameworks were set up long ago, in an era when China was a large, developing nation with a low GDP and questionable manufacturing quality. Those days have come and gone yet the existing patchwork of agreements still offer China favorable export terms and domestic protection against foreign competition that don’t apply to developed first-world nations. To the Chinese the present trade advantage represents the economic equivalent of an entitlement; politicians change entitlements at their peril.

Successful investment decisions acknowledge the obvious as a starting point, rather than the folly of hope. As China has no political will to accept a reduction in terms on their present trade arrangement, then the appropriate response of the US government is to levy tariffs on EVERY Chinese good dropped onto American shores. Tariffs are a blunt tool; analogous to using ciprofloxacin, a harsh antibiotic, against a stubborn infection, blanket import tariffs against an intransigent Chinese government do work, with some side-effects. Tariffs represent the last, best and likely only remaining response to use against a Chinese government that refuses to play fairly and to first world global norms, in the modern era.

Tariffs succeed in defending domestic economies against foreign products. There is hundreds of years of hard data to back that up and thousands of years of anecdotal reports to support tariffs. Every country on the planet applies them in some fashion. For most of the previous two thousand plus years, the global economic framework was largely one of closed economies, with little free trade. The notion of free trade is truly modern; global free trade advocates have only about fifty years of data to work from. That is likely too short a time to consider free trade a success and maybe it might even, one day, be considered a failed experiment. Accordingly, we need not litigate the historically proven effects of tariffs.

In the case of tariffing an entire country, the impact needs to be put into some perspective.

1. American companies will, in the near term, experience increased costs of imports from China. These impacts will persist for the duration of purchase contracts with Chinese manufacturers. All importers of Chinese goods will seek to find substitute suppliers, presumably from other parts of Asia, that can offer needed products at lower prices. For American companies, any hits to their bottom line should be temporary; those that are unable to find supply of goods outside of China will be hit worse than those who are proactive.

2. Non-Chinese Asian competitors to China will win. A 25% markup on Chinese goods should make other Asian countries products more acceptable on a cost basis. There will be massive changes in the global supply chain in the near term as numerous Asian suppliers of products will seize upon the opportunity to take market share from Chinese firms.

3. China will lose far worse than America. Despite Chinese government and media rhetoric, China remains an export driven GDP with more than $520 billion of Chinese goods exported to the US; the bulk of these exports are primarily manufactured goods and component parts. In contrast, just $120 billion of US product is exported to China, primarily petroleum products, bulk commodities and agricultural products. The initial $200 billion of Chinese goods that will be impacted by tariffs are primarily high value computer and telecommunications related items.

Chinese officials are publicly bellicose on retaliation; the only options that they have, which would be punitive, will be to arrest Americans in China, or to expropriate American joint venture holdings in China. It may get to that, but should outright confiscation of American property and capital occur in China, that nation will be branded a global pariah and may never see a single dollar or Euro ever invested in China again.

A 25% reduction in competitiveness, on a pricing basis, for almost every Chinese good entering America, will punish the Chinese economy greatly and possibly permanently. Chinese officials appear to have miscalculated the will of a republican administration that actively seeks to modernize antiquated trade deals, with every nation, for the 21st century. It appears that China was operating on their long-held and time tested strategy of “running the clock out” based on American presidential election cycles; paying lip service to an American presidential administration for a period of 4 years can easily be achieved through the process of negotiation, revision, renegotiation and even translation errors. A Chinese decision to simply walk-away represents a calculated bet that the present Trump administration may lose to a democratic challenger in 2020. I believe that this will backfire on China. Once 25% tariffs are levied on Chinese goods, the Chinese economy, heavily reliant upon foreign capital inflows to support debt fueled capital spending, could come to a screeching halt.

The risk to the global markets is not that American companies will experience much lower profits on a permanent basis, nor is it that consumers in America will experience a massive increase in the cost of their imported goods. Imports can eventually be displaced through substitution. Risks for America are transitory at best. No, the risk is that China goes into a meaningful recession and that their government, who has always stalled their way out of modernizing trade agreements, has no easy solution to remedy that recession. China is heavily indebted and has a terrible track record when it comes to full disclosure of the state of their economy and national balance sheet. Politically, China has few true allies on the international stage.