Trading with China, by the numbers

Yesterday, President Trump announced trade tariffs on imported steel (25%) and aluminum (10%).  Although such measures were in line with campaign promises, financial markets reacted negatively and many commentators darkly warned of impending doom.  Earlier in the week, the President commented that foreign trade was the one problem which could threaten bilateral relations with China.  What to make of all that?

China’s steel production capacity is almost 8 times that of the US; it employs a lot of people and, like any heavy industry, it needs to operate at a high utilization level to remain viable.  This had led to the creation of a variety of subsidies, ranging from grants to loans at preferential rates, price controls on key inputs, lax environmental regulations, and equity infusions.  Such subsidies, in turn, triggered capacity expansion and the need for further subsidies.

Findings of Chinese anti-competitive practices are not new, nor are they limited to the US: last year, the European Union imposed duties of 17.2% to 28.5% on a variety of Chinese steel imports. 

So far, it is unclear to whom, how and when these tariffs will be applied.  As usual with this administration, seemingly good ideas are weighed down by poor presentation or poor execution.  Furthermore, one can question whether the US should want to expand an industry, steel-making, which is highly polluting and generates modest value-added.

But the steel dispute highlights a much deeper problem, which is how to deal with an economy that is the second largest in the world, yet enjoys a treatment which is normally applied to emerging countries.  The table below points to a striking imbalance which is difficult to ignore:

         US Foreign Trade with China in 2017

US exports of goods	$130 billion
US imports of goods	$506 billion
Trade deficit	($376 billion)

Adding back the US surplus in services would reduce the above deficit by only $30-$40 billion.

Looking into the main components of trade is instructive:

Main components of US-China Trade in 2016

Top US exports		Top China exports
Grains, seeds, fruits	$15 billion	Electrical machinery	$129 billion
Aircraft	$15 billion	Machinery	$  97 billion
Electrical machinery	$12 billion	Furniture and beddings	$  29 billion
Machinery	$11 billion	Toys and sport equipment	$  24 billion
Vehicles	$11 billion	Footwear	$  15 billion

The largest US export to China is low value-added agricultural products;   Chinese machinery exports are 10 times the size of the US ones.

By comparison, the European Union trade deficit with China is about half that of the US, in both absolute and percentage terms.

Much more important than steel imports from China is the ongoing investigation into Chinese practices relating to intellectual property and technology transfer.  These deal with US assets which have far greater value, both strategically and financially than steel and aluminum products.

In parallel, the US (and the EU) continue to oppose recognition of China as a “market economy”.  This goes beyond matters of prestige: such recognition would limit the ability to impose tariffs on China for unfair trade practices.

Taking the broad view, pressure has been building up under the US-Chinese trade imbalance for a long time.  In recent years, it was exacerbated by the Great Recession, yet critics didn’t get much support from Washington as proponents of globalization were better organized and better financed.

This seems to be changing as President Trump made “fair trade” with China a major plank of his campaign and won significant voter support for it.  There is not much argument that the US consumer benefitted from low prices brought by globalization.  The question which is being asked today is whether this should be the ultimate goal.

To the extent that other very large economies make their products artificially attractive and their own markets hard to access, this will result in a hollowing out of their competitors’ industries and result in some social hardships.  In the end, will American consumers willingly trade a somewhat lower purchasing power in exchange for greater social stability?  That is the question.

Steel, aluminum, intellectual property, we are at the beginning of a struggle between the No. 1 and the No. 2 world powers, not about which has the best nuclear arsenal, but how the greatest engine of wealth will work for their respective populations, and indirectly, their political establishments.  The current US administration launched its campaign by lowering corporate taxes and cutting down regulations.  It is now entering the more political and aggressive field of tariffs.

Who will be the winner?  Will there be a (lasting) winner?  I don’t know.  But I would bet that the current system will change. 

The Trump Prism

One cannot count the number of verbal bombs which Donald Trump threw during the 2016 presidential campaign.  Many were calculated provocations, baiting TV networks to put him front and center of the day’s evening news, others were fodder for his enthusiastic fan base. 

Trump’s campaign was brutal and divisive.  But it led him to victory, Pyrrhic as it could still turn out.

So what did we learn about Donald Trump that will likely shape his presidency?  What is he likely to focus on? 

From the campaign, we learned that:

·        He wants to “win” and that winning is everything,

·        To that end, he will fight to the last minute,

·        He sees himself as the leader of a movement, not a staid party,

·        He feels that middle class Americans want him to put them first.

Whether it is Hugo Chavez, Charles de Gaulle or Donald Trump, there is much to be learned from their earlier writings.  This is what the President wrote 30 years ago[1]:

“Most people are surprised by the way I work.  I play it very loose.  I don’t carry a briefcase... You can’t be imaginative or entrepreneurial if you got too much structure.  I prefer to come to work each day and just see what develops…I can be a screamer when I want to be.”

Running the Trump Organization is not the same as running the US government, but a 70 year old man will not drastically change his habits, particularly if he considers that they made him very successful.

Summing it all up, it is reasonable to conclude that for President Trump, ultimate success will mean winning (or believing he could win) a second mandate, that progress will be measured mostly by domestic milestones (“the economy, stupid”[2]), and that foreign policy will be a means to that end.

Priority #1 will be improving Americans’ disposable income.  This necessitates growing the economy faster.  Regulatory and tax reforms will be necessary but not sufficient.  As I see it, he and his advisors believe that China is the single biggest external obstacle to reach their goal. 

As this effort will consume vast amounts of political and financial resources, and these are to an extent limited, it will be imperative to reallocate some existing ones.  So, Europe will be asked to shoulder more of the security responsibilities which are regional (Eastern Europe) and near-regional (Middle East) in nature: hence the call for NATO members to meet the 2% of GDP defense threshold. The same will go for Japan and South Korea.

Finally, I believe that the talks of a “rapprochement” with Russia stem from the same rationale – freeing time and resources – rather than an infatuation with Putin.  It shouldn’t be difficult to improve on the current bilateral relationship, but by how much is an open question: Russia has its own priority objectives, some of them expansionary in nature; additionally, any effective accord will have to also involve Europe.

Let us look at the foreign trade issue into some details.  The table below depicts the US trade in goods and services with select partners in 2015:

Trading Partner	Trade volume	US deficit w/partner	Deficit as a %
China	$   659 billion	$336 billion	51 %
European Union	$1,063 billion	$  99 billion	9 %
Japan	$   290 billion	$  57 billion	19 %
Mexico	$   584 billion	$  49 billion	8 %
Canada	$   663 billion	$  12 billion	2 %
South Korea	$   129 billion	$    8 billion	6 %

      Source: US Trade Representative. Statistics are for goods and services. Korean data is for 2012.

It is clear that there is only one critical imbalance - with China which accounted for 2/3 of the overall US trade deficit - and a few important others.    

The US economy is perhaps the most efficient and advanced in the world, yet it has consistently produced trade deficits for four decades!  Either its currency has been overvalued, or the terms of trade have not been fair.  It is difficult to conceive of many other explanations.

Germany, with a 2015 US goods surplus with the US of $74 billion (42.6%) has benefitted from a very undervalued currency[3].  China has long managed its currency and tightly protected its domestic market[4].  So has Japan.

I have no doubt that rebalancing trade will be a bruising battle.  Trump has chosen a very experienced cadre of international trade specialists[5].  As for China, it has not succeeded in really boosting domestic consumption[6], its slowing economic growth has called for ever increasing credit creation and popular sentiment is uncertain (low wages, high pollution, no ready outlet to vent frustrations).  It is apparent that the new US administration believes it holds strong cards to force a change, while the Chinese leadership probably feels that it has little margin for error[7].

Mexico is a different situation.  Over the last 20 years, it has not had a single annual global trade surplus, but in 2015 it had a US surplus of $49 billion vs. a global deficit of $15 billion.  The surplus was mainly the result of its close integration with the American economy[8], favorable cost differentials and history.  Politically, it is an easier target than China, but a trade war would have immediate fallouts because its industrial integration with the US is often based on just-in-time supply chains and of its extensive shared border region.

Nafta will be amended/updated with a view to reducing the trade imbalance.  This will mainly be done by boosting US exports and taking advantage of the opening of the energy sector to foreign operators.  Mexico will not send a check for the “wall”, but president Trump will likely declare victory by pointing to the reduced trade deficit.  In the end, Mexico is a better place for US companies to invest (where they can operate freely and aren’t forced to share their technology) than China, and it is likely to benefit from any relocation away from Asia.

A word of caution:  There is little point in repatriating basic industries which generate low added value (and thus pay low wages) and cause the kind of pollution that chokes big Asian cities.  Furthermore, creating high paying jobs requires qualified labor.  There were 5.5 million unfilled job openings last November[9]; while employers’ expectations were often too high, it is clear that there is a skill gap, and so far there hasn’t been any broad initiative to help displaced or unskilled workers bridge that gap.  Upgrading the skills of millions will take time.

While Donald Trump has a track record of being a successful negotiator, all of the above reforms – if successful - will take time to bear fruit, months and more likely years.  It took over two years for Ronald Reagan’s policies to translate into tangible economic improvements.  In the meantime, a president needs to retain the support and confidence of the people.  In today’s divided society, it will be a quite a challenge.

The Trump agenda will also take place in the context of a more fluid global scene.  The world is no longer divided between two stable political and security blocks, Europe is economically weak and more politically frayed than ever, Islamic Jihad is a new threat, and the list goes on.  This will give the new president more room to move, but big mistakes will still be costly: they might just result in chaos rather than war.

My crystal ball has a faint green glow.

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[1]  The Art of the Deal.

[2]  The famous slogan of James Carville who was Bill Clinton campaign strategist.

[3]  According to former Fed chairman Ben Bernanke, that undervaluation likely exceeded 20% in 2015.

[4]  Even if it is now struggling to keep its currency from depreciating too fast.

[5]   Wilbur Ross as Commerce Secretary Robert Lighthizer as US Trade Representative, among others.

[6]   The percentage increase in the share of GDP accounted by domestic consumption resulting mainly from a drop in capital investments.

[7]  Politically and socially.

[8]  The top US imports for Mexico were machinery (US$ 112 bn) and vehicles (US$ 74 bn).

[9]  US Bureau of Labor Statistics. 

On the head of a pin

The Republican primaries are effectively over.  Donald Trump has won.  The Democratic ones continue, with Bernie Sanders hammering at the only Establishment figure left, Hillary Clinton.

2008 was the year Americans felt they had come together behind an historic candidate, Barak Obama.  Eight years later, they are angry, frustrated and more divided than ever since the Vietnam War.  So much so that they are betting on two outsiders who promise to bring the “corrupt” system down. 

Now what?  Reality is starting to dawn on Republican Party grandees that Donald Trump is not their candidate, rather that they are his supporting cast.  Who is the boss?  The question is being asked now and will be answered soon.

Republican mediators hope that Donald Trump will change his tone to unite the Party.  This is unlikely for several reasons.  Dumping a winning strategy has risks for Trump.  Besides, one of the most surprising sights of the primaries was to see prominent politicians taking little offense at being called corrupt, liars, weaklings or told to shut up on live tv.   

My view is that Donald Trump calculates that the Republican Party leaders lack courage and vision and that they will ultimately back him up in order to save their sinecures: better being tame courtiers than proud exiles.

A Trump president would likely go over the heads of Congress and the Senate to appeal directly to voters, make extensive use of executive decrees, and go for big targets: big infrastructure programs, NATO shake-up, big budget and spending battles.  He obviously believes that he would win most of these; he would enjoy the negotiating game;  but the US is not the NY real estate market, or even France, Germany or Russia:  Gamesmanship at the US level has far greater potential destabilizing effects.  Unpredictability may be a good negotiating tactic but it is not a strategy for the world leader[1].  Likewise, loading the US with debt – because if the economy rebounds it is easy to pay it off, and if it fails you just restructure – can’t be the best way to sell  hundreds of billions of US treasuries every year.

The Trump candidacy will have had some positive effects, such as exposing the dysfunctionality of the Republican Party, imbalances within NATO contributions and the not so hard nose negotiating abilities of the Obama administration.  But the negatives of a Trump presidency are difficult to fathom and potentially huge.

What about the Democrats?

Hillary Clinton is unloved and polarizing, but is the safe pair of hands among the last three remaining candidates.  Yet she has been pulled further to the left by Bernie Sanders than she wanted or expected (and her miseries are not over yet).  That Senator Elizabeth Warren is talked as a possible running mate makes that very clear.

She also has hanging over her head, as the Sword of Damocles, the inquiry into her use of a private server and the sharing of “classified” emails.  It is possible but unlikely that the Department of Justice pursue a criminal indictment against her; but if this decision were a close call, some disgruntled FBI or DOJ staff could leak embarrassing related documents; then, we would have a new ball game.

To succeed in the general elections, she would need to retain the support of Sanders’ voters while attracting independents and non-Trump Republicans: no small task.   

If she succeeds, and unlike the other two candidates, she is more likely to seek consensus because she won’t have a solid base of believers.  She would need a good communicator to help get her message through that, as Talleyrand once said, governing is the art of the possible. Would this be her Vice President, her Secretary of the Treasury or her Secretary of Labor?  I don’t know.  Would she succeed?  Way too soon to tell.  Besides, if she didn’t heed Sanders’ entreaties, over time his supporters could set up the Democratic equivalent of the Tea Party.

In summary, and as of today, this presidential election looks like the most frustrating in years.  The two most likely candidates are viewed more negatively than positively.  The two with the greatest fan bases are party outsiders who promise the moon and howl that the political parties whose banner their carry are rigging the primaries against them and their voters.  The cooler headed one enjoys stronger support from party officials than from party members.

Fasten your seat belt but don’t get off the plane!  

Because if you think this political season can't hold any more surprises, THINK AGAIN.

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[1]   But it has been for North Korea.

Sister Souljah moments

It seems that all major political campaigns have their Sister Souljah moment, when the candidate(s) face a high risk question or situation which opens or closes their path to success.

The original one of course was when candidate Bill Clinton, speaking to Jesse Jackson’s Rainbow Coalition, chose to publicly rebuke a well known black activist’s justification of black on white violence.  Clinton did endure harsh criticism from some quarters, but he gained the broader support of moderate Democrats who had had their doubts about him.

In 2012, Mitt Romney and the rest of the Republican presidential candidates had their own Sister Souljah moment, and they blew it.  When a debate moderator asked them if they would accept a hypothetical deal to increase taxes by $1 for every $9 in spending cuts offered by the Democrats, they hesitated, looked at each other, and demured.  How could getting 90% of what you want be unacceptable to those “conservatives” when their idol, Ronald Reagan, famously said he would settle for 80% and fight for the rest another day?  They were so afraid of losing fringe support that they ended losing the support of the majority.

This year, we have seen Republican presidential candidates being called liars and other names in front of millions of TV viewers and hundreds of spectators by Donald Trump, and not responding.  Is their sense of value so distorted that they didn’t think such attack on their honor deserved the most vigorous response?  Or were they afraid of Donald Trump?  Either way, they let their Sister Souljah moment pass and will live to regret it.  So will we.

Yet another such moment came in yesterday's debate: after arguing, sometimes literally, that Donald Trump was unfit to be president, his three opponents pledged to support him if he was nominated.  I am glad they do not work as check captains at my favorite airline.

The Yellow Brick Road

It is too soon yet to guess who will be the next president, but not too soon to detect a change in the dynamics of the country.  And that is good news.  Perhaps unexpectedly, the American voters seem to take a greater interest in the substance of the debate and to realize that any solution will have to be negotiated in the political middle.

I think that it all began with the first presidential debate.  The Republican candidate, Mitt Romney, surprised almost everybody: he won, did so on substance and was much more moderate than the press had painted him to be (in fairness, he moved back to the center after having won the nomination on the right).  By contrast, the President demonstrated that eloquence needed a base in facts, in experience and in a successful track record to be effective, at least if you are the incumbent.  Though it had lapped screaming TV talk shows and the vacuity of The Wives of … reality programs for some years now, the public gave Romney a decisive victory in post debate polls because he had presented sounder arguments.

To my mind, the vice-presidential debate reinforced this trend towards problem-solving.  Vice-president Joe Biden was very aggressive as expected but was also very rude and at times contemptuous of his opponent.  His arguments often lacked substance and his tone was generally populist in the extreme.  By contrast, Paul Ryan was composed and displayed greater command of facts and numbers; he was also surprisingly at ease debating foreign policy.

Democratic pundits were delighted: Joe Biden has come out with all guns blazing.  Yet I think that this strategy was flawed.  For one, he made his boss, President Obama, look weaker.  For another, his demeanor seemed to have turned off the Independents and undecided voters who were less interested in televised combat and wanted to hear solutions to their and the nation’s problems.  Paul Ryan may have taken a lot of verbal abuse but he seemed to have won on points so to speak.

The next presidential debate will be interesting and likely will determine the outcome of the elections.  By temperament, President Obama is more collected than his vice president; he also will be faced by Mitt Romney, some 20 years his senior and a person with a strong track record in private and public life.  As is clear to most already, winning over the American Middle is the key to winning the presidency and there is ample evidence that the winner will need to win on substance: that is what people want, besides, while Obama is generally viewed as likable, Romney is no longer viewed as a cold hearted money-maker.

Whoever becomes president in November, it looks to me that the American people are realizing that the solution to the country’s problems will cause pain to everybody rather than a few thousand plutocrats: effective tax rates will have to rise (sorry Republicans) and public spending will have to be cut (sorry Democrats).  Failed experiments in Japan and Western Europe have brought this country back to reality and none too soon.  Welcome back to the Center!