Financial markets are in turbulence as China announced to raise tariff of US$60B of US exports to 25% from 10%, effective June 1. This was followed by US’ threat to levy tariff on the remaining Chinese exports (worth of about US$ 300B) in as soon as summer. While China’s retaliation on US’ increase of US$200B of Chinese exports had been widely anticipated, the market has reacted rigorously upon its announcement. Risk assets got dumped as led by US equities. Commodity currencies (especially Australian dollar due to the close economic relation between China and Australia) slumped while safe- haven currencies, e.g. Japanese yen and Swiss franc jumped. UST yields slumped as led by the front end of the curve, with the market more than fully priced in a rate cut by December.

As a recap, US imposed 25% tariff on US$50B of Chinese exports back in July and August 2018. In response, China matched by imposing same rate of tariff on the same size of US exports. US then imposed 10% tariff on US$ 200B exports from China in September last year. It also threatened to raise the tariff to 25% in January 2019, together with new tariff on remaining Chinese exports. China retaliated by imposing 5-10% tariff on $60B of US goods. As trade negotiations proceed, Trump announced in December to postpone the increase in tariff rate as well as imposition of addition tariff. While the market has been anticipating a trade deal within reach, Trump surprisingly increased tariff on US$200B of Chinese exports to 25% last week. The move was followed by China’s retaliation and US’ further escalation of tariff on the rest of Chinese goods.

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Why Re-Escalates?

Besides narrowing trade deficit with China, the most important objective of US’ initiation of trade war is to correct the unfair trade and investment practices in China. We summarize here the unfair practices into three key areas: 1. Forced technology transfer and theft. 2. Prolonged license approval process as overseas firms seek to do business in China, 3. Foreign companies have to form JVs with Chinese firms as they seek to operate in China. Despite pledges to o eradicate forced technology transfer and theft at the National People’s Congress in March and drafting laws to open up its market, it appears that the Chinese government “broke the deal” by reneging on earlier commitments made during months of negotiations.

1. Forced technology transfer and theft.

There have been numerous criticisms that US’ initiation of trade war is to prevent China from taking over US’ leadership in global economy and technology. Such rhetoric has grown rapidly as the trade war was believed to be a response to China’s “Made in China 2025” grand plan, lain down by Premier Li Keqiang in 2015.According to the Chinese government, Made in China 2025 is a 10-year plan to transform the Chinese manufacturing sector to be innovation-driven, and a high-tech one. It aims at raising domestic content of core components and materials to 40% by 2020 and 70% by 2025. The government has also pledged significant role by providing an overall framework, utilizing financial and fiscal tools, and supporting the creation of manufacturing innovation centers. Some believe that the plan would change US- China trade relations change form “complementary” to competitive” and this is a key reason triggering US’ dissatisfaction.

Yet, those who have made this claim has omitted the fact that China required transfer of core technology knowledge to local firms as overseas companies attempt to run business in China. Although China has insisted that forced technology transfers are against its policy and denied such things had occurred, the government drafted a Drafted new law in December 2018 to fight against such practice. It also pledged to eradicate this at the National People’s Congress in March.

2. Prolonged License Approval Process

Despite a WTO member since 2001, China has no intention to open up its market. It protects the “core” businesses in areas such as pharmacy, insurance, credit cards’ payment clearing and settlement by taking longer-than –international-standard time in the license approval process. Back in 2012, WTO ruled that China is discriminating against foreign credit card companies. Yet, little has been done to reform this as Union Pay remains the only company eligible in handling renminbi payment and settlement.

3. Foreign companies have to form JVs with Chinese firms

As a requirement to operate business in China, foreign companies have to form JVs with Chinese firms. They are prohibited from holding majority stake, let alone taking full control, in its Chinese operations. In order to alleviate US’ discontent and to get better terms in a trade deal, China announced that it would allowing foreign financial institutions (banking, securities and insurance industries) to take control of domestic securities brokerages biz of up to 51%. UBS has got approval in December. China also indicated that it would accept applications this year from foreign insurers seeking to take control of their local joint ventures and is even weighing giving them full ownership

Impacts on Economic Outlook

Trade war would likely be lose-lose scenario on both sides. As a tax on consumption, the increase in tariff might dampen household spending, business investment and sentiment. These could lead to deceleration of economic growth in coming quarters. The real impacts depend on the duration of the current stand-off. The market has priced in over 100% of a Fed funds rate cut by December. Undoubtedly, re-escalation of trade war might have increased the odds of a precautionary rate cut. Yet, we for now opt to retain the expectations that the Fed would stand on the sideline for the rest of the year, while closely monitoring the developments of trade war.

The economic impact on China would be more severe, in particular the country is torn between huge debts and growth slowdown. It is obvious since the start of trade war that the Chinese authority has prioritized growth stimulation. We expect PBOC to maintain a easing monetary policy by cutting RRR later this year. It might need to cut interest rate if the situation worsens. Deceleration of renminbi is a dilemma. While a weaker renminbi might help exports and act as retaliation to the US, excessive depreciation would trigger capital outflow and instability in China’s domestic financial markets.

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