The situation in China as the trade war with the US beckons

On Monday, I mentioned that White House Director of the National Economic Council Larry Kudlow had said on CNBC that the US wants to build a “coalition of the willing” to fight China on trade. And so, the fear in China, I understand, is that the US moves from unilateralist to ‘coalition of the willing’ in confronting China on trade issues. I’ve heard this from multiple sources. But Tom Mitchell in yesterday’s FT says it best:

As another fruitless round of China-US talks to avert a trade war wrapped up in Washington on August 23, foreign officials were arriving in the US capital for a potentially far more consequential meeting the next day. The occasion was an unusual trilateral forum that brings together trade officials from the US, EU and Japan. Their mission: to combat the allegedly unfair trading practices by unspecified “third countries”… But there was little doubt about the identity of the elephant in the room. As EU trade commissioner Cecilia Malmstrom said at the time: “There’s no secret that we think China is a big sinner here.”…

What really keeps [the Chinese] up at night, however, is a potential co-ordinated assault by the Trump administration, EU and Japan on their unique model of Chinese “state capitalism” that has been integral to the country’s economic success over the past 40 years.

Will China acquiesce?

I think more aggressive action from the US is likely, whether or not Trump is able to get other countries onside. To reiterate, on Friday Trump told reporters $200 billion in tariffs are coming “very soon depending on what happens.” And he also said “I hate to do this, but behind that there is another $267 billion ready to go on short notice if I want.” He’s not bluffing.

There are two questions then. Will the Chinese change their economic model to suit Trump? And the second question is: what happens to the Chinese economy.

Let’s take the first question first because the South China Morning Post has a good answer. A headline in today’s paper read “As trade war escalates, China intensifies role of state-owned enterprises“. So it seems the answer is no, the Chinese will not change their economic model. They are doubling down on it. I have underlined parts of the text for emphasis below:

Beijing has affirmed the leading role of state firms in China’s technological and economic progress amid the escalating trade war with the United States, with a major nationwide conference planned for the end of September.

Two sources have confirmed to the South China Morning Post that the conference will be chaired by China’s top economic adviser and will showcase Beijing’s strong support for state-owned enterprises (SOEs). Washington’s strong objection to the prominent role of SOEs in the Chinese economy is at the heart of the trade conflict.

Vice-Premier Liu He – President Xi Jinping’s top economic adviser and chief trade negotiator with the US – is expected to urge China’s state enterprises to “make breakthroughs in key aspects” of cutting-edge technologies and call on them to “take a leading role at the front” of the country’s drive to make technological progress, according to one source involved in the planning for the conference.

Speaking to the Post on condition he not be identified, the source said the meeting would highlight the role of SOEs in advancing technological innovation as the government pushes ahead with its plan to play a large, if not dominant, global role in 10 major hi-tech sectors by 2025.

This tells you we are on a trade war collision course now.

The Chinese economy is soft

The real problem for the Chinese is that, as the trade war looms, their economy is weakening. And while there is little doubt that trade tensions have caused investor sentiment to worsen, much of the slowdown is due to tightening monetary and fiscal conditions.

In China’s official sector, debt accumulation – both via bonds and shadow bank lending – has slowed dramatically as the government cracks down on excess credit growth in the sector. The government has also withdrawn financing guarantees for local government funding vehicles (LGFVs) and ended many private-public partnerships in this effort to clean up balance sheets in the official sector.

The worry about debt accumulation in China is everywhere. So one could argue this balance sheet clean-up is a necessary evil to prevent a financial sector ‘black swan’ down the line, due to the buildup of excessive debt. But, the clean-up is slowing credit growth, which has in turned slowed investment and economic growth while also hurting the private sector.

Here’s the SCMP from June:

In the first five months of the year, 13 companies defaulted on about 20 bonds worth a combined 14.8 billion yuan (US$2.3 billion). Both the number of defaults and their combined value were significantly higher than the corresponding figures for the same period of last year.

Of the seven companies that experienced their first (onshore) bond default in the period, six were privately owned, according to Zhou Hao, president of China Chengxin International Credit Rating Co, a joint venture with Moody’s.

A growing number of private firms could face cash flow problems in the second half of the year as they are the most vulnerable to the government’s crackdown on shadow banking, he told a conference in Beijing.

“It is the private firms that are mainly affected in this round of the deleveraging campaign.”

Will the Chinese turn on the turbo boosters then?

Before the threat of a trade war, the slowing of credit growth and the balance sheet clean-up efforts were positive factors. Sure, growth would slow as a result. But, stronger state owned enterprises would enhance the resiliency of the economy. And, in China’s directed economy, Beijing could always drain the risk slowly.

Now, China is faced with an external growth threat and the existing internal one. And it’s not clear to me what they will do. I believe that at some point, if the growth slowdown gets out of hand, China will crank up the stimulus.

But let’s get real here. The vaunted Chinese model is very overrated. It’s what has led to excess debt to begin with. Matt Klein made a good case against it back in April. When Beijing wants to inject stimulus, it does so through the state owned enterprise sector. And that sector has low efficiency. Basically, stimulus will just make China’s problems worse, reversing the efforts to clean up SOE balance sheets.

I’m not a China bull here. There are a lot of moving parts to this story and a lot of landmines as well. As for Chinese shares, the market is trading near 2016 lows, with the recent bear market having shaved $5 trillion off of market cap. In fact, the Shanghai Composite Index is down 20% so far this year. That makes it the worst-performing major stock index in the world, only bested by declines in the emerging markets. I see no catalysts for a big rally, even if we do get stimulus.