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China Weekly Letter – Will the Tech War Threaten a Trade Deal?

  • US-China ceasefire off to a rocky start – but we still look for a deal in 2019
  • The US-China trade deficit at a new high in October as China cuts imports
  • China PMI surprised to the upside but we see more downside in coming months

A rollercoaster week as ceasefire trade talks kick off

I use most of the space for trade this week as so many things have happened – and it is by far the most important thing for China right now. The first week of the ceasefire got off to a rocky start to say the least. On Tuesday, in a storm of trade tweets, Trump spooked markets with one tweet in particular about being a ‘Tariff Man’. However, on a more positive note, he also highlighted how farmers would benefit and that Chinese car tariff rates would come down. Moreover, he tweeted he believed a deal would be reached.

The news that really shook markets was the arrest of Huawei’s CFO Sabrina Meng, who is also the daughter of Huawei’s founder, Ren Zhengfei, and vice-chairman of the company. She was arrested in Canada for extradition to the US on claims of violating sanctions on Iran, see the SCMP. She will appear at a bail hearing on Friday morning in Canada. For more on the importance of the company Huawei, see CNN and Reuters.

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The reaction in the Chinese state media was strong and among other things called the attack on Huawei a part of the US’ strategy to contain China. A China Daily editorial used the headline ‘Containing Huawei’s expansion detrimental to US-China ties’. For a good overview of state media responses, see The Guardian. However, according to the SCMP China’s foreign ministry spokesman denied a link between the arrest of Sabrina Meng and the trade negotiations. Trump’s National Security Adviser, and ultra-hawk on China, John Bolton, on the other hand stated that Huawei would be a major topic in the talks, see transcript of interview with NPR. On Thursday, Japan announced that Huawei telecom equipment would be banned from state-backed projects, see Reuters.

That China would not link the case to the trade talks was apparently confirmed on Thursday, when the Ministry of Commerce said China would immediately start implementing agreements on agricultural products, energy and cars. The ministry spokesman also called the talks with the US ‘smooth’ and that China is ‘fully confident’ it will reach an agreement with the US within 90 days, see Caixin. In a tweet Thursday night, Trump followed up by quoting this message and said ‘I agree!’. A Bloomberg story today says there is an internal debate in China on potential retaliation. The report says there is a division between those working on the economy, who want to separate the two things and those who deal with national security (normally more hawkish), who want to push back.

On Tuesday, China followed up on the ceasefire agreement with the announcement of strengthened punishments for theft of Intellectual Property Rights (IPR), see Bloomberg. China set out a total of 38 different punishments to be applied to IP violations, starting this month.

Comment: While the Huawei case was clearly a blow, I believe Xi and Trump will aim to separate the Trade War from the Tech War. On Trump’s side, I think it is noteworthy that he chose to tweet about the positive statement from China rather than bashing Huawei for the potential violation of Iran sanctions. It suggests to me that he is really quite eager to reach a deal with China.
On the Chinese side, the challenge is that the Huawei case puts domestic pressure on Xi not to be too soft on the US. But I think he will go for reaching a trade deal as the Trade War hurts the Chinese economy – and that he will fight the Tech War with other tools. We cannot rule out that Chinese consumers would start to take part in the Tech War and support Huawei in the Chinese market at the expense of Apple (the world’s largest company by market cap).

My main case for Trump making a deal continues to be that he is keen on supplying gifts to key voters in swing states such as Iowa (agriculture) and Michigan (autos) as he eyes the 2020 Presidential election. Typically, the election campaign starts one and half years before the election, which would be late Q2 next year. A restarting of the trade war after 90 days would jeopardise the strong economy and risk sending US stocks into a bear market. It would weaken Trump’s hand significantly and failure to reach a deal would also hurt some of the key voters he wants to benefit from a deal. While we continue to expect a bumpy road, we still expect an agreement in 2019. The deadline of 90 days may be extended, though. Trump revealed in a tweet earlier this week that an extension could be a possibility.

US-China trade deficit at new high in October

US trade data on Thursday showed a significant drop in Chinese imports from the US in October (see chart on front page). It took the US-China trade deficit to a new all-time high of just below USD500bn measured on an annualised basis.

Comment: Trump is clearly not going to like this. But the drop in Chinese imports reflects a sharp decline in purchases of US agriculture and illustrates that while China cannot put tariffs on as many goods as the US can, it can divert purchases of some goods, such as soy beans, to other countries and hurt the US economy this way.

PMI data stronger but look out for more weakness short term

PMI manufacturing from Caixin surprised to the upside, as it rose to 50.2 in November from 50.1 in October. The services PMI rose to 53.8 from 50.8.

Comment: While it looks good on the surface, I still expect more downside in the short term. The NBS PMI is weaker and other indicators point to more slowing, too, see China Leading Indicators – It gets worse before it gets better, 21 November 2018. After a weak Q1, I look for a recovery driven by policy stimulus and a trade deal with the US.

Other China news:

The CNY had its biggest two-day gain against the US this week. It was likely a combination of short sellers of CNY being flushed out after the ceasefire and possible intervention by China to strengthen the CNY. US Treasury Secretary Stephen Mnuchin said Monday that the US had a “strong commitment” from China to deal with CNY devaluation. The strengthening of the CNY clearly puts downside risk on our 12-month forecast for USD/CNY of 7.20 (currently 6.88). We plan to revisit the forecast next week.

Chinese FX Reserves rose slightly in November from USD3.05trn to USD3.06trn. This suggests China did not intervene in the currency market in November.

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