Markets & Economy

Simmering trade tensions have captured investors’ attention in recent weeks as President Trump takes aim at what he sees as a highly problematic trade deficit between the US and China. The White House has ratcheted up pressure on the bilateral trade relationship by announcing significant tariffs and suggesting that America can and would win a trade war.

The US has run a large, stable trade deficit with China since the mid-2000s, and each side is dependent on the other. We speculate the President is aware that a trade war is a lose-lose situation, with each side possessing significantly more retaliatory measures beyond tariffs. For example, China could sell US Treasuries, the US could restrict Chinese companies’ investment in the US, and so forth.

We believe negotiations will inevitably take place and that President Trump is engaging in game theory in hopes of getting some movement out of China to a more cooperative position. China enforces a number of competitive restrictions and tariffs that could be considered unfair—such as auto import tariffs of 25% compared to the 10% and 2% levied by the EU and US, respectively—suggesting that there is room for negotiation.

To better prepare for the ongoing trade debate, investors should be aware of these five facts that we believe add important context about the US-China trade relationship:

1. The net goods trade deficit of $375 billion isn’t as representative as the shock value suggests

The $375B goods trade deficit ignores a number of factors inflating the headline number. The total includes imports from Hong Kong, which while a quasi-Chinese state, is technically a different country. The headline number also includes exports of foreign-owned firms operating in China. Over 40% of total Chinese goods exports to the US fall into this category. It is also worth noting that Chinese sales by these same foreign companies, including those of US-owned companies, are not captured in trade data (i.e., not counted as Chinese imports). The $375 billion also does not adjust for supply chain value-add effects (i.e., finished goods made from previously imported intermediate goods), which amount to one-third of the value of goods exported from China to the US. As an example, the full value of iPhones assembled in China and shipped to the US count toward the trade deficit, even though many of the components of the iPhone are produced elsewhere.

2. China is America’s third largest and fastest growing export market

America exports $130 billion worth of goods to China. This represents 8.4% of total American exports, and the quantity has more than doubled in the past ten years. Services trade is another important consideration as the US exports $56 billion worth of services to China annually and actually maintains a large and growing services trade surplus with its Asian counterpart ($38 billion last year). Nearly 80% of the US’s total service exports to China are accounted for by the high-value add areas of travel, financial services, and intellectual property charges.

3. US consumers benefit greatly from low-cost Chinese production

The US-China trade relationship has allowed Americans to purchase goods at far cheaper prices than they could have if produced elsewhere due to the low cost of production in China. For example, the average Chinese worker’s wage was just $3.30 in 2015. By comparison, the average hourly pay of the next nine largest exporting countries to the US was $24.96. If the US aggressively restricted Chinese imports, it could cause production to shift to higher cost markets, increase inflationary pressure, reduce overall consumer purchasing power, and weigh on economic growth.

4. US foreign direct investment (FDI) in China significantly outweighs Chinese FDI in the US

US companies have been directly investing in China for a number of years. As of 2016, cumulative US FDI within China totaled $93 billion. This compares to cumulative FDI in the US by Chinese companies of approximately $27 billion. Importantly, the investments made in China generate healthy returns for US businesses, with the investment income from FDI in China totaling over $12 billion per year.

5. The trade deficit is largely a structural problem

Compared to the US, China has an extremely high savings rate contributing to the huge trade imbalance. Americans consume a lot, whereas the Chinese do not consume enough. Another structural factor contributing to the large trade deficit with China and 101 other countries is that the US Dollar is the reserve currency of the world. The implication is that large inflows of capital and the resulting large capital and financial surpluses are supportive of the US continuing to run persistent current account deficits.

While these are important considerations, we see the US-China dispute as going beyond trade and reducing trade deficits. This is really about a longer-term foreign policy strategy that the US is working to develop in regard to China.

It is a relationship of a rising power versus an established dominant power. It is also an attempt to contain/slow China’s development in high-tech and/or other areas where the US currently holds a competitive advantage and China is becoming a more direct competitor.

This rivalry has meaningful implications for global governance structure and industry competitive dynamics. It will be important to monitor in regard to effects on business/consumer confidence and economic growth expectations going forward.