US-China Cold War heats up

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From the FT:

The appointment of Peter Navarro, a campaign adviser, to a formal White House post shocked Chinese officials and scholars who had hoped that Mr Trump would tone down his anti-Beijing rhetoric after assuming office.

Mr Navarro, a Harvard-trained economist and University of California Irvine professor, is the author of Death by China and other books that paint the country as America’s most dangerous adversary.

“Chinese officials had hoped that, as a businessman, Trump would be open to negotiating deals,” said Zhu Ning, a finance professor at Tsinghua University in Beijing. “But they have been surprised by his decision to appoint such a hawk to a key post.”

Adding to rising tensions between the two countries, the US Office of the Trade Representative yesterday put Alibaba, China’s biggest e-commerce platform, back on its “notorious markets” blacklist of companies accused of being involved in peddling fake goods.

Hua Chunying, a Chinese foreign ministry spokesperson, said Beijing would monitor the policy positions of the incoming US administration. “As two major powers with broad mutual interests, co-operation is the only correct choice,” she said on Thursday.

Speaking hours before the appointment of Mr Navarro, which was first reported by the Financial Times, China’s foreign minister Wang Yi told the People’s Daily, the ruling Communist party’s flagship newspaper, that China and the US faced “new, complicated and uncertain factors affecting bilateral relations”. He said the world’s two largest economies must respect each other’s “core interests”.

Cui Fan at the China Society of WTO Studies, a think-tank affiliated with China’s commerce ministry, warned that Beijing would respond to any unilateral action by the incoming Trump administration. “China is preparing itself for US trade actions,” he said. “China will respond with counteractions of its own.”

What will China do? It rather depends what the US does. If it’s targeted tariffs then it would probably respond in kind. Having said that, it will do much more damage to China than it will the US given the huge trade deficit, from Deutsche:

…the US would have three objectives: (i) reduce trade deficit; (ii) boost growth, and (iii) “bring jobs back” (in the President-elect’s own words).”:

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The likely targets are:

 Computer and electronics;

 Automobiles, trailers and parts;

 Apparel, leather and allied products;

 Electronic equipments and parts; and

 Furniture

If it’s Trump’s generalised import-adjustment tax then China will respond in kind along with everyone else and we’ll get a global inflation surge:

One of the least talked about but possibly most important tax shifts in the history of the United States is House Speaker Paul Ryan’s and President-elect Trump’s “border tax adjustment” proposal.

This is part of the “Better Way” reform package and also figures prominently in the writings of senior Trump administration officials.

Put simply, the proposal would tax US imports at the corporate income tax rate, while exempting income earned from exports from any taxation.

The reform would closely mirror tax border adjustments in economies with consumption-based VAT tax systems.

If enacted, we believe the plan would be extremely bullish for the US dollar. What’s more, it would have a transformational impact on the US trade relationship with the rest of the world.

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To be sure, there are uncertainties related to all estimates above. First, there is a question mark on whether a border tax adjustment based on a territorial corporate tax system (as opposed to VAT) would be allowable under WTO rules. The question is highly complex, but senior Trump advisers have stated they would be willing to take the issue to the WTO.

It is also not clear what types of goods the new tax would cover – the broader the coverage the bigger the impact and vice versa.

Second, the impact on trade highlighted above should be considered an upper bound, as the post-crisis responsiveness of current account balances to relative price shifts has proven to be much lower.

Still, it is hard to argue that such a fundamental shift in tax treatment of US exports and imports would not have a material impact on trade relations and flows with the rest of the world. More importantly, Saravelos argues, the second-order impact of “re-shoring” may be more material given that US corporate activity has been disadvantaged due to the current unfavorable tax treatment of offshore profits.

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In the way is business, via Salon:

As lawmakers set out to implement one of the broadest reforms to the tax code in decades, one proposal has companies gearing up for a rebellion against politicians they traditionally view as close, pro-business allies. Republicans in the House of Representatives and President-elect Donald Trump seem prepared to deal a blow to import-dependent companies with taxes aimed at penalizing them for not buying “Made in America” goods.

The proposal is part of the House Ways and Means Committee’s blueprint for the tax overhaul, a sweeping raft of tax cuts its authors say would lead to an era of unprecedented growth. According to the House proposal, taxing imported goods “will eliminate the incentives created by our current tax system to move or locate operations outside the United States.”

Though technically not an import tariff, the so-called border tax adjustment prevents companies from writing off import costs on their taxable income, effectively raising their tax bills. Trump has repeatedly called for protective tariffs, so it’s likely he will be on board unless he’s convinced otherwise by industry leaders.

“Our goal should be to try to make everything we can in the United States so that the money gets put in the pockets of Americans,” incoming White House Chief of Staff Reince Priebus told radio host Hugh Hewitt on Wednesday. “And we want to see the potential for a change in that border adjustability so that American jobs are protected.”

To import-reliant businesses, the border tax adjustment is a poison pill, and bigger companies are preparing for war to ensure President-elect Donald Trump and his Republican allies in Congress know just how much they hate this idea.

More from Goldman which sees it as still unlikely:

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1. The potential switch to destination-based taxation in the US has far-reaching implications for the US Dollar. Under the current US taxation regime, goods and services are taxed based on their origin, rather than where they are sold. Under a new proposal being considered by House Republicans, taxes would be based instead on where the goods and products are sold, with a so-called “border adjustment” that would allow firms to deduct domestic wages. This would result in a lower tax rate for firms that are net exporters and a higher tax rate for net importers (“Tax Reform: Is the Destination-Basis Tax Coming to America?”, US Daily, November 22, 2016). In this FX Views, we give our initial take on the likely path for the Dollar should this switch actually occur, which we think has about a 30 percent probability (“Q & A on Tax Reform”, US Economics Analyst, December 16, 2016). While models suggest the adjustment should be uniform across other currencies, we expect the reaction would be quite different against EM and G10 currencies given the various countervailing forces that would come into play. Whatever the merits of the proposed legislation, we think markets would treat it as an escalation of trade tensions between the US and the rest of the world. We therefore expect the largest net exporters – such as KRW and the RMB – to weaken substantially against the Dollar. This would probably be compounded by concerns over supply chain disruptions for firms, weighing on investor sentiment which could contribute to a risk-off environment. For the G10, previous risk-off episodes demonstrate that the market acts by rolling back expectations for Fed hikes. In February of this year for example, the market went so far as to price some probability of a rate cut.

…In its current format, the House Republican plan also incorporates a plan for “border adjustment,” where firms can deduct the domestic cost of exports, like wages (that’s the tax rebate of $9 shown in column 2 of Exhibit 1). The plan that appears to be envisioned in the House Republican blueprint is probably not WTOcompliant, and could lead to an adverse ruling by the WTO. Since trade rules are ultimately enforced through tariffs, a decision by the US to continue implementation of this type of tax policy could ultimately lead to tariff retaliation among US trading partners, something our Global Economics team has shown would have significantly negative effects on US GDP growth (“Global Economic Implications of the Trump Agenda”, Global Economics Analyst, November 13, 2016). Less trade, and by extension lower potential growth in the US, could translate into a slower, smaller Fed 20 December 2016 Page 4 Goldman Sachs FX Views hiking cycle. In addition, concerns about supply chain disruptions that we highlighted above could weigh on investor sentiment. Moreover, this would obviously be seen as a negative impulse on China (not least because the exchange rate adjustment would take time, hurting China exports). That sets up for a repeat of the market dynamics from Q1 of this year, where China worries led to significant bouts of riskoff, and provided an additional boost to safe-haven currencies like JPY as markets rolled back Fed hike expectations (Exhibit 5). We expect in this environment the Dollar would strengthen again EM, but the net effect against the G10 is less obvious (Exhibit 6). We therefore expect EUR and JPY to outperform EM, as in most risk-off periods.

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I think it very unlikely that China responds by either dumping Treasuries or the yuan. That way risks financial crisis for itself.

There is nothing good here for Australia and we can only hope that Trump is using this stuff as leverage because if a trade war erupts then:

  • global inflation will surge and the Aussie dollar collapse;
  • local inflation will surge as both pour higher prices into Australia;
  • the RBA may be forced to hike interest rates but even if not offshore funding costs will jump for any and all externally funded lowflation dependent economy (ie one with high debt like us);
  • both sides may force us to choose between them with either/or strategic and economic punishments;
  • Australian housing will confront its sternest test at our weakest moment.
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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.