China/US: Don't underestimate domestic politics

Domestic politics in both China and the US stand in the way of a deal: but China may ultimately have the edge.

It is something to cling onto that over the weekend President Donald Trump's top economic advisor, Larry Kudlow, did at least admit that sharply increased tariffs on imports from China are going to hurt America (which is more than his boss conceded in a barrage of tweets and various speeches etc since last week — a claim with which even Fox News is openly disagreeing!).

On the other hand, as this morning's leader from the Financial Times (subscriber access only) recalls, it is still two to three weeks before the impact of last week's tariff hike begins to hit since (unusually) they will not be applied to goods which had already left port in China when the increase 'came into effect' (so to speak) on the morning of 10 May. To judge from the relatively modest reaction of stock markets globally on Friday (and even taking into account the additional slide in Asia this morning), investors have either taken account of this or, at least, believe that there will be a deal soon (or both).

However, sentiment could take a further knock today when Washington is expected to announce plans to slap tariffs on the USD300bn or so of imports from China not covered so far. And, of course, we have to expect Beijing to announce retaliation in the imminent future.

Some may also take heart from Mr Kudlow's noting that talks are likely to continue; and his suggestion that Mr Trump and President Xi Jinping may meet in the margins of the G20 summit. But that isn't until 28/29 June, which is still a long way away.

Where we go in the interim is going to be driven for the most part by domestic politics in the two protagonists. Here, I think the US is seriously underestimating two important factors at play in Beijing, ie:

(a) The Communist Party of China's — and Xi Jinping's personal — strong commitment to the role of the state in the economy, which runs completely contrary to Washington's efforts to force China to put an end to state subsidies; and,

(b) China's history with 'the West' during the "century of humiliation" from 1839 to 1949 and Beijing's consequent total inability to sign up to anything which smacks of the 'unequal treaties' (which is, effectively, what Washington is demanding).

On the other hand, Beijing may be underestimating the downside electoral risk to Mr Trump in signing up to any deal which is perceived in the US as 'weak' given the high degree of cross-party antipathy towards China. Nevertheless, Beijing is correct in its calculation that US voters, suffering potentially significantly higher retail prices, are likely to become increasingly unhappy if the trade war continues to escalate and drags on for a lengthy period. Not forgetting either that Chinese retaliation will almost certainly target in particular Mr Trump's base, not least the key constituency of the mid-West farming community.

Thus, although I was certainly overly optimistic about prospects last week I still think that a deal is likely to be struck in the nearish term, ie probably before the end of the G20 summit. And it will help get us there if, as I now expect, things (including investor sentiment) get worse between now and then.

Alastair Newton

Footnote: The image is a 19th century French political cartoon, China – the cake of Kings and Emperors, showing Britain, Germany, Russia, France and Japan dividing up the country.