Can't China just open its financial gates and win this?
They could try to attract the foreign capital that America doesn't want anymore. It's a risky move, but it's what the CCP might already be working on.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
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TLDR Summary
China objectively lost the 2018 to 2020 trade war. Their stock market underperformed its US counterpart greatly during that war and afterwards. They had to accept lower export proceeds which put their labor market under pressure and which intensified their private sector debt problem. It seems that this makes many people (including me initially) believe that this trade war will have to resolve with China losing again. Economies with export strategies always bust eventually. Trump certainly seems encouraged from last time. At least that’s what his draconian approach suggests.
However, it may not be so simple this time. China had four years time to prepare for Trump 2.0 and based on their initial reaction, they seem extremely comfortable about sitting this out without any interest in negotiations. I can imagine a scenario where China seizes this moment. By opening up their capital account, they could attract the capital that the US doesn’t want anymore. If successful, their currency might appreciate rapidly which could add a lot of wealth for its citizens.
It’s an approach that comes with risks. If it doesn’t work, the country might experience an unemployment shock that could suffocate momentum from international investment flows. And if it works too well, the country could experience another unsustainable boom of the kind they have had several times in the last 20 years and that Japan had decades ago and had to pay a huge price for.
China’s unique approach to Liberation Day
In my initial reaction to Liberation Day, I argued that the US will obviously be the relative winner in a trade war because their unparalleled trade deficit gives them a quasi monopoly in international trade which should in theory enable them to set the terms in their favor. It’s therefore in the interest of trade partners to accept those terms quickly. They will eventually have to do so anyway and by doing so early, they might avoid unnecessary hardship in case of a lingering conflict. Initial reactions from many countries suggest that they are indeed taking that route. Or at least that they are willing to negotiate.
China is taking the opposite route. In contrast to other large economies such as the European Union, Japan, India, UK, Brazil and Canada, their leaders don’t even want to talk to the US administration, let alone work towards an agreement. They simply match the tariffs and mostly remain silent.
They are also increasingly using mocking strategies. For example, in their latest retaliation announcement, they said that they will not continue further retaliations because current tariffs are prohibitively high for any US imports anyway which makes further increases obsolescent. They announced that they will simply ignore additional tariff increases from the US. You might want to read an attempt of de-escalation into that. I view it as ice cold powerplay. And it’s frankly quite funny because it’s obviously true that it doesn’t matter whether you impose 125% or 250% or 500% of tariffs. No sane consumer would consider a product with such a ridiculous tax burden. It makes Trump look silly when he imposes the next 50%.
Or look at this post published today by the X account of the Chinese embassy below:
Could you imagine a similar reaction from representatives of the European Union? Think about Ursula von der Leyen posting a meme on Donald Trump. I can’t.
It has only been a bit more than a week. But so far, China is not showing any signs of blinking. If they are bluffing, they are doing it really well.
This begs the question: Could they actually come out of this as a winner? Against the contrary evidence from 2018-2020 and against what I have believed so far and what many still believe?
How could a trade surplus country win a trade war?
In my last article, I shed some light on how the 1980s trade conflict resolved. The US forced its trading partners, most importantly Japan, to sell their Dollar reserves to allow for an appreciation of their currencies. As a result, Japan received a monster bid of international investment flows. Denominated in Dollars, their stock market rallied more than 400% in just four years.
The Yen offers an important clue that Japan’s extraordinary 1980s bull market had something to do with money from abroad. One of the most important methods of fundamentally anchoring FX rates is to look at purchasing power parity (PPP) based on the idea that identical goods should cost the same in different countries.
This idea has its limitations of course. There are lots of cultural, geographic and economic reasons why certain goods and services should have persistent price differences between jurisdictions. For example, labor is naturally cheaper in countries with lower wealth levels which makes labor-intensive products less expensive, esp. if they can't be imported easily. Think about hair dressers, plumbers, construction workers etc. This phenomenon is widely known as the Penn effect.
In spite of that, it is still helpful to look at PPP-implied FX rates, particularly at their movements over time. If a currency rises against its PPP-implied rate, it means that demand for it is strong either for transactional or for investment purposes.
The chart below illustrates how strong the US Dollar was against the Yen in comparison to its PPP-implied rate. It fell rapidly after 1985 which serves as evidence for the investment bid mentioned above.
This example got me thinking whether the 2025 trade war will resolve in a similar way, i.e. by investment flows being redirected to other countries that could end up benefiting from the pivot in US trade policy.
The natural first candidate for that is China because China plays the role today that Japan played in the 1980s. Couldn’t they just seize the moment, appreciate their currency and attract the investor money that the US doesn’t want anymore?
In theory, they should have headroom to do so. Based on PPP, the Yuan is quite undervalued. As mentioned above, the absolute level of a PPP-implied FX rate is not necessarily meaningful. But it’s noteworthy that the US Dollar has increased its PPP-based valuation premium to the Yuan by 40 percentage points in the last three years.
What about China’s problems though?
As you may recall from previous articles, I believe that the Fed mainly drove this US Dollar strength. Their rate hikes sucked capital into the US like a giant vacuum cleaner.
At the same time, the PBoC had to keep easing to address its private sector leverage problem. Chinese money supply has grown much more slowly than US money supply during the last years and their inflation has been lower as a result. At the same time, the FX rate has remained stable which caused US Dollar appreciation in real terms as illustrated in the chart above.
In theory, this should put upward pressure on the Yuan once the Fed’s SuperCycle unwinds. The Chinese government could actively support that by opening their financial markets for foreign investors and by using their huge FX reserves to aggressively invest in growth domestically.
I believe that scenario to be possible, perhaps even likely. In fact, the CCP’s policies over the last 10 years suggest that they are already moving into that direction. For example, they have not actively suppressed the value of the Yuan via FX purchases for almost ten years. Instead, FX reserves have come down and the PBoC’s balance sheet growth is almost exclusively driven by loans to the domestic banking sector in an effort to stimulate the economy and address the private sector debt problem. It’s the Chinese version of a QE program. I called this the Great Decoupling in the article below.
It sounds like a bull case is in the making here. But there are a few caveats to appreciate. Most importantly, Japan is far from being an ideal blueprint for China. Japan paid a huge price for the excesses of the 1980s. They had to deal with stagnation, deflation and a brutal 25 year bear market. China is already feeling early signs of a similar development and might be eager to avoid a similar fate.
Secondly, Japan’s 1980s party was driven by an almost perfect demographic environment with a huge number of people reaching their peak productive ages. It’s questionable whether China can unleash a similar momentum given that they are at least 10 years past the point where Japan was in its demographic cycle when the Plaza Accord was struck.
If China fails to create growth momentum from opening up its capital account, they may have to deal with an unemployment shock that could challenge the power of the CCP. The country has been dealing with unemployment issues for a while, in particular for its youth. It’s challenging to obtain reliable data, but it’s quite telling that the National Bureau of Statistics decided to suspend reporting youth unemployment figures after the rate hit a record 21.3% in June 2023 and resumed reporting in December 2023 with a revised methodology.
In sum, this trade war is a highly challenging topic to opine on. But as you have read between the lines above, I don’t consider myself a China bear anymore. I am not a bull yet, but this may be a step in the process of getting there.
Sincerely,
Rene
Is it possible that foreign exchange reserves have declined due to capital flight?
Find it hard to imagine China seeing the Japanese experience as anything but a warning to avoid.