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June 11, 2005

China Trade Wars
by David Chapman

Will starting trade wars with China be what tips the world's financial system over? China has certainly grabbed its share of ink lately even amongst the hype over the rejection of the Euro constitution by France and the Netherlands. The focus on China started last month when the Bush Administration acceded to cries from Congress and US manufacturers that the US was losing ten's of thousands of jobs to China and being flooded with cheap Chinese imports with the expiry of global quotas in January under WTO rules.

Following on the heels of slapping quotas on a host of Chinese goods the US was also crying that China's currency policies were distorting world trade and were a serious threat to China's economy and the rest of the world. The US also warned that China was in danger of being accused of being a "currency manipulator". The US wisely stopped short of such an accusation because if they had then Congress would have been free to take the next step of imposing trade sanctions on China. In the next breath Treasury Secretary Snow tried to soften the accusation by saying that he certainly hoped Congress would not impose trade sanctions as the world's financial markets would shudder.

World markets shuddered once before in an earlier period when in 1930 the Smoot-Hawley Act imposed high tariffs on numerous foreign goods in order to protect US industry and farm products. Instead of the high tariffs having their impact other countries soon followed and imposed high tariffs themselves. The result was that world trade slowed and it exacerbated the Great Depression. After WW2 in order to prevent something similar from unfolding it led to the Bretton Woods Agreement (1944) and the General Agreement on Tariffs and Trade (GATT) in the 1950's. Of course later on this led to the World Trade Organization (WTO) the European Union and the North American Free Trade Agreement (NAFTA) between Canada, the USA and Mexico.

That numerous global trade concerns remain is testament to the difficulty in getting agreement in a world where different political agendas cause trade frictions everywhere. Europe and the US have protection for farmers preventing numerous third world countries, where agriculture still dominates, from being able to export their products and therefore dig themselves out of their poverty. The aerospace industry is no stranger to the global trade wars witness the battles of Boeing and Airbus and the protection they are provided. Globalization opponents of course protest (and sometimes riot) over the ills of globalization.

But starting a trade war with China is one that could potentially backfire. The US is currently running a trade deficit that is around 6% of GDP. For almost any other country in the world running a trade deficit totalling 6% of GDP would ensure that the IMF was knocking on the door and instructing the country what it had to do to correct this imbalance. But while the IMF has gently hinted that the US should correct this imbalance there has been no overt action directed against the US. It helps of course that the US effectively runs the IMF.

In order to lower the trade deficit the US$ must fall further. Thus far this year the US$ is instead rising. In April 2005 the US trade deficit with China was $14.7 billion the highest by more than double Japan at number 2. A year ago the number was a $12 billion deficit. That the US is having a problem with China is an understatement. They are hooked on cheap Chinese goods and there is very little on the horizon that is going to change that.

And given the problems of General Motors (GM/NY) and Ford (F/NY) it is only a matter of time before the Chinese get the hang of making good cars and there will be few in the US be able to resist a car selling for under $10,000 even if it is Chinese. China already has a large budding automobile industry and its cars outsell GM in China 6 to 1. China already exports to Malaysia and Iran. North America is not far behind.

On the other side, all those excess US dollars in China finds its way right back to the US by purchasing US bonds. The US savings rate is abysmal not much above zero while savings rates in developing countries like China is quite high. So the excess capital is exported back to the US by purchasing their bonds and thus financing their deficits. Currently China holds in excess of $175 billion of US bonds number 2 behind Japan who holds more than $700 billion of US securities.

Ever since the world was shaken by the Asian Financial Crisis of 1997-1998 the developing countries have been building up their reserves in order to keep control of their currencies and gain control of their economies. So the developing countries, which includes China and even Russia, India etc. have been placing their excess savings back with the US in order to maintain their currencies against the US$ and to keep their factories humming. The US on the other side is becoming hysterical in its demands for China to revalue their currency upward as not only is the US losing jobs to China they are becoming more and more dependent on the largesse of foreign countries to finance their lifestyle. As if a 30% jump in the Yuan putting the average Chinese worker producing goods for America at $1.30 instead of $1 will make a major difference in demand in the US. What better way for the US to default its huge debt then devaluing its currency.

It probably wouldn't and the Chinese will continue to act in their interest by not being pressured by the US do their bidding. China is concerned that the vast majority of its goods production is low end goods destined for foreign markets (yes Europe is making the same noise about goods flowing in from China as well). Worse many of the Chinese firms producing these goods are foreign owned firms including numerous American firms that closed shop in the US only to reopen in China to take advantage of the low wages. China would like to export more goods of its own including the high end goods that the developed world specializes in. Ergo why we believe it is only a matter of time before Chinese cars put the nail in the coffin of GM and Ford for good.

Another problem China has is a very shaky banking system. Some even consider it bankrupt because of unfettered lending and some of the loosest lending practices in the world. Chinese banks have also encouraged lending money for consumer goods (especially cars) to a population that has only recently become accustomed to getting loans of any sort. This is an accident waiting to happen. Couple unfettered lending, inexperience in dealing with loans, loose banking and lending practices and quite likely an investment bubble and the banking system is an accident waiting to happen.

The trade differences could heat up. China believes that the US attempt to put quotas on Chinese goods is in contravention to WTO rules and plan on taking the US to the WTO. They just might win. But as Canada knows only too well when fighting a trade battle with the US even if you win you lose. Canada has taken the softwood lumber issue to NAFTA and even though the rulings go in Canada's favour the levies remain.

Despite the US desire to have a lower US$ and issuing threats against China there are some who believe that the US Trade Deficits are fine. Just this past week Federal Reserve Bank of Dallas President Richard Fisher told CNBC that "where would the world be if Americans did not live out their proclivity to consume everything that looks good, feels good, sounds good, tastes good? We provide a service to the rest of the world ......So I think we are doing our duty here." There we go without the US consuming everything (and going into debt to do it) the world would collapse into a depression. We have heard this analogy from other analysts as well.

Of course that is pure stupidity. When the end comes the consequences will be even worse because events will overwhelm the Fed and ultimately the US consumer and banking system. Simply the US has no savings and is totally dependent on foreign countries, some of whom like China are not exactly their friend, to finance their huge deficits. Threatening a trade war with China may play well in Peoria but Beijing will just snub their thumbs at them.

And of course trade tensions are not the only area of tension. We outlined earlier the global fight for oil. Since then Chinese companies have made further investments in the Canadian Oil Sands and there are more in the works. Washington is watching nervously. And China is investing in Russia as well including the Russian oil industry. The Chinese need for energy is growing rapidly and there are willing to pay up for the privilege of securing supplies. We note again that the Chinese have made huge investments in Iran a country that the US has threatened over its nuclear program. It almost seems inevitable that at some point in the future that the US and China might clash over resources.

And the conflict between the US and China goes into the political and military arena as well. Recently Donald Rumsfield mused about China's growing investment in the military and what they might be building it up for. While China's record as a one party state and its human rights record remains thoroughly dismal we can't but help note that the US spends more on the military then the next 10 nations combined including China.

The US is the only country that has actually invaded another nation in the past few years (Afghanistan 2001, Iraq 2003). As well it is clear from their actions and words that the US would like to move to the militarization of space. And finally the US's human rights record was slammed by Amnesty International and Human Rights Watch over its holding of prisoners in Guantanamo Bay, the Abu Ghraib scandal and the recent Koran scandal. Are we saying that the US's human rights record is worse than China? No not by a long shot but the number of abuses has been growing from the nation that touts democracy and human rights. Couple this with the Patriot Act (and still near by on the shelf Patriot Act II) and increased search capacity for the FBI and the concerns expressed by the American Civil Liberties Union (ACLU) and the international human rights organizations are a growing concern.

All the foreign funds flowing into the US is having a perverse impact on the US bond market pushing yields to their lowest level since 2003. This in turn has continued to fuel a bubble in the housing market with low interest rates. Even Alan Greenspan has expressed concern about the huge flow of funds and what it might mean in the US as it pushes US interest rates ever lower. Continual low interest rates was not a panacea for Japan and not likely to be for the US either. And Greenspan is also very concerned about an upward revaluation on the Chinese Yuan and the potential impact it might have on domestic prices in the US and on Chinese purchases of US Treasuries.

Economic conflicts over trade and oil, political conflict and the potential for military conflict is the growing legacy between the US and China. One could flow from the other. And that is why the trade spat is of grave concern because if could be the tip of the iceberg that will increase in the coming years.

We leave you with a monthly chart of the US$ and a chart of the sinking auto giants GM and Ford. The monthly chart of the US$ lops off the huge run-up in the early 1980's followed by the collapse after the Paris Accords of 1985. It took several years through to the mid-nineties when the Japanese and the US collaborated to try save the sinking US bond market, the sinking US$ (and the very high Japanese Yen). Under Clinton the Federal Reserve opened up the monetary spigots setting in motion a frenzy of lending creating the bubble tech mania of the late 1990's. This coincided with the huge rise of the US$. This was followed by the US$ collapse under Bush II even as the Federal Reserve kept the monetary spigots on and the bubble shifted into the housing market.

The recent rise in the US$ has been strictly technical. Many believe it is the start of a new rise in the US$. We doubt it as even in the 1990's it took several years before the US$ rose again and even then it took huge intervention. We don't have those conditions today. Instead we have the world's most indebted nation (budget and trade) who also happens to be the world's reserve currency and the US administration openly wanting the currency to fall. Today it is held together by the fear of the foreign developed countries wanting to keep a lid on their own currencies propping the US$ up through huge purchases of US Treasuries. Not a healthy situation.

GM and Ford are the personification of America. Instead these two giants are sitting on the edge of bankruptcy failing to keep up with demands of today as their market share collapses and overburdened with the promises of yesterday in pensions and health care supporting upwards of a million people. The consequences of a Ford and GM bankruptcy would be huge and probably require government intervention. With China pushing on a string and about to enter the international car market their demise is almost sealed. China an economic, political and military threat to US's power in the world. Trade wars are but a part of the bigger conflict.

DavidChapman.com
Technical Scoop

Charts and technical commentary by:
David Chapman of Union Securities Ltd.,
69 Yonge Street, Suite 600,
Toronto, Ontario, M5E 1K3
(416) 604-0533
(416) 604-0557 (fax)
1-888-298-7405 (toll free)

David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

Note: The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete.

The information in this report is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does Union Securities Ltd. assume any responsibility or liability. Estimates and projections contained herein are Union's own or obtained from our consultants. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is intended for distribution only in those jurisdictions where Union Securities Ltd. is registered as an advisor or a dealer in securities. This research material is approved by Union Securities (International) Ltd. which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the U.K. The investments or investment services, which are the subject of this research material are not available for private customers as defined by the Financial Services Authority. Union Securities Ltd. is a controlling shareholder of Union Securities (International) Ltd. and the latter acts as an introducing broker to the former. This report is not intended for, nor should it be distributed to, any persons residing in the USA. The inventories of Union Securities Ltd., Union Securities (International) Ltd. their affiliated companies and the holdings of their respective directors and officers and companies with which they are associated have, or may have, a position or holding in, or may affect transactions in the investments concerned, or related investments. Union Securities Ltd. is a member of the Canadian Investment Protection Fund and the Investment Dealers Association of Canada. Union Securities (International) Ltd. is authorized and regulated by the Financial Services Authority of the U.K.

Copyright © 2002-2008 David Chapman

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