With the much-anticipated Chinese Yuan denominated futures scheduled to start trading on Monday 26th March, the US government has officially responded by firing a big shot across the bow on Friday 23rd March, with a multi-billion dollar trade war with China. Today, President Trump’s tariffs on China come into effect. Trump’s tariffs are expected to generate up to $60 billion in tax revenue for the US government, closely matching the latest US trade balance figures. And while Trump cites the growing trade deficit with China as the main culprit, along with his desire to ship back manufacturing jobs to America, the reality is, this is both a geopolitical move aimed at China and a domestic move aimed to secure support among his base of disenfranchised working class ‘deplorables’ ahead of mid-term elections.
Some would argue that China started the trade war, with their protectionist policies, trade dumping and low exchange rate. However, as Trump touts that trade wars ‘are easy to win’, the economics of trade wars and tariffs are usually adverse not only for foreign exporters, but also for the domestic population (the US population in this case). Higher tariffs will be passed down to consumers in the form of higher prices, as businesses try to maintain profit margins. This will result in the US importing higher inflation. The US trade balance is hovering around the -$50 billion deficit range, which measures the amount of money relative to the rest of the world that leaves the US in exchange for goods and services. As China retaliates, it too will begin to suffer the same fate. However, from a game theory perspective, Trump and his protectionist economic advisers are hinging on that this could hurt China more, due to US markets being so dominant to their exports. China has started to retaliate, by imposing its own tariffs on major US exports to China. Ultimately however, tariffs are a temporary bandaid solution to low US productivity, and not the deep, structural changes needed to bring back manufacturing industries to the US. While tariffs could theoretically ‘equalize’ prices, China and America have fundamentally different cost structures and standards of living. This in turn drives the US and China to pursue different economic goals, with China being a developing export growth-based nation, while the US is a developed consumer-based nation. China will eventually have a large middle class that will be able to sustain its growth with domestic consumption, and when the Politburo is ready to switch from export-based growth, the peg with the USD will be ditched. This is the inevitable path China is on and it will happen. It will also elevate the Yuan into greater reserve currency status. The US will view this with mixed feelings. On one hand, the US has always complained of China’s undervalued Yuan, and will welcome the de-peg, which will appreciate the Yuan. On the other hand, a rising Yuan will mean more competition against the Dollar hegemony. The US has to work out which one it favours more. China will at some point overtake the US economy in the next 10 years. It already consumes more oil than the US, which is why Yuan denominated oil futures markets make so much sense. It already has a bigger GDP by purchasing power parity, i.e. when normalising for local costs.
What’s interesting is how this could lead to China ultimately abandoning the US dollar peg, and ditching its Treasury purchases, something the US would both welcome (the removal of the peg) and fear (Treasury dumps). As Trump has mainly singled out China (and Japan) for the time being, putting other tariff measures on hold against the European Union and other nations, the latest bout of trade wars could blow back by crashing the stock market, which has given Trump much confidence up until now. The markets are not reacting well, understanding how this could slash corporate profits and hamper global financial flows. Lets also not forget that all this is happening on the back of the Fed unwinding QE and interest rate hikes, affirmed by the Fed as a policy continuing in to 2019. Which doesn’t bode well for the US stock market. The peak could very well have already passed, or sometime this year, before a big correction falls due. Trade wars will undoubtedly add to more uncertainty and volatility in financial markets. Bond markets and gold could be looking to rally amidst such an atmosphere.
In geopolitical terms, what this all means is none other than a manifestation of the famed old Thucydides Trap. During the height of Spartan dominance in the Hellenic empire, a rising Athenian city-state threatened an established power, Sparta, both militarily and economically. So what the Spartans decided to do was pre-empt this threat by going to war. And while Sparta was the dominant power, the colossal toll of the war on Sparta proved to be a pyrrhic victory, resulting in the weakening and ultimate demise of Sparta itself, hence the ‘trap’. The US is a naval power, while China is a land power. The new theatres of war between these two rivals span cyber and finance, with the US going on the offensive (as usual) to escalate financial war with China. Another favourite tool of the US empire in financial warfare is sanctions. It tends to apply these tools on military threats such as Russia, Iran and other states challenging US hegemony. Sanctions are not preferred against China, because China is the biggest economic threat to the US, and sanctions will backfire tremendously on US markets. Nobody knows how this will play out, but given the general decline of the US empire across the board, it probably won’t end well with its intended aim of reducing the deficit or containing China. On the contrary, there will be plenty of blowback. Trump could also very well be using this as a negotiating strategy, given his business background. China could opt to negotiate, and in that regard Trump would have scored a victory. However, if China holds firm and retaliates in asymmetric means that the US won’t foresee, it could implore the US to negotiate as well, thus levelling the field with some sort of grand bargain. In any case, a financial war is preferable to a hot war, however, history shows that the former often leads to the latter.
While the US empire looks to put down an increasing number of geopolitical ‘rebellions’ around the world by rising powers, it would be better for the US itself to loosen its grip on reserve currency status. If you wish to understand why, here are some concepts to look into. A country with global reserve currency status is somewhat of a curse, as it has to run consistent deficits, and this comes with all sorts of consequences. Tariffs in no way address this fundamental fact. But the main reason as to why an empire would want reserve currency status, is that by invoicing global trade in its own currency, it can essentially print the money and buy what it wants without exchange rate risk, and ensure a strong demand for its debt. This is the underlying financial strength of the US empire, backed up of course, by military force. Agreements such as the Petrodollar help to prop this system up. One of the more peaceful ways US leaders can try to escape this trap should it drag the US into deeper debt, is to try and ‘pass the baton’ of reserve currency status to China. However, China will be extremely careful to weigh up its options. I doubt China would want to assume this unenviable role any time soon. What we could see instead is greater competition between ‘reserve currencies’ (starting with the Yuan oil futures), the rise of cryptocurrencies as new, alternative reserve currency assets or some other multilateral frameworks based on the SDR. What this trajectory does suggest is that the world is slowly but surely moving towards a new financial order, one that could be defined by a growing multi-polar world, with greater roles for developing nations. Lets hope that the developed Western world won’t fall into the Thucydides Trap in the meanwhile, as war still remains a real possibility.