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Jim Rickards, "Trade War Just Got Hotter"

Tuesday, September 18, 2018 15:41

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“Trade War Just Got Hotter”

by Jim Rickards

“President Trump announced 10% tariffs on $200 billion worth of Chinese goods yesterday. They will take effect Sept. 24 and are scheduled to increase to 25% on Jan. 1. Trump also threatened to slap tariffs on an additional $267 billion of additional Chinese goods if China retaliates.

Of course, China immediately retaliated with tariffs on $60 billion of U.S. goods. Unfortunately for China, it is in a much worse position to wage a trade war than the U.S. China’s problem is that it will soon run out of U.S. imports to tariff. China has a trade surplus with the U.S. of several hundred billion dollars per year. Even if China tariffed every good purchased from the U.S., it would run out of items to tariff long before the U.S. does.

Nonetheless, story after story, year after year reports how China’s economy is outgrowing that of the U.S. and how China will soon pass the U.S. as the world’s largest economy. These same stories report how China’s economic growth had enabled it to entangle Asia in a “debt trap.” Don’t believe any of these stories; they’re all hyperbole. The reality is quite different.

China’s economy is slowing and the trade war doesn’t help. Meanwhile, the Chinese stock market has been in a bear market since June. Whether it’s the trade war, the currency war or the war of words, China’s weakness is under a spotlight. China is caught in its own debt trap with no way out except inflation or default. China’s growth rate is grossly overstated because it consists largely of wasted infrastructure investment on projects that are white elephants or ghost cities.

Trump has correctly spotted China’s weaknesses and is using them as leverage to get better trade deals and less theft of intellectual property. Trump will keep up the pressure; he never backs off and always doubles down. Besides tariffs, Trump has ample financial warfare weapons such as bans on Chinese direct investment in the U.S., improved cybersecurity, forced divestiture and freezing of assets.

China is obsessed with saving face and hasn’t budged in the face of U.S. pressure (so far), so a recession or credit crisis there is definitely in the cards. China’s alternative to U.S. pressure is to cheapen its currency, but Trump is ready to call out China as a currency manipulator in a U.S. Treasury report to be released on Oct. 15. Markets shrugged off the trade news today, as the three major indexes were all up on the day. But you shouldn’t read too much into that. Markets had been expecting the news for some time, so it came as no real surprise. It was already “baked into the cake.”

The trade war will nonetheless get worse and will take its toll on U.S. stocks. If China is running out of scope on tariffs of U.S. goods (it is), China can turn to extreme currency devaluation as another way to retaliate, despite the likelihood that Trump will label it a currency manipulator. China has already allowed the yuan to devalue against the U.S. dollar almost 10% since June and some analysts expect a further 10% devaluation between now and the end of the year.

In August 2015, China engineered a sudden shock devaluation of the yuan. The dollar gained 3% against the yuan in two days as China devalued. The results were disastrous. U.S. stocks fell 11% in a few weeks. There was a real threat of global financial contagion and a full-blown liquidity crisis. A crisis was averted by Fed jawboning, and a decision to put off the “liftoff” in U.S. interest rates from September 2015 to the following December.

China conducted another devaluation from November–December 2015. This time China did not execute a sneak attack, but did the devaluation in baby steps. This was stealth devaluation. The results were just as disastrous as the prior August. U.S. stocks fell 11% from Jan. 1, 2016, to Feb. 10. 2016. Again, a greater crisis was averted only by a Fed decision to delay planned U.S. interest rate hikes in March and June 2016.

The lesson is that China cannot win the trade war, but it can attack the U.S. stock market with devaluation. Less dramatic devaluations of the yuan have clearly led to U.S. stock market crashes. What does a new maxi-devaluation portend for U.S. stocks? We might have an answer soon enough. Below, I show you why you should prepare for the distinct possibility of a Chinese “maxi-devaluation.” As you’ll see, this is no time for complacency. Read on.”

○

“Prepare for a Chinese Maxi-devaluation”

By Jim Rickards

“The U.S.-China trade war is back in the news today. But this trade war has been brewing for years and came as no surprise to readers of my newsletter, Project Prophesy. In fact, the new trade war is simply a continuation of the currency wars that began in 2010. I’ve warned for over a year that President Trump’s threats of tariffs should be taken seriously, while most of Wall Street discounted Trump’s talk as mere bluster. Now the trade wars are here as I expected, and they will get much worse before they are resolved.

Currency wars arise in a condition of too much debt and too little growth. Economic powers try to steal growth from their trading partners by devaluing their currencies to promote exports and import inflation. But China can’t keep going with tariffs. They only import about $150 billion of U.S. exports. At the rate they’re going, they’ll run out of goods to impose tariffs on. Trump can keep going because the U.S. imports so much more from China than they buy from us.

But the Chinese are obsessed with not losing face. Chinese President Xi has just been named in effect dictator for life. He doesn’t want to start out his new dictatorial regime by backing down from a stare-fest with Donald Trump. So he needs another option. For China to keep fighting, they need an asymmetric response; they need to fight the trade war with something other than tariffs.

China holds over $1.2 trillion of U.S. Treasury securities. Some analysts say China can dump those Treasuries on world markets and drive up U.S. interest rates. This will also drive up mortgage rates, damage the U.S. housing market, and possibly drive the U.S. economy into a recession. Analysts call this China’s “nuclear option” when it comes to fighting a financial war with Trump.

There’s only one problem. The nuclear option is a dud. If China did sell some of their Treasuries, they would hurt themselves because any increase in interest rates would reduce the market value of what they have left. Also, there are plenty of buyers around if China became a seller. Those Treasuries would be bought up by U.S. banks, or even the Fed itself. If China pursued an extreme version of this Treasury dumping, the U.S. President could stop it with a single phone call to the Treasury. That’s because the U.S. controls the digital ledger that records ownership of all Treasury securities. We could simply freeze the Chinese bond accounts in place and that would be the end of that. So, don’t worry when you hear about China dumping U.S. Treasuries. China is stuck with them. It has no nuclear option in the Treasury market.

But if you can’t win a trade war, you can try winning a currency war instead… I just argued that China’s “nuclear option” in the trade wars is a dud. But, that does not mean China is out of bullets in a financial war. China cannot impose as many tariffs as Trump because they don’t buy as much from us as we buy from them. China cannot dump Treasuries because there are plenty of buyers and the president could stop the dumping by freezing China’s accounts if things got out of hand in the Treasury market. But China could use a real nuclear option to counteract the trade war by fighting a currency war.

If Trump imposes 25% tariffs on Chinese goods, China could simply devalue their currency by 25%. That would make Chinese goods cheaper for U.S. buyers by the same amount as the tariff. The net effect on price would be unchanged and Americans could keep buying Chinese goods at the same price in dollars.

The impact of such a massive devaluation would not be limited to the trade war. A cheaper yuan exports deflation from China to the U.S. and makes it harder for the Fed to meet its inflation target.

Also, the last two times China tried to devalue its currency, August 2015 and December 2015, U.S. stock markets crashed by over 11% in a matter of a few weeks. So, if the trade war escalates as I expect, don’t worry about China dumping Treasuries or imposing tariffs. Watch the currency. That’s where China will strike back. When they do, U.S. stock markets will be the first victims.

Maybe you think that’s unlikely because it would be such an extreme reaction by China. But you have to put yourself in the shoes of China’s leadership. These aren’t academic issues to China’s leaders. They go to the heart of the government’s very legitimacy. China’s economy is not just about providing jobs, goods and services. It is about regime survival for a Chinese Communist Party that faces an existential crisis if it fails to deliver. The overriding imperative of the Chinese leadership is to avoid societal unrest.

If China encounters a financial crisis, Xi could quickly lose what the Chinese call, “The Mandate of Heaven.” That’s a term that describes the intangible goodwill and popular support needed by emperors to rule China for the past 3,000 years. If The Mandate of Heaven is lost, a ruler can fall quickly.

Up to half of China’s investment is a complete waste. It does produce jobs and utilize inputs like cement, steel, copper and glass. But the finished product, whether a city, train station or sports arena, is often a white elephant that will remain unused. Chinese growth has been reported in recent years as 6.5–10% but is actually closer to 5% or lower once an adjustment is made for the waste. The Chinese landscape is littered with “ghost cities” that have resulted from China’s wasted investment and flawed development model. What’s worse is that these white elephants are being financed with debt that can never be repaid. And no allowance has been made for the maintenance that will be needed to keep these white elephants in usable form if demand does rise in the future, which is doubtful.

Essentially, China is on the horns of a dilemma with no good way out. On the one hand, China has driven growth for the past eight years with excessive credit, wasted infrastructure investment and Ponzi schemes. The Chinese leadership knows this, but they had to keep the growth machine in high gear to create jobs for millions of migrants coming from the countryside to the city and to maintain jobs for the millions more already in the cities.

The two ways to get rid of debt are deflation (which results in write-offs, bankruptcies and unemployment) or inflation (which results in theft of purchasing power, similar to a tax increase). Both alternatives are unacceptable to the Communists because they lack the political legitimacy to endure either unemployment or inflation. Either policy would cause social unrest and unleash revolutionary potential.

China’s internal contradictions are catching up with it. China has to confront an insolvent banking system, a real estate bubble, and a $1 trillion wealth management product Ponzi scheme that is starting to fall apart. A much weaker yuan would give China some policy space in terms of using its reserves to paper over some of these problems.

A maxi-devaluation of their currency is probably the best way to avoid the social unrest that terrifies China. When that happens, possibly later this year in response to Trump’s trade war, the effects will not be confined to China. A shock yuan maxi-devaluation will be the shot heard round the world as it was in August and December 2015. China doesn’t have a trade war nuclear option. But it does have one very powerful weapon. And it looks like it could be getting ready to use it.”

- http://www.thedailyreckoning.com

Source: http://coyoteprime-runningcauseicantfly.blogspot.com/2018/09/jim-rickards-trade-war-just-got-hotter.html

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