Cracking the trade war code: why China and the US may quietly reach an agreement

The trade war rhetoric doesn’t reflect the reality of China-US relations. To understand where the two sides are heading, we should consider their economic interdependence, stock markets and coded messages they have been sending

John Woods

Published: 10:00pm, 29 May 2019

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On May 20, 1970 – a date every Chinese pupil knows by heart – after American and South Vietnamese forces mounted an incursion into Cambodia, Chairman Mao Zedong famously issued a statement, “People of the world, unite and defeat the US aggressors and all their running dogs!”, which was read out the next morning to a 500,000-strong crowd at an anti-US rally in Tiananmen Square.

On May 20, 2019, a cheering crowd in Jiangxi province listened as President Xi Jinping called for a “new Long March” and a new start in the face of escalating trade tensions with the United States.

What the crowd didn’t know in 1970 – which only became public decades later – was that at the same time Mao was urging countries to “take up arms and control the fate of their own country”, he, through premier Zhou Enlai, was engaged in secret negotiations with the US, which ultimately led to the withdrawal of US troops from Vietnam and the normalisation of China-US relations.

We will need to wait, probably until around the G20 meeting in Osaka at the end of June, to see if China and the US have successfully negotiated a resolution to the trade dispute.

It has been said history doesn’t repeat itself but sometimes rhymes, and I’m sure this is still true today.

Isolationist “Long March” rhetoric may resonate powerfully with the domestic audience, just as “running dogs” rhetoric did 49 years ago, but I am less certain it reflects the reality of US-China relations right now.

While this is rapidly becoming a non-consensus view, I still believe – for three reasons – that a negotiated resolution to the trade conflict is the more likely outcome when Presidents Xi and Donald Trump meet in five weeks’ time.

First, the economies of the US and China are like conjoined twins; any move towards separation needs to be surgical in its precision and lengthy in its timing and consideration.

The risk of serious injury, or worse, suggests a need for preparation, planning and cooperation for a successful conclusion.

If anything, the trade dispute has brought into sharp relief the scale of economic interdependency between the US and China, to say nothing of the concentration of supply-chain risk and, for many companies, the lack of a manufacturing alternative.

Indeed, as ripples from Huawei radiate outwards, the fear of the trade war impacting US businesses in ways not yet understood or expected poses a genuine underappreciated risk.

Second, I don’t believe the Chinese economy is strong enough to withstand a protracted trade war. Nor, it would appear, is the A-share market, which has corrected around 15 per cent from the highs of last month.

The US’ apparent flexibility in easing or lifting tariffs may be a hopeful sign

At the same time, I don’t think the US economy is as robust as the S&P 500 Index, down around 5 per cent from its highs, would like us to believe.

More pertinent is the 10-year US Treasury note yield, which recently hit a low level, last seen in October 2017, and tells an altogether more concerning story about the US’ growth prospects.

An economically enfeebled China is in absolutely no one’s interests.

Not only would it put the global economy back on a substantially slower growth trajectory, it would also bring China’s credit-driven growth model closer to what former People’s Bank of China governor Zhou Xiaochuan warned could be a “Minsky moment”, meaning a sudden collapse of asset prices triggered by a debt, currency or trade crisis.

Such a risk should be avoided at all costs.

A Chinese investor reacts at a brokerage house in Beijing on May 6, after US President Donald Trump warned on Twitter that he would increase tariffs on Chinese goods. Photo: Simon Song

Finally, there are certain coded signals and messages which encourage us to look beyond the rhetoric, and which suggest both sides are still keen to pursue a deal.

Most important is the Chinese yuan, the midpoint of which has been fixed by the PBOC at just below 6.90 (US$1.00) for the past six days. It’s a bit like the way Russian ships stopped just short of the US quarantine line during the Cuban missile crisis.

I would also cite the purported buying activity of China’s “national team”, which has done much to smooth volatility in the A-share market and prevent retail sentiment from plunging alongside equity prices.

Indeed, barring the day following Trump’s infamous May 5 tweet, the market has actually moved in a reasonably tight, 3.5 per cent range, in subsequent days.

Were we to see both markets break above or below key levels, it would send a pretty negative signal that bilateral trade discussions had probably ended.

Meanwhile, recent hints from Trump that Huawei could become part of the trade deal are carrots being dangled in front of Chinese negotiators in the hopes that a deal can be successfully concluded.

Similarly, the US’ apparent flexibility in easing or lifting tariffs may be a hopeful sign.

Mao Zedong, shown on a train in 1963, would eventually engage in secret negotiations with the US, leading to the withdrawal of US troops from Vietnam and the normalisation of China-US relations. Photo: CFP

Ultimately, there remains a good deal of uncertainty.

A deal is likely to be struck, and so we maintain our “outperform” view on China’s A-share market. Nevertheless, it is still worth considering a hedge. Given the likely upside of a positive outcome to the dispute, the risk-reward looks favourable.

Of course, May 20 has also come to symbolise a favourable relationship between two people (in Chinese, 520 is the text abbreviation for “I love you”).

And, as the G20 meeting draws nearer, we can only hope Trump and Xi will become closer, perhaps exchange more beautiful letters, put aside rhetoric and their differences, and support a successful resolution.

John Woods is chief investment officer for the Asia-Pacific at Credit Suisse

This article appeared in the South China Morning Post print edition as: Talks can still deliver

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