The World Trade Organization is the world’s courtroom for trade disputes between nations. China was accepted into the WTO on December 11, 2001. It was done after a long process of negotiation. It required monumental change to the Chinese economy, change that began decades earlier.
President Trump, in imposing tariffs on China, bypassed the WTO dispute settlement process. So far, $50 Billion of tariffs have been enacted on product being imported from China into the United States. The magnitude of the tariffs range from 10% on all things not steel, to 25% on imported steel. The total amount of product imported from China into the United States is about $500 Billion annually. Using some simple math, this means 10% of Chinese imports are being “tariffed”, and on that 10% of product, the additional tariffs will amount to somewhere between $5 and $12.5 billion annually. That is the equivalent of an additional $5-12.5 Billion of revenue for the US Customs and Border Patrol. On the $500 Billion of imports from China, this amounts to a marginal tax rate of 1% to 2.5%. It’s a very small increase to whatever import taxes are already in place. Since the imposition of the tariffs, the decline in the value of the Yuan, China’s currency, against the US dollar has neutered the impact of the tariffs. Since April 1st, the Yuan has declined in value about 8%. This means that it’s actually cheaper now to buy Chinese imports than before. The maximum theoretical effect of the current tariffs will be to add a 2.5% tax on imported Chinese product. The 8% reduction in Yuan value versus the USD has erased that tax, plus 5.5%. The tariffs would have to have a taxation effect of greater than 8% in order for them to be effective (make Chinese imports more expensive).
The above may explain why the US markets have been unaffected by the Trump Tariffs, thus far. Rather than start a trade war, what President Trump needs to instead start a currency war. In a world where currency rates float, dictated largely by trade and interest rate policy, it is impossible to use tariffs alone. There is evidence that Trump is realizing that the strength of the dollar is rallying against him. The rise of the dollar due to the Federal Reserve’s interest rate normalization process is an issue for President Trump. The Federal Reserve is raising the benchmark short term federal funds target rate. When this rate rises, the US dollar also rises relative to other world currencies. The Federal Reserve is raising it’s short-term federal funds rate because of the very strong economy, stimulated by the Trump Tax Cuts, and a decade’s worth of low interest rates and Quantitative Easing. Trump touts the fact that GDP in the US grew at an annualized rate of 4.1% most recently. That type of growth is further reason why the US Dollar will gain in value; foreign money will continue to convert into USD seeking to participate in said growth.
On Thursday July 5th, President Trump made comments to the media that seemed sure to rattle markets. He announced an additional $200 billion in tariffs in response to retaliation on the part of China against the original $50 Billion that the US had imposed. John Harwood of CNBC, when reporting the Trump announcement said that, “this news of an additional round of tariffs totaling $200 Billion will surely rattle global markets.” When US markets reopened on Sunday evening, July 8th, markets were completely unphased. It was indicating an additional 0.4% of gains for the Monday morning US market open. It was as if Trump had announced great news rather than an escalation of war.
Tariffs as a headline are impactful, but drilling down to see what’s on the tariff list, they can be more humorous than scary. The tariffs that went into effect at midnight on July 6th, amounted to $34 Billion of goods imported into the US (from China), and (in retaliation) $34 Billion worth of goods imported into China (from the US). The list of items that make up that $34 Billion of retaliatory tariffs China is placing on US products can be found here on Time Magazine’s website. Lots of produce on the list! Everything from cantaloupes to figs to fresh almonds is on there. It’s clear that some sort of impact will be felt by farmers, specifically, farmers in California and Florida. With that said, farming, in 2017, represented 0.67% of the US GDP (gross domestic product). In other words, farming contributed 0.67% to the output of the US economy. This is very small, and the Chinese tariffs would impact an even smaller portion of that number, as only a portion of farm produce is exported to China. In addition, the Chinese tariff’s are priced at 25% of value, so the magnitude of the tariff is actually 25% of $50 Billion, or $12.5 Billion. Given that the US exports $1.55 Trillion worth of goods to the world, the marginal increase on cost of tariffed goods is 0.8% of total goods exported. Minuscule, to say the least. The largest effect has been felt on soybean farmers, and the Trump Administration is compensating them for the cost they are paying. Just another farm subsidy; the legacy of Roosevelt’s New Deal grows.
China has seen both it’s currency and stock market lose considerable value in 2018. It’s been a bad year for Chinese stocks. Based on that evidence, President Trump can pat himself on the back. Except that the correction downward in Chinese markets is not necessarily because of tariffs; China has been reeling in excess in its banking system. Money is not as easy to borrow in China anymore. That alone, without tariffs, could have caused the Chinese market correction. In reality, we’re still in the early innings of the China-US trade war. Much of the US economies growth, if not all, is fueled by debt. The same can be said of China, but China is also a saver country, which means consumer debt is very, very low. This means that China has massive reserves of cash, most of it in USD, that they can use to cushion the blow of tariffs, or any other economic turmoil. Chinese monetary policy can be very flexible given its massive foreign currency reserves. The amount of those cash reserves can be seen in China’s US treasury holdings, which are massive. Treasury TIC data released on August 16th, 2018, shows that China’s treasury holdings were at ~$1.1 Trillion. Japan is second, at slightly less.
The US, on the other hand, is a debtor nation. The US government and the US consumer (as a consequence of the government) eat and breathe on debt. Just as the US government funds itself through debt, via Treasury Auctions, the US consumer funds himself through credit card, mortgage, and personal loan debt. What the US government does have though, is willing buyers of its securitized debt. Securitized debt is debt sold to investors as a bond, yielding a certain interest rate. These buyers exist because of the safety that comes with investing in a certain type of US debt, that being US government debt (aka US Treasury debt). US Treasury debt theoretically has no default risk; this means an investor is guaranteed to get his/her principal back at the end of the loan, plus interest. Investing in US debt is like no other debt on the face of the planet; it has a guaranteed return. This is the full faith and credit of the US government at work.
President Trump has used the credit worthiness of the US government debt as a tool in policy decision making. He threatened not to pass the spending bill known as Omnibus, if Congress did not appropriate funds for building a wall along the border with Mexico. He threatened to veto the Bipartisan Budget Act of 2018, which was particularly important because it suspended the debt limit for 1 year.
What exactly does it mean to suspend the debt limit? It means that the debt limit, which caps the amount of debt the government can take on, is temporarily unenforced. The debt limit was suspended on February 12, 2008. It was suspended because a budget was NOT negotiated in time to raise the debt ceiling. When the Omnibus Budget Bill was finally passed 1 month later, President Trump didn’t like it. He was disappointed with the bill, as it did not appropriate the funds the White House had requested for the Border Wall with Mexico. President Trump vowed he would never sign another bill, “like that one again”. What that means is anyone’s guess, but in the worst case scenario, it could lead to a US default on debt obligations. Why? Because the US pays its debts with more debt, and a budget must be passed in order to authorize the issuance of more debt. Admittedly, it would take a lot of things going wrong to get us to that point, but the inability for Democrats and Republicans to work together on a long-term budget that cuts spending and works to balance the budget, certainly helps.
When Omnibus was signed, it did not address the debt limit; the suspension of the debt limit the month before had already cleared the way for unlimited spending on credit, for a period of 1 year. The Treasury department would raise the money to be spent by auctioning treasury bonds to investors world-wide. The most recent debt limit suspension will end on March 19, 2019. At that point, the debt limit will be automatically increased to reflect how much additional debt was added over the course of the suspension. How much is that estimated to be? According to Bipartisan Policy Commission, over $1 Trillion.
Without suspending the debt limit, the Treasury would not have been able to raise money congress had appropriated in the budget. The Trump Tax Bill had delivered massive tax cuts, which meant lost revenue for the IRS and US Treasury. Besides the money the treasury receives from tax receipts in the spring (regular filing deadline) and late summer (extension filing deadline), the government would not have them money to keep paying its bills without issuing debt. According to the Bipartisan Policy Commission, without further debt issuance, the government would have only enough money to keep the paying bills through summer 2019, after which it would begin defaulting. A default by the US government would trigger a massive credit event, and would throw the world into a Great Depression. The interest rate on US treasury debt is known as the risk-free rate. If the US government defaulted on its debt, it would mean US debt is not risk-free. A default would trigger a repricing of risk unlike any seen in the history of money. Pretty much all debt around the world uses the risk-free rate as a benchmark. All other debt issued, whether it be mortgage debt, auto loan debt, corporate debt, credit card debt, or foreign sovereign debt, is benchmarked against the risk-free rate. If the risk-free rate goes up, then all other interest rates also go up. Because asset prices move inverse to interest rates, a sudden spike in interest rates triggered by a US debt default, would devastate the price of everything from houses and cars, to corporate bonds and stocks.