ED HARRISON: Welcome to Real Vision Access. I am your host Ed Harrison, and in this week's edition, we are talking to Brian McCarthy, who is a managing principal at MacroLens LLC. He is an analyst who actually follows China pretty well, pretty closely, and so we're going to talk a lot about China, China trade. We're going to talk about the Chinese economy to a degree, but also the effects of all of that on the US economy earnings and on his investment outlook. Brian, thank you for joining us.
BRIAN MCCARTHY: Thanks for having me, Ed.
ED HARRISON: I was telling you right before we got on I was wondering-- because we were talking before we got on whether or not talking about all of these things ahead of the call is going to talk us out, but I think that we have tons to talk about. And we won't have any dearth of topics to go into. I want to start with this whole phase one thing. So the phase one China deal-- my question to you is, is that what you expected to happen or not?
BRIAN MCCARTHY: Sure. So full disclosure, I was a big fan of President Trump's approach on US-China trade relations until a week ago. It was a surprise to me. From the China hawkish perspective, I think it's going to prove to be a big disappointment to a big part of his base.
I view it largely as a capitulation, frankly, and we can delve into the specific aspects of the deal, but in terms of the proposed structural changes and the enforcement mechanism, if this deal sticks, it essentially looks to me like a US surrender on the issue of trying to force structural change in China. And one of the reasons I was sort of supportive of tariffs ahead of time is that that was a fool's errand to begin with. So the foundational-- the bedrock of this view in my opinion is that further marketization in China is incompatible with the degree of control that the Communist Party of China requires to run the place.
So Xi Jinping is not a reformer. He's a hardliner. He is fully in charge. We have plenty of data points in the economic realm and elsewhere that tell us this is the case. So China's not going to change. I think the administration has realized that.
The hard liners-- I saw Steve Bannon last week suggesting that Trump should bring the hammer down with the December 15 tariffs. I'm not of the camp that the tariffs have been the economic disaster that they're made to be in the media, and I thought that that was the right move, both economically and politically. So surprised, yes. And I would say disappointed from the perspective that I thought the tariff wall, given that China will not change its behavior, is really the only way that we can protect our economy and the global system of trade and finance from being infected with the inefficiencies that are inherent in China's central planning.
So you have a behemoth central planner, and if that entity is going to be fully integrated into the global system of trade and finance, then we don't have a market system anymore. And we've seen this in the steel industry, the solar industry. We see this in macro imbalances that refuse to move towards equilibrium. And so there's a whole litany of human rights and geopolitical rationales for threatening China with decoupling, but let's just stick to the economics.
It's not a market system. It's not going to be a market system under this leadership. So we need to alter the degree to which we are intending to integrate with them.
And the last point on this is that the word integration came up a number of times in Robert Lighthizer's appearances over the weekend. And let's both get rich together with the US and China, and let's figure out how we can integrate these two different systems. And we can't. We can't. Yet this is what they seem to want to try to do.
ED HARRISON: So I mean, you say this is what they seem to try to want to do, but the question really is, is it really what they want to do? What's the tactical reason for this about face? Is it possible that it's because basically Trump sees the markets moving up and down based upon whether this so-called phase one deal comes in or not?
And the Chinese basically said, look, we want a phase one deal just much as you do. We know that you want the phase one deal. We're not going to give it to you unless you basically capitulate, as you were saying.
BRIAN MCCARTHY: So there's a lot to unpack here, and, again, my call on these tariffs were that they were going to go up. So I was just sort of publicly burned trying to figure out what is going on in Donald Trump's head. So I'm a bit reluctant to travel down that path again, but we're all stuck trying to do this if we're active in these markets.
So there's two big issues here. We can talk about the tactics and the politics being one, but I am no longer convinced I have a sense of what his real-- the president's endgame objective is here. We had several accumulated data points that suggested it was, in fact, decoupling. And this deal-- the way it's structured suggests that that may really not be the way he's been thinking all along.
So again, the structural components-- capitulation. So it's intellectual property, forced transfer of technology, financial opening, and currency. All of those issues coincidentally line up with half measures that China has already taken and preannounced that are widely viewed as inadequate. So I anticipate the verbiage will look like that.
Enforcement is a complete capitulation in my view. Lighthizer, for many months, has laid out a system of unilateral enforcement, which would allow the US to determine that China was in breach, the US to unilaterally determine a penalty, and enact a proportional response in terms of tariffs or some other penalty to which China could not respond. This would put the onus of breaking the deal on China. So we could take incremental penalties to keep them in compliance, and if China wanted to push back on that, they would have to blow up the whole deal.
This has now completely flipped on its head with a bilateral system, whereby both sides can determine a breach and the appropriate penalty at their own whim. Now, if the US decides China is in breach, that means that the issue has gone through the various chains of dispute resolution, gotten to Lighthizer and Liu He, they can't come to an agreement. And the US says China is in breach. We're going to do a proportional response in terms of tariffs.
By definition, China doesn't agree with that, because they couldn't agree in the process. So now the US, in China's view, is in breach, and they're going to respond. So any enforcement action now risks blowing up the whole deal, which means the nuclear bomb-- these deals are only good until some side says we're out, but now that nuclear bomb is the US responsibility instead of China's responsibility in the original construction as this was described to us by Lighthizer and others, which means our only enforcement action is basically to blow up the whole deal. And now each specific incident of Chinese misbehavior in isolation will probably not be big enough to blow up the whole deal, and they're going to salami slice us to death on this thing, as they have done in other issues.
So Mnuchin, Lighthizer, and others are playing up this enforcement. They're saying in phase two and three we'll adhere to the same enforcement mechanism. The enforcement mechanism is toothless.
Now, what did we get in return? For only a minor sacrifice on the tariffs, we have gotten China to pledge that they will buy $200 billion in additional US goods and services off of a 2017 baseline over the next two years. Now, that might be $20 billion next year, and then they promise to do $180 in 2021. We don't really know, but this is what the US has gotten.
So if I put these components together, I'm starting to think that maybe President Trump is not really into decoupling at all. Maybe he envisions this balancing of the books by force-- that we basically have used tariffs to shake down the Chinese to promise to buy hundreds of billions of dollars of our goods to put the books in balance. Now, how do we determine which of our goods they'll purchase? Lighthizer has a list. It's secret, but he has a list.
So we have a central plan that will dictate what China needs to do to balance the account that is in balance because of their central plan. I'm not a fan of this approach, but we have a transactional president. So again, in terms of what he's thinking, I don't know, but I am now concerned that this is actually what he's envisioning rather than decoupling, which looked like it was going to be really messy. Go ahead.
ED HARRISON: When you talk about his being a transactional president, I thought that was kind of an interesting verbiage, because obviously when I talked to you, I was talking about the concept-- there was a tactical response, meaning that this is transactional. And so therefore, this juxtaposition to the previous notion-- we don't know what it is. We can't really know what's in his mind, but when you think about it from a strategic perspective, one of the things that you said that was very interesting was about decoupling and the fact that it's necessary because China is not really a market based economy, and they're not going to become a market based economy. So my question to you is, is that decoupling going to happen irrespective of what happens in this particular phase one deal?
BRIAN MCCARTHY: No, I don't. I mean, decoupling will happen if the US wants it to happen. And if we want to integrate, then that's what's going to happen. The US holds all of the cards here in terms of its position in the big bilateral imbalance, in terms of its control over global finance, and the Europeans are playing footsie with China, but I think actually ultimately the US has a lot of leverage there, as well. So I think the US holds all the cards in this decoupling game, and China, for obvious reasons, would like to avoid that outcome.
But to talk about the tactics, I hate this from a tactical perspective in terms of domestic politics from the Trump perspective, as well. I think he's walked into a trap here. So as we talked about in the pre-game, there's this static analysis that is going on in this package, which is Trump only gave up a tiny sliver of tariffs. We maintain 25% of $250 billion, and the increments on $110 billion went from 15 to 7.5. Tiny, right? Insignificant.
No, it's highly significant, because the symbolism is Trump blinked. He obviously did not have the stomach for the December 15 tariffs, because if you read the press reports on this, apparently if iPhone prices went up by 10%, there were going to be mobs in the street. So he backed off on that, and the tariffs are now going down.
So the direction of travel for tariffs right now is down, not up. So put yourself in the position of a multinational corporate or mid-sized company that's got a supply chain vulnerability in China. You were very nervous about that. You're less nervous now. So if you haven't made the decision to move yet, I think I'll wait, because this is going backwards now. This is why China wanted rollback of any volume. So I believe it was a critical win for China tactically in terms of removing this pressure that the supply chain exodus was putting on them to get something fixed here.
ED HARRISON: It sounds like what you're basically saying is that now they have the goods on Trump. They know phase two and three where that's going to go.
BRIAN MCCARTHY: Yeah, and it's not even phase two. Phase one isn't an agreement. China is not agreeing to buy $200 billion more of our stuff in the next two years with tariffs remaining at this level. They've repeatedly said that they have been told or their impression is that there's an ongoing process of rollback here. Whether it's in the fine print of the text we get in January or not, no one knows, but I can promise you that China will be back, whether it's in March, or April, or who knows, probably sooner. And they're going to be back, and they're going to be asking for more rollback.
And they may tell the administration, you want to do a phase two? Fine. We'll do some other-- we'll promise some other thing we don't have to adhere to for more rollback. But they're not going to buy that $200 billion unless Trump displays more goodwill, which, from a political standpoint, is going to look a lot like weakness.
So he's going to have to pay more politically, I believe, to get these purchases that he wants to get done. And the other dynamic here is, as we just discussed, who the heck really knows what Donald Trump is thinking, if anything? I mean, he may not be committed to decoupling or integration one way or the other. He's got 18 different political balls in the air, and he may just be going seat of his pants for all I know.
China doesn't know either, and I'm telling you, if I'm Xi Jinping, I do not want to see that guy unfettered in a second term, because I can't guarantee that this isn't all just a ploy for him to try to punt for 12 months, and then he locks China out of the dollar payment system two months after getting re-elected. Who the heck knows? So I believe it's in China's interest to try to cause him trouble next year.
ED HARRISON: That's interesting.
BRIAN MCCARTHY: And I don't think this deal puts us in a smooth equilibrium for 12 months to get through the election. Q1 might be a different story.
ED HARRISON: One of the other things about this deal-- there's been some activity in the treasuries market, and actually we have one or two questions on that. So let me use this as an opportunity to ask these questions. This is from rogue wave, who is thinking about this. He asked, does China have to guarantee that they will purchase x percent of treasuries according to this deal?
BRIAN MCCARTHY: China is buying no treasuries, nor are they really selling treasuries on balance. This leads into a whole other issue that actually viewers can get in full depth in the video that Real Vision posted last week that I did-- a few weeks ago. The impossible trinity framework basically dictates that China's capital account is closing. So they have a monetary policy, which requires very high rates of credit growth, or their financial system is going to unwind. We can unpack that in a bit if you'd like-- important topic. And they have a heavily managed exchange rate, which is going to be more managed, as long as this phase one deal lasts, because whatever is in there on currency, the US is not going to be happy with a sharp devaluation of the RMB.
So they are running a disequilibrium between their domestic monetary policy and the value of the currency. If they had an open capital account, they would either have to tighten monetary policy or let the currency go to put those two variables back into balance, but they don't. They keep tightening the capital account, and the key point here is that they don't really have capital controls. The capital controls don't really work in China.
They cannot disentangle trade flows from capital flows. So the approach they've taken is just to restrict all access to foreign exchange so that the FX reserves went from $4 trillion to $3 trillion. It's really inadequate relative to a $42 trillion dollar financial system. They have ring fenced the reserves.
So that pool of reserves is not going to be allowed to-- it's not going to be allowed to shrink, and it's not going to grow because the market pressures don't want to take it that way. They want to take the RMB down, not up. So Chinese reserves are not growing, and whatever FX comes into China is what is supplied to people who either want to buy dollars out of China to import widgets or want to buy dollars out of China to buy real estate in Vancouver, Sydney, or San Francisco, or wherever else. And all of those people are being restricted in their availability because they have just said, whatever comes in will be allowed out, and the reserves will be 0.
So China's pool of reserves is not growing, and their proportion of treasuries has been fairly static, and I think will remain so. Now there's always the risk-- if phase one blows up and we get back into a tiff with China, there's a lot of talk about using that as a weapon, but those assets is really the only visible pool of hard money capital that China has. And it really is, in a way, the capital behind their entire financial system. So it's really shooting themselves in the foot. It would do far more damage to China for them to liquidate those treasuries in a fit of anger against the US than it would hurt the US.
ED HARRISON: That brings up a question I have, and by the way, I just want to say that a guy, one of our viewers, Tobin Bereznick-- he was asking, can you speak a little bit about the Chinese actions with the US treasuries? And I think that you answered that question, but I just wanted to give him a shout out.
What you're saying to me points to this-- the way that I'm looking at it in terms of the interest rates for treasuries and the currency, meaning that, if the Chinese were to stop buying treasuries, which they could only do according to these reserves that you're talking about changing, it would not have an impact on the actual rate of interest in the United States. It would have an impact on the currency valuation between the dollar and the yuan. And as you were just saying, they don't want the yuan to depreciate, because that's what would happen. Appreciate, rather.
BRIAN MCCARTHY: Correct, correct. Anything that leads us to China aggressively selling US treasuries as a financial weapon means we're in an environment where you want to be long treasuries. Something really bad is happening out there. That is not good for equity markets, and there will be an infinite bid of treasuries for them to sell to if we get into a situation where they want to weaponize that portfolio. So that's sort of another reason why it really does not work.
So they could do it without altering the RMB, because they would basically just-- but here's what they would do. When they sell the treasuries, the PBOC balance sheet shrinks. That's not the direction that that balance sheet needs to go to keep their credit bubble floated.
So they would purchase RMB assets, do a sort of a domestic QE to keep the PBOC balance sheet the proper size. But now you've got that $40 trillion resting on an equity base of all domestic currency assets, and I think you're probably