Trade Wars: The Cautious View on China
Featuring Tony Nash
Published on: May 16th, 2019 • Duration: 32 minutes • Topic: China, Debt, Demographics, Yuan, Credit-cycle, MacroTony Nash, founder of Complete Intelligence, sifts through the noise regarding the trade war and discusses his current view on China. He highlights the extreme buildup in debt over the past 20 years, discusses the country’s poor demographics, and reviews where he thinks the Chinese Yuan is headed next, in this interview with Jake Merl. Filmed on May 15, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl, sitting down with Tony Nash, founder of Complete Intelligence. Tony, it's great to have you on the show for your very first Real Vision interview.
TONY NASH: Thank you.
JAKE MERL: So, as we've seen, this trade war has really heated up over the past few weeks or so. US stocks are taking it on the chin, Chinese stocks are falling, the yuan is weakening, global growth is slowing. And you're someone that spent a lot of time in Asia over the course of your career. You know the situation better than anyone else, or just as well as anyone else. So, what's your take on the current environment right now?
TONY NASH: Sure. You know that we've been writing about the trade war for about a year and a half. And our view is, the US is definitely in a stronger position on the trade war. And we have a very large global database of world trade. And we do forecasts of world trade. And looking at how world trade has come together, we've done a lot of analysis around the types of products that China exports to the US and who's competitive with those products. The real issue right now is that five of the top 10 products that China exports to the US are also produced in Mexico, and they're among Mexico's top 10 exports to the US. You have other products like mobile phones. Mexico really isn't strong yet. But they're building that pretty quickly.
So, the real issue that China has is they make manufactured goods largely. They don't export primary goods, like agriculture goods to the US. So, there's a lot of competition for manufactured goods. Of the rest of those goods, say three or four their top 10 exports to the US, they're things like suitcases and chairs, very low-level manufactured goods that can be made in Vietnam or Bangladesh or other places. So, there's an assumption from developed markets and investors that China has some competitive advantage with their manufacturing. And the fact is they don't.
So, who pays for the tariffs? Well, if China was the only source of these goods, then the Americans would be paying for those tariffs. But the fact is, there is a lot of competition for manufacturing of those goods. And when there's a lot of competition, the receiving end doesn't pay for the tariffs, the manufacturer has to absorb those tariffs. Okay? So, I think when I hear people saying Americans are actually paying for the tariffs, it's not true. Okay? It's something that's absorbed by the manufacturer, because those goods can be made in Mexico, those goods can be made in Vietnam, Korea, Japan, Germany, elsewhere, okay?
And so, when you look at places like, in 2017, it was the first year in many years that the US imported more TVs from Mexico than from China. The global trade environment is changing, and it's a move toward regionalization that has been underway for about four years, has been talking about regionalization for probably 20 years, and China joining the WTO really disrupted that move toward regionalization. After NAFTA was signed in the early '90s, there was this move toward regionalization, but China entering the WTO really change that trajectory and move to more reengaged globalization.
But let's say the subsidies, the non-tariff barriers that China's put on since joining the WTO has made them uncompetitive, okay? It's great if you're a manufacturing firm in the early days going into China, and up until say, 2008, 2009, taking advantage of those subsidies for competitive advantage. It's a no brainer, right? Why not do it? But at this point, supply chains have been so centralized in China, that it's actually a risk for those firms, for those manufacturing firms.
And if you look at Japanese firms in 2012, they're a great lesson to what happened to Japanese manufacturing firms. In 2012, there was a real pushback, political pushback against Japan over the Senkaku, Diaoyu Islands between Japan and China. The Chinese government whipped up anti-Japanese sentiment, and they rated a lot of Japanese companies and this sort of thing. So, Japanese firms, a number of them closed down their manufacturing sites or severely drew them down in China and moved them to other parts of Asia. There are those risks for American firms and for other developed market firms that have such concentration in China. So, they have to be really careful, especially in the highly charged political environment today, to diversify out of China.
And so, the trade talks, the trade wars, whatever you want to call them, they're really putting the pressure on those firms to make a choice. Do they want to have a diversified supply chain? Or do they want to have a concentrated supply chain? And the risks of having a concentrated supply chain are coming to light. So, those companies that have a concentrated Chinese supply chain right now are a real risk. Okay? So, I would take a really close look at how diversified those supply chains are if I'm investing in companies. I would want to understand the risks that those guys have of trade stoppage, the risk that those guys have of tariffs, and I would question their executive team. It's not as if this happened overnight.
Why on earth have you not diversified your supply chain over the last two, three, five years? Why did you not see what happened to Japanese manufacturing firms in 2012? These are no brainer things that should have been happening already. Many firms did it, but the ones that haven't who were exposed, it's really a leadership problem. JAKE MERL: So, who's the biggest loser from this trade war? Is it the US consumers? Is it China? Or is it manufacturing companies? Or is there collateral damage somewhere else that's going to be affected?
TONY NASH: There are two losers, I think, of course, nobody wins 100%. Okay? So, there are issues in the US and of course, certain goods will be more expensive. But there are two losers. One is China, one is Europe. Okay? And actually, Southeast Asia loses as well, some countries in Southeast Asia. But China loses because the margins for private sector companies in China are pretty thin. They're heavily loaded with debt. And if they have to absorb the cost of these tariffs, you're going to have mass closures in China.
You saw this in 2008, and '09, when say toy factories and these other types of really low margin goods factories closed in Guangdong province and other provinces in China, and you had massive layoffs and a lot of unemployment. And the Chinese government had to come in and stimulate and give those guys jobs. Not really give them jobs but help them get jobs. And you had DD drivers, which are the equivalent of Uber drivers over that time. So, you had growth of those types of businesses to help absorb those jobs.
So, China loses, at the same time, there's this you have African swine flu that's hit the pig farms in China as well. Officially, they've called 20% of their herd, I think it's probably double that, okay? So, you have food inflation, you have a hit to CPI, you have a weakening CNY, you have manufacturing firms who have lower margins. So, you have this nightmare scenario for the Chinese government. At the same time, you have slowing growth, industrial production, retail sales, all these things have been down this week. And so, you have a very, very difficult environment for the Chinese government. The
problem that the Chinese government has is if they make the reforms that the US government wants them to make, the central government loses control of the economy, maybe not overnight, but gradually. And if the central government of China loses control over the economy, then the Chinese Communist Party loses control of the country. That's a very difficult play for the CCP. And that's why we're seeing the pushback. It has nothing to do with Chinese manufacturers. It has nothing to do with fairness in global trade and all this stuff. It ultimately has everything to do with the Chinese Communist Party keeping power.
So, another loser in the same region in Southeast Asia, okay? You have countries like Vietnam, who are going to do very well out of the rotation of manufacturing out of China. But you have other countries like Thailand, or Malaysia, other places that have good manufacturing plants, but they're a part of the overall Chinese supply chain. If you look at Korean data, semis are down over 20% year on year. And so, Korea is suffering. Southeast Asia suffering as a result of this because China is the largest trading partner of every country in Asia.
The third loser is the EU. The EU will lose because any good that China can't export to the US, okay, and then if you go back to the Japan point in 2012, Japan's imports from China are down I think $40 billion a year since 2012. So, China can't offload those goods to Japan, okay? So, who has the income profile that the US has? Its Europe, okay? So, China will send that deflation to Europe, because they have to put those goods somewhere. And that puts the ECB in a very, very difficult position.
So, ECB was talking about getting out of stimulus in Q3, Q4. If the trade wars keeps going, if China can't send goods to the US, then the ECB is going to have a real dilemma, because inflation, you could potentially see deflation accelerate in Europe. So, there are a number of issues globally. And if China can't get itself off of the subsidies, and off of the non-tariff barrier addiction, I think it's a real problem for everybody.
JAKE MERL: So, how do you actually see these trade negotiations playing out? Do you think we're actually going to get a deal? Do you think we're not going to get a deal? How do you see it unfolding?
TONY NASH: I've never really thought we would have a single deal. I think you have to have a series of confidence building measures. Look, this deal- I hear people say the US should be in a multilateral stance against China, with Europe, Korea, Japan, so on and so forth. That would never work. China is amazing at splitting up multilateral parties, okay? The only way this can work is in a bilateral environment. And so, I think you'll get a series of deals. China needs US agriculture. They need US soybeans.
There's a lot of talk about why US soybeans are down. And there's been a lot of false causality signs saying soybean actually exports are down because of the trade war, that's absolutely false. Soybean exports are down because of African swine flu. US soybeans are used for animal feed in China. Those exports are down because the Chinese have cut 20%, 30%, 40% of their porker. I think you'll start to get ag and energy agreements in place. So, they can take those things with lower, no tariffs from the US. Because they need it.
They need low cost energy. They need our corn, our soybeans, our pigs, everything. The US will then lower some tariffs on things as a good faith measure with some contingencies and agreements. Will China stop subsidizing overnight? No, it's going to take a matter of years. So, there has to be a plan, an implementation plan for that to happen. Now, the subsidy removal is not a Trump era issue necessarily. The Obama administration in 2016 had the Chinese remove 1500 subsidies. So, I don't want people to think that this is simply a Trump administration issue, these issues have been going on for years.
So, I think you'll see some ag agreements, good faith movements, I think you'll see the tariffs stay at 25%. Now, keep in mind, under the gap, which was the precursor to the WTO, global tariff averages were 35%, on average, okay? This was up until the '80s. A 25% tariff by historical post-World War II standards is really not that high. So, when Trump says he could push things about 25%, that's feasible, that's possible. And that would revert to historical mean. And so, I really don't think 25% is where things stop if things need to intensify.
So, and we may actually need to see that. So, we see the real question is, what leverage does China have to play with if this intensifies? So, we have to look into that a little bit. We also have to look at how can both sides balance a little bit. Okay? And what we really see, as I said before, happening is a reemergence of regionalization. So, the USMCA, the replacement for NAFTA, will help Mexico develop, and will help Mexico become a substitutional origin for Chinese goods to the US. And that's good for the region, right? That's good for economic development, that's good for wages, that's good for society in Mexico to have more income, better institutions and more wealth.
So, I think all of this- the big winner out of the trade war, it's not China or the US, it's Mexico.
JAKE MERL: If we do get this series of deals over the next few years, will it include intellectual property? What do you see going on there?
TONY NASH: Well, I think it has to. I think it has to. I think there has to be an inventory of what major intellectual property violations have there been. I think there has to be an assessment of damages done- commercial damages. And I think there has to be a transparent governing set of data going forward. Okay? The real issue around trade is trade values are tracked a lot. Trade volumes are terrible. So, anybody who tracks trade volumes, what they're actually getting is, say 60% of the volume. Volume reporting is terrible in International Trade Statistics.
There is no tracking of subsidies. You can go to the WTO website and scour it, there's no tracking of subsidies.
JAKE MERL: Why is that?
TONY NASH: Maybe they don't want to track it. Okay? There's no tracking of non-tariff barriers. Again, maybe they don't want to track it. Okay? Those things must be tracked. Okay? There has to be transparency. And I hope that coming out of the agreement, is an agreement on what will be tracked for those things. Okay? Additionally, IP has to be tracked as well. There has to be transparent, publicly available data on subsidies, non-tariff barriers, which is really a regulatory issue. Okay? And intellectual property violations.
If those are in place, if there is transparency around that, then it'll be easier for the parties to have a discussion around that. And I think the US and China can actually set a global standard for reporting of subsidies, non-tariff barriers and intellectual property violations with some publicly available, say, database of this stuff.
JAKE MERL: And so, shifting back to China's economy, what do you see going on there? PMIs have been weak, the Chinese yuan is weakening, it looks like it might break through that key seven level. So, what do you see going on there?
TONY NASH: The Chinese economy has really been weak since say, July, August of last year. I was told that senior levels of government and other areas have been really on edge since last summer, when there were assumptions over here that China was still strong, and they were getting hit 6.7, 6.8 GDP growth. I was telling people, it's breaking down, it's breaking down quickly. Okay? I think there has been a real panic for about nine months in China.
We saw the industrial production numbers yesterday. We saw the retail sales numbers. And now, these data are- what you're seeing are the officially reported data and you can discount those, I would guess by about 30%. Okay? And so, things in China are reported to be slowing down. They're slowing down even more. So, our outlook on China for 2017- or sorry, 2018 was growth of 5.8%. So, we don't think China came close to the reported 6.6 or 6.7% growth they said. For this year, we think Chinese growth has a four handle on it. Okay?
So, we're not the doom and gloom negative growth or zero or whatever. We do think there's growth, we do think China's matured very quickly. But we think there's a drag based on debt. Okay? China has slowed down as debt has been contracting. It's corporate debt, it's personal debt, it's government debt. And as you have a contraction of debt, you necessarily have a contraction or a slowdown of the economy, because you don't have as much fuel to fire the economy. And so, that's really the main issue. The causality of the trade war slowing the Chinese economy. Yes, there's a bit of that, but I don't necessarily think it's the trade war that's slowing the economy. I think China has bigger issues with CPI associated with ASF, with African swine flu, with the debt drawdown, with any number of other things.
So, when you look at the currency, our expectation has been that we would cross seven this month. Now, it's just a breach, it could be event based, we believe will approach it on a sustained basis by July, we believe will breach beyond seven for a few months, and then the currency will appreciate again. And that's you're looking at maybe late Q3, Q4, okay? So, you do see these cycles where China deteriorates and then comes back. And it's gradual, so we don't think we're going to hit 6.5 again anytime soon. But we do see things deteriorating pretty bad. And then coming back later in the year.
So, in terms of the markers of health, things like industrial production, things like fixed asset investment, things like total social finance, expansion, those things will likely continue to slow down. We won't necessarily see an expansion of Chinese yuan as a global currency. Right now, it's 4% of currency action globally. Not huge, not a major global currency. We don't expect Chinese to sell treasuries. It's like, why would I sell gold? Why would I sell treasuries? It's a core asset. And if you don't have dollar reserves, or don't have as much as you need, you have to hold those treasuries. So, it would be a really silly thing for them to do.
Even with all of the problems that China has, I do believe that the economic planners in the NDRC, the planners in the PBOC, they're all extremely smart people. So, I hear people say publicly that they're not that bright. They don't know what they're doing. That's absolutely not true. Okay? These are incredibly smart people. There are political forces working against those economic forces that are stumbling blocks, and there are I will say economic infrastructure impediments to the evolution of the Chinese economy that are holding them back. But I think the guys who are in place of say, planning the economy and making economic, say three, four, five-year plans, those guys are really smart. A lot of Chinese CEOs are really smart. So, it's not an intelligence issue. It's not a capabilities issue. It's a legacy issue.
JAKE MERL: So, we've recently had Kyle Bass on Real Vision a couple of times, and he's bearish on the Chinese economy. He's worried about the leverage of the banking system, the current account going negative, and the fact that they're massively short dollars, does that worry you at all?
TONY NASH: Yeah, it all worries me. I've thought for a long time that China doesn't have the dollars that they claim to have. And so, it all worries me, but I don't believe that we're going to wake up a week from now and