Didn’t I say this would happen? Let’s go back to yesterday’s article.

…there’s fat chance China won’t make a deal. And there’s little chance Trump will cave in and make exemptions to his initial deal…

And guess what happened? Trump doesn’t seem to be backing down. He’s got more tariffs at the ready, expected to be launched by Friday. China, on the other hand, is putting on a brave face.

Beijing called Trump’s tariff ultimatum a trick ‘to increase tensions and generate pressure on the other side.

Well, looks like it’s working…

The two charts that show Trump’s weapon

How did this all start? I think the words ‘jobs’, ‘technology’ and ‘theft’ were involved. When Trump was running for president, which seems like an age ago, he talked about the theft of American industry and jobs by the Chinese.

This is of course because it’s cheaper to make certain products in China than in the US. But you don’t play facts in politics, you play emotions. There was plenty of people who wanted jobs, or better ones at least, when Trump ran for office.

He also talked about the technology transfers (sometimes unwillingly) that go on in the Middle Kingdom.

Sometimes it happens through joint ventures between US businesses operating in China. Other times it might happen when Chinese employees come to the US.

Trump doesn’t want China riding American coattails, this was one of the main points in a possible trade deal. But during the latest negotiations, Chinese officials seemed to backpedal on this very point, or so we’re told.

Bloomberg writes:

The Trump administration plans to increase duties on Chinese imports at 12:01 a.m. on May 10, Lighthizer said Monday. “We felt we were on track to get somewhere. Over the course of last week we have seen an erosion of commitments by China. That in our view is unacceptable,” he said, adding that significant issues remain unresolved, including whether tariffs will remain in place.

China was “well prepared for other potential outcomes” of its trade talks with the U.S., “including a temporary breakdown in talks,” the Global Times newspaper said in an editorial Tuesday. The door wasn’t closed to talks even if the U.S. raises tariffs, the newspaper said.

Lighthizer and Mnuchin told reporters on Monday that the Chinese backsliding became apparent during their visit to Beijing last week, but that they had been reassured by their Chinese interlocutors that everything would turn out.

That changed over the weekend when China sent through a new draft of an agreement that included them pulling back on language in the text on a number of issues, which had the “potential to change the deal very dramatically,” Mnuchin said. At that stage about 90 percent of the pact had been finalized, he said, and the Chinese wanted to reopen areas that had already been negotiated.

“We are not willing to go back on documents that have been negotiated in the past,” he said.

According to two people familiar with the U.S.’s position, China backtracked on committing to legal changes that American officials saw as key to selling the deal domestically as the biggest concession any U.S. administration has ever gotten from China.

Such perceived foot-dragging has emboldened the trade hawks who advise Trump to keep the pressure on China.

Now we have people sitting on either side of the fence: those that think more tariffs are stupid and those that think more tariffs are great.

I liked the headline Vanity Fair put out…

‘Trump Threatens to Blow Up Trade War as China Says Do Your Worst, Pal’.

I like it because it couldn’t be more wrong. While it might seem like China is standing strong and not bowing to pressure, they are in fact in the worst position imaginable, and Trump knows it. [openx slug=inpost]

China needs US dollars!

Thousands of Chinese businesses rely on US demand. If demand falls, then so does Chinese economic growth. There’s also reason to believe American businesses are rerouting their supply chains through Taiwan and not China.

South China Morning Post (SCMP) writes:

The US is set to create its own supply chain as it girds for an imminent technology war with China expected to follow the countries’ trade battle, Foxconn’s billionaire chairman and aspiring Taiwanese presidential candidate Terry Gou says.

At a news conference in Taipei on Monday, Gou said the markets on the mainland China and in the US would face drastic structural changes as the two superpowers continue fighting – if and when the trade dispute is resolved.

…Gou said with Washington doing all it could to build or reshape its supply chain and mainland China upgrading its market structure as the countries lock into a technology war, the developments were “good timing for Taiwan”.

If this is true, then it could be a disaster for hundreds of thousands of Chinese businesses relying on demand from the US. There’s something else too. China needs US dollars!

They need dollars because they act as a reserve asset for Chinese banks. With more dollars in the kitty, they can create more loans, which will hopefully spur on demand and production leading to growth.

This is why Trump is fighting this tech war with dollars. He knows China needs them. And right now, they’re running low on foreign currency reserves.

Take a look at how China’s reserves are tracking:

Source: Trading Economics

Now ask yourself, why did China rapidly spend their reserves leading into 2016? It was in part to prop up their currency and part to recapitalise their banking system. The latter just means the central bank bought bad loans from commercial banks at par and let them sit on their balance sheet.

This pool of reserves only replenishes when China has a healthy trade surplus. But look at how their current account (transfer of wealth between countries) is tracking:

Source: Bloomberg

What was once more than US$250 billion a quarter is now only US$49 billion. And there are few who think this surplus might turn negative soon. As long as Trump keeps up the war, that is.

China’s central bank has also reduced their required reserve ratio, meaning banks can create even more money backed by what little reserve assets they have.

I believe this is because China is expecting to soon starve of dollars. And with fewer USD, all they can do is lower reserve ratios to keep the easy money flowing.

Only the first domino…

Without a juicy current account and foreign reserve balance, China can no longer grow by any means necessary. They can’t encourage banks to lend money to anyone and everyone, while also picking up the bill of bad debts at the end of the day (like they did in 2016).

They can’t continue to peg their yuan to the dollar. They won’t be able to grow their economy like they have in the past.

Trump knows all of this. And he’s using the US dollar as a bargaining chip.

The truth is, China would be better off if they underwent dramatic change. Not just technological, but structural. Such large changes won’t likely come about until something drastic happens.

Of course, this is just one part of what’s wrong as we look out at the financial horizon. Yes, there’s more anvil floating above our heads waiting to crush the lofty stock market you now see.

Your friend,

Harje Ronngard