After months of back and forth, the Phase One trade deal between the U.S. and China has finally been signed. In a previous analysis of this long-awaited deal, I looked at technical issues with enforcement and faulty underlying assumptions, with the conclusion being that it would be almost impossible for the agreement to shrink, let alone balance, the U.S. trade deficit with China.
Now that the deal is officially in force, we can take a different angle, and from a purely logical standpoint, try to deduce what the consequences could theoretically be under the three following scenarios.
Logically speaking, either the trade deal shrinks the trade deficit or it doesn’t. Deficit shrinkage is certainly the goal here, as can be seen from the following paragraph (Article 6.2: Trade Opportunities):
"During the two-year period from January 1, 2020 through December 31, 2021, China shall ensure that purchases and imports into China from the United States of the manufactured goods, agricultural goods, energy products, and services identified in Annex 6.1 exceed the corresponding 2017 baseline amount by no less than $200 billion."
Scenario #1
For this scenario, let’s assume the mission is accomplished and the Chinese increase U.S. imports by $200 billion, closing the trade deficit by that amount. The problem is, you can’t push on one part of the system without a wrinkle appearing elsewhere. If China increases imports from the U.S. by $200 billion without a corresponding increase in its own exports to the U.S. (this is the literal meaning of a shrinking trade deficit), then China can only pay this bill by drawing down on its existing stockpile of U.S. dollars. To the degree that those dollars are locked in U.S. Treasury securities, China will have to sell those down for dollars to pay for U.S. imports. The selling pressure will push up U.S. borrowing costs, all other things being equal.
A further effect will be $200 billion more dollars circulating domestically in the U.S. banking system. This will push up domestic U.S. consumer prices. Since most of the $200 billion increase will be coming from U.S. agricultural exports, then in addition to the purely monetary phenomenon of $200 billion more dollars circulating in the banking system, we have a constriction in the domestic supply of agricultural commodities. This increases agricultural price pressures from two directions at once – both monetary and supply side. Together with rising borrowing costs, these are the ingredients for stagflation.
Investors should be able to track whether this is actually happening by monitoring China’s foreign exchange reserves in tandem with the U.S. China trade deficit. Chinese forex reserves have been in decline since a $4 trillion peak in June of 2014, but have leveled out at about $3.1 trillion over the last three years. A shrinking deficit to the tune of $200 billion should have the effect of pushing down these reserves to around $2.9 trillion.
Scenario #2
The next logical possibility is that the Chinese do in fact increase U.S. purchases by $200 billion, but U.S. imports from China increase in tandem. In this case, the trade deficit with China would remain the same or increase, and instead of the dollar’s value falling domestically, it would have to fall internationally on foreign exchange markets as an increase in both imports and exports in dollar terms would increase the velocity of circulation of the dollar globally. Since a currency’s value on international exchange is proportional to the desire to hold that currency versus other currencies or goods/services, increased trade in U.S. dollar terms should mean a fall for the dollar internationally.
Scenario #3
The third possibility (and probably the most likely, in my opinion) is that the Chinese do not actually increase their imports from the U.S. that much at all, because implementing a $200 billion increase would be a logistical nightmare and could upset China’s other trading partners. In that case, of course, this is all much ado about nothing, and everything continues as before.
Read more here:
- New Study Could Clear Johnson & Johnson on Talc, but Is It a Buy Signal?
- Why the 2020 NASH Revolution Could Prove Underwhelming
- Why the Phase One Trade Deal Won't Make a Dent in the Trade Deficit With China
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