China Set to Trump Trump

Understand first why the Yuan has been losing value...

I RECENTLY returned from a weeklong trip to China, specifically Shanghai and Nanjing, writes Jim Rickards, author of the New York Times best-seller, The Road to Ruin, in Addison Wiggin's Daily Reckoning.

In Shanghai, I met with a group of forty of the top China economists, mostly from major Chinese banks and brokers, at an annual event called the China Chief Economist Forum. I was a keynote presenter to 400 invited guests made up of major institutional investors and wealth managers.

In Nanjing, I met with provincial government officials and economic development experts. They are building a high-tech research center of excellence called UTown on the southern outskirts of the city. I was even permitted to enter a top-secret Huawei laboratory used for testing new internet data-mining algorithms.

Huawei is closely affiliated with the People's Liberation Army – and is banned from most business in the United States because they are suspected of hacking and espionage aimed at US critical infrastructure.

In addition to our proprietary models and analytic techniques – including complexity theory, causal inference, and behavioral psychology – I have always been of the view that there is no substitute for foreign travel and face-to-face contact with both experts and everyday citizens in the countries we are trying to understand.

That's why I also took every opportunity I could find to speak with drivers, clerks, bellhops, and passersby. That's not as difficult as it sounds. In a country like China, few citizens have traveled abroad and they are often eager to practice English conversation with a real American.

People you meet in the street are often a better source of information than the experts in the hotel conference rooms. I asked one student if people in China were trying to get their money out of the country.

His eyes lit up and he replied, "Yes, everybody I know!"

Why are the Chinese moving their money out of the country? Because they know, as I'll explain below, the Yuan could lose its value any day now.

The process of connecting the dots between the political, economic, and social forces buffeting China is complicated. By using technical analysis and information gathered on the ground, we are able to cut through the haze of political rhetoric and propaganda coming from Washington and Beijing. Then we bring you a reasoned estimate of what the near future holds in store for markets as the world's two largest economies – China and the US – work out their differences for better or worse.

In 2016, we know that China, the world's second largest economy, defied predictions of a slowdown by unleashing massive amounts of government spending and adding mountains of debt to stimulate its economy.

But we expect 2017 may turn out very differently. China is encountering hurricane force headwinds that will cause its nonsustainable debt-driven policies to reach a critical state.

These headwinds include: confrontations with President Trump on issues of trade, tariffs and currency manipulation; internal political instability from Chinese President Xi's efforts to expand and centralize his political power; possible geopolitical crises connected to North Korea, Taiwan or the South China Sea; Trump's pivot toward Russia and away from China; the Chinese credit bubble; capital flight; and China's delicate relations with the IMF.

In an interview with Chris Wallace on Fox News Sunday on Dec. 11, 2016 then President-elect Trump was asked about a phone call he had taken from the President of Taiwan. Trump replied as follows:

"I fully understand the One-China policy, but I don't know why we have to be bound by a One-China policy unless we make a deal with China having to do with other things, including trade.

"I mean, look, we're being hurt very badly by China with devaluations, with taxing us heavily at the borders when we don't tax them, with building a massive fortress in the middle of the South China Sea which they shouldn't be doing, and frankly with not helping us at all with North Korea.

"You have North Korea, you have nuclear weapons, and China could solve that problem and they're not helping us at all. So, I don't want China dictating to me..."

That one quote neatly summarizes the bundle of challenges confronting China as a result of the election of President Trump.

The first challenge is that Trump is plainspoken and does not hide behind the usual diplomatic babble. That can be difficult for the Chinese to tolerate because their culture is dominated by the concept of "face" or the need to avoid direct conflict or embarrassment.

When Chinese lose face as the result an adversarial thrust, they try to regain face by being adversarial in return. The result can be an escalation of tensions independent of the policy substance involved. That can make agreements more difficult to achieve.

President Trump and President Xi are on a collision course involving issues of trade, tariffs, and currency manipulation. Geopolitical issues will make the economic issues even harder to resolve.

The quote also lists the main areas of contention – trade, tariffs, taxation, currency manipulation, North Korea, Taiwan, and the South China Sea. China's response to these conflicts might take the form of a maxi-devaluation of the Yuan, much tighter capital controls, a severe downturn in its economy or all three.

But none of the extreme outcomes will be contained to China. Any significant departure from China's current growth trajectory has serious negative implications for investors around the world.

In short, we may be witnessing a break-up in the China-US global condominium that has dominated world growth and world politics since 2001.

US policy for the past sixteen years through the Bush and Obama administrations had been soft-pedaling all of these issues in return for cheap manufactured goods and China's willingness to finance trillions of Dollars of US government debt.

Now Trump is changing the rules of the game. He's saying lost jobs in the US are not worth the cheap goods and cheap financing. He's betting that China has no alternative but to keep producing those goods and keep buying our debt, even if the US imposes tariffs to help create manufacturing jobs here.

Trump is willing to use leverage from the geopolitical sphere on issues like Taiwan, North Korea, and the South China Sea in order to get concessions from China on the currency issue and China's trade subsidies such as state support for money losing export sectors (like steel).

As Trump settles into office, he's backing up his words with actions. His team is now packed with seasoned officials and advisors who have been vocal critics of China's trade policies for decades. The new US Trade Representative, Robert Lighthizer, has a record of imposing tariffs on unfair trading partners going back to the Reagan administration in the 1980s. Trump's transition advisor on trade, Dan DiMicco, is the former CEO of Nucor steel and has been on the receiving end of China's steel dumping.

Another senior Trump advisor, Peter Navarro, is an academic and outspoken critic of China. Navarro wrote the book "Death by China", and his work is a roadmap for the kinds of policies Trump will pursue. While Obama advisors such as John Kerry and Jack Lew were mostly talk and no action, the Trump team is ready to rumble.

The problem is that China may not have much to offer, despite the pressure. Trump may not realize that China's currency is going down not because of government manipulation, but because of market forces in the form of capital flight. In fact, China's main currency manipulation today is an effort to strengthen, not weaken, the Yuan. It wants to keep the US appeased – although those efforts appear to be failing.

China may not be in a position to keep buying Treasury debt either. China's reserves are dropping and it has become a net seller of Treasuries. It looks like the days of cheap foreign finance are over for the US, regardless of Trump's policies.

This does not mean US interest rates will spike, despite recent increases. The US will simply force US banks to buy the Treasury debt that China cannot. To the extent that China still runs trade surpluses, it is allocating its reserves into gold, Euros, and special drawing rights (SDR or world money) and away from Dollars.

The bottom line is that China cannot end its subsidies to exports because it needs the jobs that its export industries create. The Chinese Communist Party is an illegitimate regime that will remain in power only so long as it provides jobs and a rising living standard for the Chinese people. Once the Chinese job machine stalls out, popular unrest could emerge on a scale much greater than the 1989 Tiananmen Square protests. This is an existential threat to Communist power and will not be allowed to happen for that reason. Therefore, the subsidies will continue.

China cannot prop up the Yuan indefinitely because it will run out of reserves and go broke in the process. In effect, Trump is trying to force China to adopt policies on trade and currency that it cannot pursue for political and financial reasons.

And Trump's leverage (the "art of the deal") including North Korea, Taiwan, and the South China Sea involves matters of existential importance to the Chinese where there is no room for compromise.

The result is likely to be confrontation rather than cooperation. This outcome involves costs for both sides. US consumers may pay more for Chinese goods. China's factories may slow down as a result of higher costs. Some US manufacturing jobs may be gained, but job losses in other sectors (entertainment, technology, pharmaceuticals, aircraft) may offset those gains.

The greatest danger may be a maxi-devaluation of the Chinese Yuan. Once the Chinese realize that they will not be rewarded by the US for trying to prop up their currency, they may just let it crash to reap the benefits of even cheaper export prices to offset the US tariffs.

We've seen this movie before. It happened in the 1930s. It was called The Great Depression.