Last week , China rattled investors by restricting margin lending and permitting more short selling, moves which some suggest are designed to cool a local stock market that has more than doubled over the last year. The Middle Kingdom followed up this week with a cut to banks’ reserve requirement ratios, freeing up more bank deposits for lending. Most pixels spilled in the press lately deal with one of the two, some tying them together. Some plausibly surmise their aim was more monetary stimulus, but not stimulus for financial markets. With all that said, we think hype over both is misplaced, and another story, which garnered much less attention, is a bigger deal: China just reduced the likelihood of a trade war between the world’s two largest economies.
Recently, China suspended plans requiring Tech firms (many of them US-based) who supply Chinese banks, universities, state-owned entities and government agencies to disclose their software codes to Chinese authorities. The now-shelved rule stemmed largely from 2013’s Edward Snowden affair, in which Snowden, a former US National Security Agency (NSA) contractor, revealed US intelligence agencies spied on many foreign countries (including China) using programs embedded in US tech exports. China positioned the rule as a response to national security concerns, claiming Chinese authorities’ review aimed to ensure the equipment isn’t carrying the NSA’s “bugs.”
Surrendering source codes is a deal-breaker for tech firms. Source code is the secret sauce—the backbone of any software program—and kept under lock and key. Someone who obtains it can easily clone the program and profit off piracy. China has long sought to boost its domestic Tech sector, and the country is not known for having ironclad intellectual property laws. Companies handing over code could lead to unstoppable copyright violation, and understandably so. Had China implemented this mandate, billions worth of US equipment trade could have ceased. That would have raised the risk of US retaliation and, if left unchecked, a full-blown trade war.
While China claimed national security was their guiding light, the move could easily be seen as a veiled attempt at protectionism under the guise of national security. Pushing banks and state-owned entities to use Chinese equipment in the name of cyber-security boosts Chinese firms without doing so in an overtly uncompetitive manner. It’s almost the technology version of food safety, often cited around the world as justification for protectionism.
When you consider the totality of the US/China trade relationship, protectionism does appear the most logical explanation—the US/China trade relationship has never been especially fuzzy. Disputes over tires, solar panels, steel, chicken, pork and clothing have erupted just over the last decade. China didn’t take kindly when the US placed its own restrictions on Chinese tech imports, under the national security guise, when approving the Sprint/SoftBank merger in 2013.[i] And it’s virtually an annual exercise for some US politicians and officials to threaten tariffs on Chinese imports, alleging China unfairly pegs its currency at artificially low levels against the dollar to boost exports. A weak currency is not necessarily the GDP or export booster many believe, but politicians often overlook this point to score political points.
Such trade squabbles, even the current Tech spat, are the sideshow in the US/China trade story. Since China joined the World Trade Organization in 2001, bilateral trade has grown from just over $25 billion to over $590 billion in 2014. The two economies benefit massively from this, and we’re sure many politicians get that at some level or another. But given politicians often make bad economic policies for political reasons—like the Smoot-Hawley Tariff Act of 1930, which punched basically all of the US’s industrial trade partners in the name of protecting agricultural interests—you can’t bank on that. Protectionism, often popular with a domestic audience, has a way of spinning out of control and doing severe economic harm. Smoot-Hawley, for example, contributed mightily to 1929-1933’s massive downturn.
A trade war between the US and China would be a negative for each. Total trade between the two represents 15% of total US trade and 13% of Chinese[ii]. But the effects would reverberate globally. The US-China connection is an important link in the global supply chain. Components of many end goods flow between China and the US before reaching the final manufacturer elsewhere. If import tariffs rose or other restrictions were put in place, it could jack up prices or create shortages not only for trade between the two countries, but goods produced elsewhere that include parts or materials that touch the two. That could whack trade globally and, potentially, stocks. It’s the sort of big, nasty surprise no one would see coming.
And for now, it’s unlikely, though this story isn’t necessarily over. The relationship didn’t suddenly get sunny. This is just a temporary pause while Chinese officials go back to the drawing board. They could eventually scrap it outright (and have an incentive to do so if the US makes it a dealbreaker in the bilateral trade/investment treaty presently under negotiation). They could water it down. Or they could just push forward with their original plans. So while a trade war doesn’t seem a probable threat today, we believe investors should continue to monitor developments like this, as a rise in protectionism impeding global trade is a major potential risk factor to the global economy.
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[i] Obviously neither company is Chinese, but SoftBank uses Chinese technology in their networks in Japan. The merger was approved once SoftBank agreed not to use Chinese tech when building out networks here.
[ii] Per United States Census Bureau and National Bureau of Statistics of China, as of 2013