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Stock markets rallied hard in relief after China’s President Xi Jinping said “The investment environment is like air, (and) only fresh air can attract more people” in a conciliatory Bo’ao Forum speech. U.S. President Trump responded respectively. What's next?

China Xi

Of note Mr Xi said that the timing is ripe to remove the restrictions for foreign investment in the automobile industry, but these are not new concessions as I discuss later. On the face of it this is huge for General Motors $GM, Ford $F and Fiat Chrysler $FCAU potentially. China also commits to cutting the import tariffs for automobiles going forward.

Other policy considerations include lowering the barriers for foreign participation in financial industries (that has JPMorgan and Goldman Sachs written all over it) and enhancing the protection on intellectual properties (this is the big one for President Trump and Tech).

In effect Xi has provided Trump with an opportunity to back down from his tariff threats while claiming a victory of sorts.The speech was poignant and also with a cross reference to Russia, not just the U.S. where he highlighted the need to move on. Xi said that the “cold war” mentality and “zero sum game” are “out of place” today. The speech was clearly in a concilitory one, something welcoming and perhaps President Trump could smooth his approach some also, though he praised Xi’s “kind words on tariffs and automobile barriers” .

China does not want to make too many concessions to the US, at least immediately and I think that will be the pattern of negotation. An interesting article from Blarney yesterday "How The Rusal and Ruble Plunge Fed China's Xi New Outlook" at TradersCommunity spelled out the backdoor card playing from the US with Russian sanctions helping China. Very clever from the US, though of course it will go unnoticed by many but not by Presidents Putin or Xi  as the Syria warfront heats up again.

China as percentage of US trade

Words are nice but it is important to watch what concrete measures China bring forth. The market is one of extremes in the past few months but the past few days display a cautiously optimistic view on China’s opening up measures. Past experiences suggest China could under-deliver however I get the tone the new PBOC and 'life long' President Xi see this as an opportunity for China also. The welfare cost of tariffs to China are problematic in a country will mutliple ethinc crises and a burgening middle class. Long term China would suffer an even bigger welfare loss should civil unrest spread.

The import tariffs lead to a deterioration of China’s terms of trade, should the US demand for Chinese products drops the price of these goods on the world market falls given the sheer size of the US  world market prices will be affected.  Should devaluation be taken as a response the Renminbi depreciation would cause China’s terms of trade to deteriorate even further as the weaker currency would make imports even more expensive. (the J curve affect).

Trade Imbalances

Its not all cut and dried and Xi and are well aware and wish to avoid CNY depreciation at this point. However US tariffs hurt the export sector and thus the Chinese economy thar will become a potential weapon. It will come down Chinese leadership deciding to counteract the short term economic effect or the long term welfare loss. China has been very astute at playing the long game.

The western market view will be about growth stabilisation as they see China more as an investment opportunity; and simply dismiss the long term welfare loss.  Another fact is the Chinese authorities have been dampening CNY depreciation expecta tions to prevent renewed capital flight as seen in 2016. That even went as far as an attack on cryptocurrencies,iIf they were to weaken the yuan intentionally now  that brings all that undone. 

The response perhaps looks more concillatory than it should be following China’s aggressive response last week to America's tariff threats, which also explains such a tone. Xi now can portray China as a responsible actor and defender of globalism and free trade while show foreign firms and governments that China is moving away from big bad communism with it's “new phase of opening up”. Keep in mind China retains much higher tariffs barriers than both the U.S. and E.U..Tariif Asymetries

The cynical view is that Xi at the forum simply re-iterated existing pledges. The current FDI shift to a less restrictive “negative list” has been evolving since 2013.  The looser foreign ownership limits in the financial sector and among automakers were announced last year. At Davos in January Xi shared plans to lower import duties on cars. That aside the speech was an opportunity to go either way, de-escalate or escalate trade tensions.

Moving forward what China must show Trump that they are moving quickly towards “free and fair trade”. Cars are significant for three reasons,  cars are the major US export sector with the most significant tariff disparity with China, secondly Trump has singled out these tariffs. Thirdly Americans love their cars and Detroit is a symbol of America going wrong. Symbolism is huge we all know there are countless other goods on which China imposes higher tariffs, but what hits home?

Summing things up, caution and an understanding of game theory is needed here. Markets will respons in bouts of hope and dismay for some time yet in what will likely be a drawn out process of negotiations. China is great at repackaging and will continue to leave room for negotiation and cooperation. Within that if America decides to ratch it up expect China to respond with tit-for-tat retaliation threats as needed.

Remember nothing is straight forward and there are a multitude of potential biruifications. What about inflation, yes we know the Fed wishes for it but I assure you mainstreet doesn't what a spike. Today we saw rising inflation in the US with producer prices surprising to the upside in March, at both the headline and core levels.

At the core level, strength was broad-based across subcategories and on an annual basis, headline PPI rose 3.0% and PPI excluding food & energy rose 2.7%. In all, the report suggests modestly stronger pipeline pressures relative to expectations. Keep in mind the final cost of the tariff tends to fall on American consumers, this is tariffs are often considered a regressive tax, with price increases hitting low-income Americans the hardest. Now what if welfae costs become an issue in the US?

Source: TradersCommunity; Goldman Sachs

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