FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
July 17, 2018

1. Trade War With China Benefits No One

2. Why the US-China Trade Deficit Will Likely Fix Itself

3. China Repels Foreign Investment, But Should Welcome It

4. Foreign Corporations Earn Lofty Returns in China

5. Why the Chinese Don’t Invest More Domestically

Overview

I have argued in recent months that a trade deficit is not necessarily a bad thing and certainly not as troubling as President Trump would have us believe. I have also made the case that as the largest and richest economy on the planet, it only stands to reason that we would run a large trade deficit with many of our trading partners – simply because we can afford it.

Still, President Trump harps on and on about how unfair the trade deficits are, especially when it comes to our whopping trade deficit with China. As you probably know, Mr. Trump just announced another round of trade tariffs on $200 billion in imports from China, in addition to the initial $50 billion in tariffs he announced earlier this year. China immediately threatened to retaliate, of course.

Fortunately, these new tariffs don’t go into effect for a couple of months so there is a chance of negotiating some kind of a compromise to avoid them. Let’s hope so – otherwise, this spirals into an all-out trade war which could be bearish for stocks.

Today, I’d like to take the tariff discussion a step further and specifically explain why our trade deficit with China is more of a problem for them than for us. In any event, it in no way justifies a trade war.

Finally, I’ll discuss why wealthy Chinese invest so little of their money in China and why many prefer to invest (and even live) in places like the US, Canada, Australia and other free countries. Hint: they don’t trust their government and even many of their fellow Chinese.

Trade War With China Benefits No One, Harms Both

The US trade deficit with China was $375 billion in 2017. The trade deficit exists because US exports to China were only $130 billion while imports from China were $505 billion. The United States imports consumer electronics, clothing, machinery and many other products from China.

A lot of the imports are from US manufacturers that send raw materials to China for low-cost assembly. Once shipped back to the United States, these products are considered imports even though some economists feel they should not be counted as such. For now they do and add to the already large trade deficit with China.

One question is why is President Trump so troubled by our large trade deficit with China? One reason is Trump’s belief that China has been guilty of dumping goods, including steel, in the US at deeply discounted prices, thereby undercutting US manufacturers and costing jobs. This has been clearly true for a long time, although most analysts agree that China has largely cleaned up its act, especially since Trump took office. 

Still, the president seems dead serious about imposing another $200 billion in additional tariffs on China, which will retaliate with more tariffs on goods we send them. Can this mutual self-harm possibly lead to any good? Almost certainly not – but Trump is intent on doing so anyway because our imports from China are so much larger than their imports from us.

Yet looked at differently, the $375 billion trade deficit is merely an increase in US indebtedness to China which stood at almost $1.8 trillion at the end of 2017. As a result, China is by far the largest holder of US Treasury debt. This fact is often described as a huge vulnerability for the United States. Yet as I have argued for years, China has little incentive to dump Treasuries.

Why the US-China Trade Deficit Will Likely Fix Itself

Here’s another way to think about the trade deficit with China. In about 1890, the US-UK relationship looked a lot like the US-China relationship today. In 1890, Britain held the world’s largest pool of investible wealth, with large global capital inflows, as the United States does today.

In 1890, the US economy was growing much faster than the UK economy, much as China’s economy grows faster than America’s today. In the 1890s, the US ran large trade deficits with the UK, much like we do today with China.

During that period, the US imported goods on a massive scale from the United Kingdom: locomotives, engineering and construction equipment, high-quality consumer goods of all kinds and even hot-weather commodities grown within the British empire – including rubber, chocolate, and palm oil.

Those imports enabled a higher standard of living inside the United States. They were paid for mainly by US food exports – but even more, by selling the British an opportunity to participate in future US growth, which is what a capital account most fundamentally represents.

It is important to note that in the 1890s, investment capital flowed from Britain (the more mature economy) to the United States – and on a huge scale. In those days, Britain invested something like 6–8% of its national income overseas, with the US as the single largest destination.

Eventually, the trade deficit problem between the US and the UK corrected itself. The point is, we don’t need a trade war with China. But it increasingly looks like we’re going to get one. The result will be higher prices paid by US consumers for products made in China. We all lose.

China Repels Foreign Investment, But Should Welcome It

Instead of attracting capital, however, China is repelling it for reasons that aren’t entirely clear. China attracts less capital than either the United Kingdom or the United States, two mature developed economies that theoretically should offer far fewer opportunities than China.

More troubling is the fact that most of the foreign investment into China – 69% of the total – comes from Hong Kong. That money looks more like recycled and/or laundered domestic Chinese money than true foreign investment. The fact that China is repelling foreign capital is not good for various reasons.

Side Bar: Foreign Corporations Earn Lofty Returns in China

While it is difficult for foreign corporations to get into China – they often have to surrender valuable proprietary technology and/or partial equity ownership – it can be very rewarding. Due to cheap labor, lower rent, etc., their profit margins are typically very high. A 2008 World Bank study found that the average return on multinational corporations’ investments in China was 22%. American multinationals earned even more, an average of 33%. Congratulations to those successful multinationals operating in China.

China’s foreign investment in other countries, on the other hand, is not working out remotely as well. Since much of China’s foreign investment is held in sovereign debt securities, it yields much lower returns than it would if it were invested in productive enterprises at home. For example, China earns less than 3% on its immense holdings of US Treasuries.

Why the Chinese Don’t Invest More Domestically

The question is, why don’t the Chinese invest more at home? The answer may surprise you.

To explain this, let’s go back to the 1890s when the US was fast industrializing. It was not the dream of every businessman in America to send his kids to college overseas or to obtain a second home offshore for himself. The 19th-century American business class not only earned its profits in the US, but it saw its future and its security here as well.

Yet Chinese business leaders invest tens of millions of dollars in second homes in foreign countries, some with dreams of living there one day. They send their kids to foreign colleges and universities. And they often send their pregnant daughters and granddaughters to America to give birth to US citizens. So, what does that say about their expectations for China’s future?

In 2007, Kellee Tsai (then a political scientist at Johns Hopkins) published an eyebrow-raising study of Chinese business class fears of the future, Capitalism Without Democracy. She looked at entrepreneurs a rung or two below the ruling oligarchy, people with some wealth but no political power.

Their overwhelming wish was to see their children emigrate to a democratic country: Canada, Australia, the United States. Their overwhelming fear: the communist dictatorship and the eventual democratization of their own country, which they worried would mean their poorer fellow citizens seizing the opportunity to plunder them.

Because China cannot or will not attract foreign capital, it must run a huge trade surplus. That means fewer food imports and thus a lower standard of living for its people. That means China must finance its future development out of its own savings – which means its people must consume much less of the proceeds of their own making.

And very visibly, those who have accumulated savings are redeploying them elsewhere. They accept radically lower returns on their investments in order to gain from Canada, Australia or the United States the security of property that their own government cannot provide.

It’s no wonder then that so many Chinese every year seek to emigrate to free countries like the US, Canada, Australia and others. Due to space limitations, I’ll leave it there for today.

All the best,

Gary D. Halbert

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