China: Phase One and Tariffs

Published on November 13, 2019
SGH Insight
President Donald Trump’s threat yesterday to hike tariffs “substantially” if there is no trade agreement with China soon, and press reports of pushback by hawks within the White House and Trump himself against Beijing’s demands that US tariffs be rolled back have raised concerns in markets over the status of current trade negotiations between China and the United States.

*** Despite those concerns, we continue to believe there will be a “phase one” deal signing, albeit most likely now in early December, and we would put the odds on that as high as 80-90%. Senior officials in Beijing, at least, believe they received assurances in a call on Friday that the US side would agree to remove tariffs imposed on each other’s products, “in different phases, after both sides make progress” in reaching a deal. ***
Market Validation
(Bloomberg 11/15/19)

Yen Falls With Treasuries on Kudlow Trade Comments

The yen weakened against all its Group-of-10 peers after White House economic adviser Larry Kudlow said the U.S. and China were close to finalizing the first phase of a trade deal. Commodity currencies rose.
USD/JPY gained for the first time in six days, advancing on demand from fast money accounts after Kudlow’s comments, according to Asia-based FX traders. “We are coming down to the short strokes,” Kudlow said referring to trade talks
Exporters bought the Australian and New Zealand dollars following his remarks, according to traders. Treasuries slipped while U.S. stock index futures rose to a record high
USD/JPY advanced 0.2% to 108.59; pair is down 0.6% this week, the most since the five days ended Oct. 4
The 10-year Treasury yield rose 2bps to 1.84% after falling 7bps on Thursday. Bloomberg Dollar Spot Index fell 0.1% in a second day of declines

President Donald Trump’s threat yesterday to hike tariffs “substantially” if there is no trade agreement with China soon, and press reports of pushback by hawks within the White House and Trump himself against Beijing’s demands that US tariffs be rolled back have raised concerns in markets over the status of current trade negotiations between China and the United States.

*** Despite those concerns, we continue to believe there will be a “phase one” deal signing, albeit most likely now in early December, and we would put the odds on that as high as 80-90%. Senior officials in Beijing, at least, believe they received assurances in a call on Friday that the US side would agree to remove tariffs imposed on each other’s products, “in different phases, after both sides make progress” in reaching a deal. ***

*** While hard to interpret that language exactly – and perhaps it is because a deal is yet to be finalized – we suspect a phase one deal will include, as widely expected, a cancellation of the tariffs on China threatened by the Trump administration for December 15. In addition, we expect it will include a roll back of the September tariffs already imposed as an additional limited concession to Beijing in exchange for its commitment among other things to agricultural purchases that will require China to drop its own tariffs on imports from the US (see SGH 11/4/19, “China: Negotiating the “Phase-One” Deal”). ***

*** As to headlines hitting the tape today over a potentially serious last-minute snag between the two sides over the inclusion of Chinese agricultural commitments in the text of an agreement, and when and by how much tariffs are lifted, we see those as final stage, even if clearly important, negotiating issues. Indeed, from what we understand Vice Premier Liu He laid out a very explicit time frame for Chinese purchases that would get to Trump’s desired $50 billion number, even if there is a dispute still on how tightly to commit to that schedule (see below). ***

*** Having said that, agreement on a deeper “September-plus” rollback deal appears unlikely. It is complicated by political sensitivities in the White House to tying more significant US concessions to the delivery of a “phase one” agreement that will admittedly leave the thorniest structural issues unresolved for a later stage, and with it leave President Trump open to criticism from both sides of the political aisle. And given Trump’s personal antipathy towards giving up his vaunted tariffs, we believe a fully scheduled, tariff rollback agreement is not on the cards, even if held out as a future incentive.  ***

Timing and Venue

The signing of a phase one deal is likely to spill over into December. More precisely, sources in Beijing say no meeting has been, or is likely to be, scheduled for November for a signing ceremony between President Xi Jinping and President Donald Trump.

As to the venue, our understanding is that Xi would be willing to travel to the United States for a signing ceremony, assuming some tariff rollbacks are included in the deal.

That appears to be the case even as news reports suggest the two sides may be looking for a neutral third country for a potential signing ceremony. Reading through the tea leaves, it seems a US-based signing ceremony could be an additional concession from Xi to Trump for a limited rollback of tariffs.

All or Nothing

In the big picture, the first phase agreement, Chinese sources maintain, is in fact the easiest to sign. That is because it does not address issues the two sides disagree on the most, and expectations thus remain high that both sides will grab the olive branch that is there and sign a deal to de-escalate tensions.

For that reason, however, if this round were to fail, they believe it would then spell a full on “decoupling” of the two economies, and the likely escalation of the trade war into a full-on tech and currency war.

And even if this phase one détente plays out as expected, Chinese sources believe a subsequent “phase two” deal will never actually happen.

The Deal Itself — Enforcement

Beijing, even while demanding rollbacks, bristles at the continued use by Washington of tariffs as a carrot and stick enforcement mechanism.

And it appears Chinese negotiators are still insisting on a joint enforcement mechanism whereby the US keeps a representative in Beijing to hear violations, while China maintains one in Washington, with unresolved disputes bumped up to an appeals process.

The exact enforcement mechanism, as a reminder, is critical in that it was one of the main disagreements that derailed previous talks. We do not get a sense that there are such major disagreements that would derail a deal here, assuming the US accepts some version of the Chinese joint enforcement proposal.

Agricultural Purchases

As to deliverables, as widely advertised, the phase one agreement is heavy on Chinese purchases of US agricultural, as well as some LNG and energy products.

From what we understand, Vice Premier Liu He offered an explicit schedule of purchases that, while aspirational and not guaranteed, would nevertheless meet Trump’s $50 billion target for agricultural exports to China by 2022. And that appears to be generally fine by Washington.

Specifically, our understanding is that Beijing offered this year to beat last year’s depressed $17 billion level of agricultural purchases (imports as of the first three quarters of 2019 were a mere $9 billion), to step up to $25-30 billion in 2020 (imports in 2018, as a reference, were $26.7 billion), to $35-40 billion in 2021, and to $40-50 billion by 2022 (SGH 11/4/19, “China: Negotiating the ‘Phase-One’ Deal”).

With an eye to the future, President Xi is nevertheless also actively hedging his bets away from over-reliance on agricultural imports from the United States.

From what we are told, Xi’s trip to the BRICs summit underway in Brasilia is not entirely innocuous on that front, in that he will give President Jair Bolsonaro assurances, even a guarantee, that China will increase its agricultural imports from Brazil as well as from the United States.

Beijing is also looking to strategically build India and Russia as agricultural import alternatives to the US and has engaged in the long term coordinated planning of massive soybean plantings in Russia.

Financial Services

Having said all that, Chinese officials believe what Washington really cares about the most, as in administrations past, is not AGs, but Wall Street, and its unfettered access to China’s financial markets.

Beijing will thus highlight the opening of its financial sector as a major prize of the phase one deal, with veiled assurances that US companies will not be discriminated against vis a vis their European peers – not that they would do such a thing.

Money, Drugs, and Brains

Going down the list of White House Trade Advisor Peter Navarro’s “seven deadly sins” that need to be addressed by Beijing, the phase one agreement will also include language, for what it’s worth, that commits China to refraining from currency manipulation.

We would imagine assurances on fentanyl and drug exports on top of last week’s highly publicized arrests of drug dealers in China would also be easy to throw into the mix as a highly visible concession to the Trump White House.

Furthermore, there is a nod in the phase one deal to the thorniest bilateral economic issue of them all, the protection of intellectual property rights.  Both US and Chinese negotiators can and will point to the implementation on January 1, 2020, of a new Investment Law by Beijing that purports to grant IPR protections to both foreign and domestic firms alike.

Having said that, Chinese sources stress there is zero chance Beijing will go beyond its domestic laws to incorporate US language into its IPR law, and the punting of the bulk of IPR grievances into “phase two” is in reality a placeholder for a dispute that is unlikely to ever go further than this.

Stuck on the Other “Sins”

The remainder of the “deadly sins” identified by the US that will be purportedly punted into phase two will also never be resolved.

Beijing continues to reject any notion that the problem of forced technology transfers is related to government policy. It instead maintains the problem, where it does exist, is an intercompany issue between US companies eager to gain access to China’s markets and their counterparts on the mainland. Any legal issues, they insist, should be covered by the new Investment Law.

And finally, beyond small tweaks in enabling foreign companies to store data on cloud systems, Beijing will not acknowledge any actual government involvement in cyber intrusion, will defer any dumping accusations to the WTO, and last but not least, will continue to draw a bright red line around its subsidies of state-owned enterprises, pointing to similar protective measures enacted in both the EU and in the US.

And that is why those issues are all conveniently tossed into phase two.

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