What next after the phase one trade deal?


(Photo: CGTN)

China and the U.S. signed a phase one trade deal on January 15 in Washington, DC. The deal is much more than just increasing China's imports of U.S. goods and services by 200 billion U.S. dollars over the next two years, as it also contained substantial and far-reaching provisions on intellectual property protection, technology transfer, and market opening regarding manufacturing, agricultural, energy and services. The two sides also agreed on regular assessment, a Trade Framework Group meeting and a dispute resolution process. 

We think the most notable significance of the phase one deal is that it marks a truce and a break in the U.S.-China relationship that had been deteriorating rapidly and spreading beyond trade until recently. The pause brought by the deal will likely slow or reduce forces pushing for a decoupling of China from the U.S. (and advanced economies), and provide some time and space for the two countries to rethink a better strategy and new framework to deal with a changed bilateral relationship. As such, the phase one deal should help reduce uncertainty and risks of further escalation in 2020, which is positive for trade and activities in China and globally, and for market confidence.

In the short term, the removal of the December 2019 tariff hike takes away a big potential hit on consumer electronics exports and related sectors, although exports and production in these sectors may see some payback initially from likely front running in November and December. To the extent the labor-intensive consumer goods exports are hit less by higher tariffs, it could mean a more resilient labor market and consumption in China. 

Increasing imports of agricultural products from the U.S. can help contain China's food prices hikes in the near term, though it may bring a mixed impact on China's own agricultural sector in the long term, and could result in China reducing some imports from other countries. We think it is highly challenging for China to import 200 billion U.S. dollars worth of goods and services from the U.S. over the next two years without reducing imports from elsewhere.          

Exchange rate stability  

In the phase one deal, China has agreed to refrain from competitive devaluation and conducting "large-scale, persistent, one-side intervention," which China had already adhered to in the past few years, and to increase the transparency of the exchange rate scheme. 

We think this translates into a broad U.S. dollar-Chinese yuan stability rather than any trend of yuan appreciation, especially given China's slowing economy, shrinking current account surplus, and underlying demand from domestic residents to diversify their assets abroad. We expect the dollar-yuan rate to trade within a narrow range of 6.8-7 for most of 2020, ending the year at around seven. A truce on the U.S.-China trade war and China's commitment to exchange rate stability may help bring more portfolio capital inflows as China opens financial markets further in 2020, and yields remain attractive.             

No phase two deal this year, uncertainty remains 

Although the U.S. says phase two negotiations will start soon, we think the chance of reaching an agreement this year is highly unlikely given how comprehensive the phase one deal already is, and the election-year politics in the U.S. Meanwhile, the deal has provisions for suspending an obligation in the deal or adopting a remedial measure (likely including tariffs being added back), should implementation be deemed not satisfactory and disputes not resolved. We expect the U.S. will keep existing tariff hikes on 360 billion U.S. dollars of Chinese exports (25 percent on 250 billion U.S. dollars and 7.5 percent on 110 billion U.S. dollars) in 2020, with no additional tariff reduction or removal. 

Furthermore, the phase one deal did not address U.S. restriction of tech exports to and the ban on Huawei, and we think the U.S. will likely tighten such restrictions going forward. In addition, risks of further complications and escalation could come from geopolitics and other areas as well, as recent events have shown. That said, our base case is for tariffs to remain unchanged before the U.S. election with no major additional escalations.

While the phase one deal will likely serve to slow and reduce the forces pushing for a decoupling between China and the U.S., the higher tariffs, uncertain path of U.S.-China trade and economic relations, and potential for supply chain disruptions, especially in the tech area, may continue to delay or reduce export-related capital spending in 2020. In addition, the ongoing supply chain shift will likely continue. 

UBS China CFO survey showed that almost half (48 percent) of respondents that are negatively affected have cut their domestic capital expenditure as of September 2019, while 28 percent have plans to do so. Meanwhile, 63 percent of the manufacturing exporters have already moved part of their production out of China, while 57 percent of respondents plan to either continue to shift away from China or start to move overseas in the future. The direct share of U.S.-related exporters and manufacturers in China's total FAI is very small, and we have taken this into account in our manufacturing FAI forecast for 2020.

Easing policies to continue  

We expect China's macro policies not to change much from the stances set in the CEWC, and the ongoing easing bias to continue. In particular, in light of lingering uncertainties, China needs to keep growth at a reasonable range (i.e. around six percent) to achieve its target for "full prosperity" by 2020 and the 13th Five-Year Plan. We continue to see an additional 50 bps RRR cut, 10-15 bps MLF rate cuts (with LPR to be lowered more), slightly higher headline fiscal deficit, a larger new quota of special LG bonds, modest credit rebound, stronger infrastructure FAI, and more support for the labor market and social welfare. We expect China's total macro leverage to rise again in 2020 as the government is unlikely to shift back to deleverage in the short term. Should China's exports and property market turn out to be much stronger, policy easing may moderate in late 2020.            

Acceleration of market opening and reforms 

China has been pushing for faster opening up and structural changes in the past two years. Measures included opening the domestic market further, lowering import tariffs, implementing a new foreign investment law that promotes a more level playing field and prohibits forced technology transfer, enhancing IP protection, and reducing entry barriers to the private sector. We expect this trend of market opening and reforms to continue, which should be positive for long-term economic efficiency. In particular, services and financial market opening can help attract more foreign investment at a time when some manufacturing exporters may be considering shifting away from China. Of course, increased imports and more competition will likely affect some domestic industries and necessitate adjustments. If China were to accelerate SOE reform in the coming two years, it could create an additional upside for the market.        

Maintain our GDP forecast of six percent for 2020 

In anticipation of the phase one deal, we have already upgraded China's 2020 growth forecast to six percent for 2020. Indeed, economic activities have shown signs of picking up since November, partly helped by low industrial inventories. With the trade war truce and deployment of special LG bonds soon, we expect economic activities to rebound sequentially in Q1 and Q2. Continued modest policy easing should help offset the negative impact of the remaining higher tariffs, while the expected slowdown in property markets should start to weigh on growth later in the year. On balance, we maintain our 2020 GDP forecast of six percent and will re-evaluate the impact of higher imports later in the year.