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Why You need to Pay Attention to the US-China Trade War

In 2018, Donald John Trump, the 45th President of the United States declared a trade war on China. Who could have predicted this? No number of visits to spirit channelers, soothsayers and tarot card readers could have prepared us. You could have read the tea leaves, waited for Venus to come into line with the nineteenth sun of Orion’s belt, consulted the ancient oracles of Stonehenge and you still would not have come close.

Trump imposed tariffs on washing machines and solar panels. The reason given was to eliminate the U.S. trade deficit with China.  On the campaign trail, Donald Trump made trade deficits out to be the Whore of Babylon. 

So what is a trade deficit?  Deficits exist when a country imports more than it exports. In 2018, the U.S. imported $540 billion from China and exported $156 billion to China.  This created a deficit of $384 billion according to data from Bloomberg. In that same year, the U.S. ran a $118 billion deficit with Mexico and $69 billion with Canada. The U.S. has been running trade deficits since Ray Kroc was flipping burgers and Saddam Hussein was building sandcastles on the beaches of the Caspian Sea.

Back in those days, the biggest deficits were run against Libya, Japan, Saudi Arabia, and Algeria. Three of the four were on account of the American insatiable appetite for oil and the need to fill up their Oldsmobiles with gas, drive across the country to buy a pizza and return home – all on the same day. 

The year in which China broke into the top 5 of the trade deficit billboard charts was in 1990 when their trade deficit with the U.S. doubled from 5 to 10 billion dollars slotting in behind Japan and Canada.

In 1999, China passed Japan as the U.S. largest deficit trading partner and from that date, the deficit has ballooned from $66 billion to $384 billion in 2018 as Americans developed a narcotic like addiction to cheap Chinese kit.

To understand deficits, it is easier to use a simple domestic example. When a family spends more than it earns it runs a deficit. For this family to keep going financially, it needs to either open a meth lab or take out a loan to finance this gap.

In the same way, the U.S. needs to go out and finance its deficit. It relies on the kindness of strangers - foreigners who lend them money.  These strangers do so through the purchase of Treasury bonds.

The biggest foreign owner of U.S. Treasury bonds as of September 2019 was China, with almost $1.3 trillion followed by Japan, Belgium, and Brazil. For now and the near future, foreign demand for treasuries is more resilient than Keith Richard's liver. This will allow the U.S. deficit to rock on. Americans have reaped the benefits of lower prices on Chinese, Mexican and Canadian goods - $3 for a pair of tube socks at Walmart is not to be sniffed at.

So what does Trump have against deficits? What did they ever do to him?  He supposedly built his “fortune” on other people’s money. In the 1980s, while we were growing mullets and bopping to Cindi Lauper, Trump was one of the most leveraged real estate investors in New York.

In 1988, when Trump bought New York's famed Plaza Hotel, he paid $407.5 million. He got a $425 million loan. "If the world goes to hell in a handbasket, I won't lose a dollar," Trump bragged to a reporter.

Trade deficits brought him into politics. In the 1980s, he bullied Japan for stealing jobs from the U.S. When Japan went into decline, he had to find another victim. He focused on China, 16-year-old Swedish climate activists, and the free press.

Fortunately, or unfortunately, we have insights into how Trump thinks via his book "The Art of the Deal". The biggest insight from this trashy novel was that the world in his eyes is binary. Deals are good or bad. In the Trumpian mind, there is black and white, but no grey. He says deficits are bad because they represented a financial loss.  

If called upon, he would use the following example: when you buy a house for $1,000,000 and sell it for $800,000, you lose $200,000. Deficits, however, do not work like that.  The analogy is closer to buying a house for $1,000,000, slapping $200,000 down and financing the balance.

Trump knows the difference. He is using deficits and tariffs as a smokescreen to distract the public away from what is at stake. The trade war of 2018/2019/2020 was not about tariffs on washing machines and solar panels. This war is about something bigger. It is about who will dominate the world in 10, 20 and 50 years.  This is Pinky and the Brain playing out in orange technicolor.

Let us go back to the 1970s when the Chinese premier Deng Xiaoping met with a former peanut farmer named Jimmy Carter and announced that China was open for business. China would dedicate certain zones to the pursuit of capitalism and the free market principles espoused by Milton Friedman.

At the time, more than 800 million Chinese lived in poverty. Jimmy was more than happy to have another trading partner. China was going to focus on low input mass-produced goods such as plastic flip-flops and garden furniture and was no threat to the U.S. machine. The biggest threat to the U.S. was still the U.S.S.R.

In 1989, the Berlin wall came crumbling down signaling the end of Soviet communism. At this point in history, the United States felt bulletproof. In the 1990s, Clinton had other priorities, such as making Monica Lewinsky a household name. After 9/11, Bush obsessed over Saddam, ISIS, the Taliban and anyone who looked as if they may or may not have traveled to Mecca at some point in their lives. All the while, China was growing and pulling hundreds of millions of people out of poverty.

Then came 2008, which was a key point in the Sino- American relationship.  First, we were treated to the summer Olympics in Beijing. This was the biggest and most expensive coming-out party in history. It was a bold statement that China was back and ready to retake its place on the world stage. A few months later, the collapse of Lehman Brothers and the biggest financial crisis in history saw all hell break loose.

This altered the Chinese view of the U.S.. Up until 2008, the Chinese business model had been U.S. centric. When Lehman’s collapsed, China started to diversify.  They had previously thought that the U.S. was the smartest person in the room and were happy to have them as their dominant partner. Lehman showed that they were no smarter than Bevis and Butthead. China frantically looked for other consumer markets to whom they could sell their goods. The first port of call was its own citizens.

Boasting a population of 1.4 billion rapidly urbanizing human beings, the Chinese Communist Party (CCP) put their back into increasing domestic per capita consumption. This is not easy in a country with a savings culture of Olympic proportions. The Chinese typically saved up to 40 percent of the income - most of this was into education funds for their kids. What happens if your kid was the next Albert Einstein and needed to go to Harvard? 

The Chinese also embarked on the belt and road initiative. This is the largest infrastructure spending plan since the Marshall Plan. It aims to spend 1 trillion yuan to connect the old silk road (the belt) and marine corridors (the road) to markets such as Africa. No, that is not a typo – the old Silk Road is the belt and the marine corridors are the road.  Belt and road caused a great deal of consternation in my continent – Africa . Our collective thoughts rushed back to British colonialism and the realization that the only good that came from it was rugby and high tea.

A third change was moving away from manufacturing nylon thongs and shifting into technology and specifically hardware. The bubble was a curious event and more curious was Silicon Valley’s reaction to it.

In 1999, the tech mania lead us to believe the internet would replace old school "bricks and mortar" businesses. Private companies only had to add .com to their names and they could list on the stock exchange and make millions. The absence of solid underlying business fundamentals was no obstacle. Then the bubble burst, obliterating trillions of dollars from the stock market.  The logical response was to restore the equilibrium between the old and the new economies.

This was not the case in the U.S. They stopped investing in hardware manufacturing such as chips, servers, and circuits.  Instead, they plotted a future of software and applications, spawning frivolous crowd favorites like Snapchat, Pinterest, and Match. All the while, the Chinese were hard at work building cellular towers and microprocessors. Hegel's paradox that what man learns from history is that man learns nothing from history held true. The Chinese recognized an opportunity and jumped on it like a fat kid onto a cupcake.

In 2016, the U.S. presidential campaign kicked off and China was placed front and center by Trump. Americans realized that the sleeping lion had emerged from its slumber.  Former Czech President Václav Havel said that the rise of China has happened so quickly that we have not had time to be surprised.

In my opinion, if the U.S. had tried to put the brakes on Chinese growth in 2008, they might have achieved something.  By the time Trump started the trade war in 2018, it was too late.  Trump's chief economic adviser assured the president that the Chinese would not retaliate against the tariffs - he could not have been more wrong. The Chinese said they would fight to the death, to which Trump's team said "o shit!"

Now we need to understand Huawei because it holds the key to the trade war. Huawei is the second-largest smartphone manufacturer in the world after Samsung as of September 2019 according to data from Bloomberg. Smartphones, however, are the least interesting part of their business.  They are the world's largest telecom equipment manufacturer with almost 30 percent of the market followed by Nokia and Ericsson who are both in the mid-teens. Huawei is the frontrunner in the race for 5G.

Sweden and Norway won the race for 4G and it provided a nice bump to their GDP and employment numbers. 5G is a far bigger deal because it introduces super-fast internet, which is exponentially quicker than its predecessor.

So what do we know about Huawei?  According to Wikipedia, the company was founded in 1987 by Ren Zhengfei. Initially focusing on manufacturing phone switches, Huawei expanded its business to include building telecommunications networks, providing operational and consulting services and equipment to enterprises inside and outside of China, and manufacturing communications devices for the consumer market.  

According to financial information reported in Bloomberg, the company generated $108 billion in revenue in 2018. Only 65 publically listed companies generated more than $100 billion in revenue in that year. Huawei's revenue is on a par with BMW, Boeing, and Bank of America. The most interesting part of their financial disclosure is the amount of money they spend on Research and Development. 

In 2016, they spent zero on R&D – the same amount that Donald Trump donated to charity and paid in taxes. In 2017, Huawei spent $13.2 billion and in 2018 they spent $15.3 billion. In 2018, Nokia spent the equivalent of $5.4 billion and Ericsson spent $4.3 billion according to information from Bloomberg.

Huawei spent 57 percent more on research and development than its two closest rivals combined. This reflects the strong drive that the company is making into 5G. Another interesting fact about Huawei is the percentage of the company that is owned by the founder.

According to Huawei's website, Ren Zhengfei as of 2019 owned 1.14 percent of the company. The rest of Huawei is owned by its employees through an Employee Stock Ownership Program (ESOP). This has been in place since the beginning of the company. If you want to make a company successful, donating almost 99 percent of it to your employees is not going to hurt.

So how will the ability to download all the episodes of "Game of Thrones" in 5 seconds lead the Chinese to world domination? Super-fast internet makes possible autonomous driving, genome processing and takes artificial intelligence and big data to new levels.  Not only are 5G servers quicker but they are also smarter. This makes possible the Internet of Things.

The Internet of Things is a system of interrelated computing devices, mechanical and digital machines, objects, animals or people that are provided with unique identifiers (UIDs) and the ability to transfer data over a network without requiring human-to-human or human-to-computer interaction.

Many companies favor Huawei’s networking and telecommunications equipment for its technological edge and low cost. The U.S. wants to hamper the ability of Huawei to build these networks because they are concerned about the security risks associated with networks maintained by a Chinese company with such close ties to the Chinese Communist Party.

It is not necessarily easier to hack into a 5G network. The security concern is that it will connect more devices and this connectivity raises security red flags.  The U.S. and other nations have expressed their concerns that Chinese 5G equipment, chips, and software could be outfitted to spy on its customers – not unlike a Trojan horse within the world's infrastructure. 

The U.S. is also concerned that if Huawei dominates the 5G infrastructure space it could be a precursor to China becoming the world’s dominant economic and political power. Regardless of who you think will win the race for 5G, the continued growth of China is a given and you need to find ways to invest and exploit this growth.

It is not always clear where Huawei ends and where the Chinese Communist Party begins. The line is blurred as evidenced by some unusual behavior out of China and Canada recently. Firstly, there was the arrest of the Huawei CFO Meng Wanzhou in 2018 in Canada for allegedly violating sanctions placed on Iran. Why Canada and not the U.S.? She smelt a big fat rat and was making a concerted effort not to enter the U.S.. Meng Wanzhou is the daughter of Huawei founder and CEO Ren Zhengfei who supposedly is a member of the Chinese Communist Party. Another event was Federal Express's refusal to deliver a P30 phone in the U.S. in June 2019. The Chinese government reacted by considering blacklisting FedEx in China. 

So what does China want? A common mistake in analyzing China is to do so through the lens of western values shaped by McDonald's burgers and the star-spangled banner. China is not a democracy and they do not aspire to become one.  They want power, affluence, and respect. They want to recover the respect they lost after the Opium Wars in the 1850s and want to retake their position as the world's dominant force. Do they want to colonize the world? 

Nothing could be further from their minds. China is the Middle Kingdom and, according to British journalist Martin Jacques, they have no interest in mixing with us lowly plebeians.  Belt and Road is an economic project to link China with new markets - not a modern version of lebensraum ala Adolf and his satanic crew.  

Investing in China needs to be done through local partners. When Uber entered China in 2014, they did almost everything right. They entered slowly. CEO Travis Kalanick met with politicians and made all the correct connections. They entered with a great product but they could not compete with the locals. They went head-to-head with the local leader, Didi, but could not sustain the price war and left in 2016 selling out to their rival. The lesson learned was that if you want to succeed in business in China, you need to associate with a local player.

This brings into play a commonly voiced complaint of Donald Trump about forced technology transfer. When U.S. companies form these joint ventures, the Chinese partner makes the deal conditional on the sharing of technology. Given that these U.S. companies desire access to the world’s most populous market, they are happy to sign the technology transfer agreement.

The rise of China also puts into doubt the future of the U.S. dollar as the world’s dominant currency. As of 2019, the share of global trade invoiced in U.S. dollars was three times more than total U.S. exports. Foreign governments accumulate dollars in reserves because they like to manage their exchange rate against the world's major trading currency.

According to the IMF, in 2019, 61 percent of all reserves are in U.S. dollars, 20 percent in Euros, and 4.5 percent in Japanese yen and only 2 percent in the Chinese renminbi. In addition, foreigners hold two-thirds of all the $100 bills in circulation. Foreigners have effectively extended no-interest loans to the U.S.

So what would it take to dethrone the U.S. dollar as the world’s dominant currency? Three things would need to happen: firstly a massive event that undermines global confidence in the U.S. dollar, secondly there needs to be a viable currency alternative to take its place, and thirdly the two biggest holders of U.S. treasuries (China and Japan collectively owned more than $2.2 trillion in U.S. treasuries as at 2019) would need to enter a wholesale selling of their bonds.

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