Hong Kong Fund Manager Explains the Economics Behind Protests and What's Next for the Trade War

Russia may have decided the last U.S. presidential election. Will China determine the next one?

It's possible. National elections are influenced by the economy, and the current expansion is fragile. It's possible, and perhaps even likely, that we'll see a recession before the next election.

One of the things that could cause one is a trade war with China. That's top of mind for the financial markets. At the end of July when President Donald Trump announced a new round of tariffs, the various indices fell around 1 percent. This week, when he announced those tariffs would be delayed until Christmas, markets jumped up.

Thus far China's responses to Trump's actions have been more symbolic than substantive, which raises an intriguing question: "What happens if China were to deploy all of the weapons in their economic arsenal?" Devaluation. Dumping treasuries. Boycotts.

To get an answer, I called a friend who has spent much of his 30 year career in Asia and runs one of the largest corporate venture funds in the world out of Hong Kong.

How are things in Hong Kong these days?

"A little tense, but certainly nothing like Paris where thousands have been injured and at least 11 people have died (so far). China's been relatively patient with this whole thing, despite some of their rhetoric. Since the handover, Beijing has remained very supportive and even tolerant of Hong Kong because they recognize it's a jewel—one of the world's most important capital markets and a place
where international companies, especially in the financial industry, can operate with great freedom.

People in Hong Kong still have freedom of the press, freedom of movement, the rule of law. The current crisis over the proposed extradition law was really set off by the local government, not Beijing, and they've mishandled it badly. But underneath the issue isn't really freedom, but economics. Young people are incredibly frustrated. There's been little wage progression. Housing costs are so high thirty-
year olds are still living with their parents. There's no way to get ahead. The government health system is over-stretched, as is education—it's harder to get into the medical school at the University of Hong Kong than it is into Harvard, Stanford or Cambridge. Ridiculous!"

So what we're seeing on our televisions is overblown?

"Unless China loses patience and decides on a more muscular response. Even then, it'd probably be done carefully. The police in Hong Kong know who's throwing the petrol bombs and it's a small number.

Peaceful protests are a powerful strategy since they deny the mainland authorities a reason for direct or overt intervention."

Shifting gears, what do the Chinese think of Mr. Trump?

"I think they're confused by him. At first, many in the Chinese business community thought he was a good thing. They saw him as rightfully raising issues around non-tariff barriers to trade that exist in China and thought his efforts would open the economy. Now, they're a little less certain.

China was prepared to make concessions. The Chinese ministries have plenty of very good U.S.-trained economists. They understand what's at stake and they understand the consequences of things like a devaluation. But now I think the prospects of an amicable, constructive process is a receding possibility.
Last week's devaluation of the yuan was a warning shot that China is ready to push back." [Editor's note: After the devaluation on August 5, President Trump announced the imposition of additional tariffs would be postponed from September to December.]

There's been some speculation that China might deploy what some have called the "nuclear option" and dump U.S. Treasuries, setting off a global recession. Any chance of that happening?

"I very much doubt it. First of all, no one really knows how much of China's foreign reserves are in dollars, but it could be as much as $2 trillion. The Treasury holdings of $1.1 trillion are only about 7% of the total U.S. public debt and a much smaller percentage of the total U.S. credit market. From an FX perspective, five trillion dollars a day is traded in currencies. Putting these together, it's very likely that
even if China got rid of a significant portion of its treasuries, the market would simply absorb it.

They probably wouldn't do it. After all, even if it worked as a retaliatory measure, it would reduce the value of their remaining holdings. And anyway, where would they go? None of the other three major trading currencies—Euros, Yen, and Pounds Sterling are particularly attractive. The other alternative, repatriating, would put upward pressure on the RMB which would make exporting to the U.S. even more difficult."

So what next? Will we see a devaluation or retaliation against U.S. agricultural exports?

"I don't think so. China has a big trade surplus with the U.S., but it's neutral overall, which means that they have a deficit with the rest of the world. Much of that is in commodities, most of which are priced in dollars. Devaluing would make these more expensive in RMB terms.

Agriculture really doesn't matter. U.S. Agricultural exports to China are tiny, $8 billion in 2018. It may be important to U.S. farmers, but it's insignificant in the overall discussion."

Of course, this isn't to say we won't see an escalation in the trade war, or that it won't affect the economy. So far, President Trump claims to have collected $60 billion in tariffs, which Newsweek's Shane Croucher reports have been passed on to consumers. That's roughly $500 per household on average.

However, the impacts to farmers are far more concentrated. Either of those could trigger a recession.

But it does say that China's not going to provoke one, at least not intentionally.