SINGAPORE (Jan 21): In the past week, the mood among investors has brightened as the US and China edged away from a suicidal trade war, Chinese policymakers adopted ever more aggressive stimulus and the US Federal Reserve signalled that it would only tighten monetary policy cautiously. With these major risks apparently diminished, emerging Asian markets celebrated.

The question is whether the fundamentals justify this ebullience? The answer is no.

US-China trade talks: Yes, a deal is likely…

The upbeat comments from both sides after talks between the US and China suggested good progress had been made on trade issues. Moreover, Chinese Vice-Premier Liu He would not have accepted the American invitation to join the next round of negotiations in Washington, DC at the end of January unless he was reasonably confident that a deal was within reach.

It looks like China was prepared to go some distance to appease American demands, allowing the broad shape of a deal to emerge. China will step up purchases of US energy, food and other items, access to the Chinese market for US firms will be eased in more sectors, intellectual property protections in China will be more strictly enforced and China will even amend how its “Made in China 2025” industrial policy is implemented to assuage US concerns. In return, the US will not go ahead with broader tariff increases that would have damaged China’s trade position.

There are still a few contentious issues that have to be settled before an agreement is finalised and they could cause difficulties. For instance, the US is demanding foolproof mechanisms to verify and enforce commitments made by China on issues related to American complaints of Chinese intellectual property theft and forced technological transfers. But the Chinese side seems keen to secure a quick settlement, probably because — as the recent data on manufacturing and exports shows — the Chinese economy is rapidly losing momentum and needs a confidence boost. So, expect a broad agreement to be reached during Liu’s visit, one which will then be finalised in time to prevent the further tariff raises that US President Donald Trump had threatened by March 1.

…but the troubles will not end there

So, why are we still concerned? Basically, we think that the strategic competition between the US and China will continue to heat up and China’s leaders may need to make up for their concessions on trade by tough action in other areas so as to placate their home base. The US is stepping up its “freedom of navigation” operations in the South China Sea that are meant to resist China’s occupation of territories in that area. After a recent such operation, China accused the US of trespassing in its territorial waters. A senior Chinese military officer threatened to “sink two carriers” to force the US to back away.

Chinese authorities are also likely to blame the US for the recent proliferation of US allies that are now accusing China of intelligence activities and of being a security threat. Poland, for example, has just arrested a Chinese Huawei executive and a Polish citizen on suspicion of espionage, while Norway has joined the US and UK in considering a ban on Huawei participating in constructing the country’s 5G network. In the Czech Republic, a Czech intelligence official publicly warned against the use of Huawei and ZTE products in telecommunications infrastructure. Even in Germany, which has been careful not to annoy China, one of its biggest export markets, the leading industry association, BDI, has spoken to the European Union about the need for a tougher policy towards China.

But it is in Taiwan where there might be a real flash point. In his New Year message, Chinese President Xi Jinping reiterated his ambition to reunite Taiwan with the mainland. China is upset about the passage of new legislation in the US, the Asia Reassurance Initiative Act that some Chinese observers interpret as laying the basis for greater strategic support for Taiwan by the US. The Act requires the US administration to sell arms to Taiwan as a measure commensurate with the growing military threat from China, as well as to encourage the travel of high-level Taiwan officials to the US, another sensitive point for the Chinese. We believe that Xi might choose to step up actions against Taiwan in order to show his people that concessions on trade does not mean that he is getting soft on the US.

Chinese policy stimulus turns more aggressive — but at what cost?

A slew of recent data leaves us with little doubt that the Chinese economy is more fragile than we thought. Auto sales fell for the first time in more than 20 years last year, down 6% y-o-y. Consumers seem to be deferring purchases of big-ticket items, a sign of declining confidence in the future. The reasons for the diminished confidence can be found in the weakening economy — exports fell in December while the plunge in imports was even more pronounced, again suggesting a sagging domestic economy. Surveys of purchasing managers suggest that manufacturing was stagnant.

China’s policymakers seem to have been unnerved by the parlous state of the economy. In the past few days, all the major economic agencies from the Finance Ministry to the central bank to the planning agency have all issued statements vowing concerted action to boost the economy. Credit will be eased, but in a targeted manner to avoid a dangerous build-up of debt. New railway projects to the tune of US$125 billion ($170 billion), or 1% of China’s GDP, have been approved by China since early December. Small firms will receive considerably more help as well. The authorities have announced US$29 billion worth of tax cuts for small firms each year over the next three years. A senior official in the planning agency has also promised policies to support consumption of goods such as automobiles and home appliances.

So, China is going to pull out all the stops to support economic growth. But a return to the old playbook of infrastructure binges and credit flows carries serious risks for China.

•             First, it means that corrective measures undertaken since 2017 to reduce debt in the system will now take a backseat. We could well see yet again another build-up of financial imbalances within the Chinese economy, setting up China to face more financial stresses in the future.

•             Second, as infrastructure spending by local governments will be mostly financed by debt, more provinces and cities could become ensnared in debt traps, especially as there are doubts about the financial viability of many infrastructure projects.

•             Third, in 2018, China’s current account balance turned into a deficit for the first time in decades. As policies ramp up investment, this current account deficit (which is essentially the difference between investment and savings) will grow. That could result in more pressure on the Chinese renminbi, which could then knock back onto other Asian currencies.

Has the market read too much into the Fed’s dovish turn?

Now, let’s turn to the US. The consistent message from the Fed’s senior officials since the beginning of the year has been that the Fed has shifted away from a policy of steady increases in its policy rate to a more cautious one of raising rates only when the flow of economic data persuades them that it is safe to do so.

The Fed does have good reasons for turning cautious. Purchasing manager surveys of both manufacturing and services have shown economic activity decelerating modestly, while inflation readings have remained well below the levels that would spark concern. The ongoing government shutdown, now the longest in history, could also last long enough to make a dent in the economy. Finally, by the end of the year, the effects of Trump’s tax cuts and raised government spending will fade and, without a new growth engine, the economy could weaken.

All this makes sense — but only up to a point.

First, the lead indicators convincingly suggest that the economy will continue to grow above its potential level through most of this year. What this means is that unemployment will continue falling and capacity utilisation in the economy will further intensify. Both these trends will eventually lead to higher wages and rising prices, which means that inflation is more of a risk than markets have priced in. Indeed, the “underlying inflation gauge” used by the Fed does show a steady rise to above 3%. Second, as wages rise, household spending power will gain strength and help to offset the dissipation of the fiscal stimulus, thus keeping the US’ growth at a vibrant pace. We believe that the Fed will raise rates and reduce the size of its balance sheet by more than what markets think. When investors finally realise that, they will once again become risk averse and shift funds out of asset classes considered risky such as emerging markets — and that will lead to a replay of what we saw last year with big corrections in Asian emerging markets.

In the near future, the markets will have reasons to cheer. The US-China trade deal that we foresee will reduce uncertainty, while aggressive Chinese stimulus measures will bolster Chinese demand and provide some support for the prices of cyclically sensitive commodities such as oil, base metals and natural rubber — all good news for Asia. But beyond this short-term respite, there are many reasons to remain wary.

•             The strategic competition between the US and China will heat up. We would not be surprised to see the US administration bringing more pressure on Asian countries to support its campaign to limit China’s inroads in sensitive areas. The US could, for example, demand that Asian countries refuse to incorporate Chinese technology into their telecommunications networks, failing which those countries could face restrictions on the use of US technology or find restricted access to US markets. Taiwan could also become a point of contention.

•             While China’s policymakers are likely to succeed in supporting growth, it will come at the price of financial and other imbalances.

•             And, finally, the markets have been too quick to price in a quiescent Fed, setting themselves up for a rude shock later.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

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