Make Global Trade War In 2017 Your Base Case Scenario

Business, China, Company Strategy, Economics, Fibre Intermediates

PTA2September19

By John Richardson

WE are trapped in a cycle of economic policymaking failure that has already led to a retreat in global free trade. What happens next could well be a global trade war as soon as next year.

The computer models built by the US Federal Reserve said that there was no systemic risk from the rise in US house prices and the lending and debt securitisation practises linked to this bubble.

The resulting Global Financial Crisis (GFC) put China’s government in an almost existential bind. It faced the choice of either launching major economic stimulus or accepting tens of millions of jobs losses that would have caused major social and political unrest.

China’s choice was to launch the huge 2009-2013 economic stimulus programme that has left behind severe oversupply in many manufacturing sectors – including in some chemicals, iron and steel, cement and aluminium.

When people in the West complain about “distorting government subsidies for Chinese manufacturing” they should give some thought to this essential historical context.

They should also reflect on what the world would have looked like if China’s government had done nothing. The social, political and economic problems confronting China could well have been an even worse outcome than today’s global manufacturing imbalances.

Policymaking failures continue: Western central bankers and politicians in general seem reluctant to even consider the reality that demographics drive demand.

Until or unless they recognise that ageing populations are a challenge that needs to be addressed, we will continue to go absolutely nowhere. US real economic growth will remain anaemic. European growth will remain similarly historically very weak. And more and more people will support populist politicians who propose solutions that threaten geopolitical stability.

So my base case – and not my downside scenario – is that global free trade will continue to decline to the point where we end up in a global trade war. When could such a trade war begin? 2017 seems logical. Here are my arguments for this:

  • June’s Brexit vote reflected the mistrust of the “experts” who had failed to diagnose and then treat economic discontent.  Those who supported Brexit find themselves struggling to “square the circle” – replacing Britain’s access to the single European single market of 500m people with alternative bi –and multi-lateral trade deals that fully replace a loss of access to this single market. They could be successful – and you may argue that all that is needed is time, and that three months after the Brexit vote is not enough time to form a fair judgement. But in my view the signs so far offer little cause for long-term optimism.
  • The European Commission has submitted the proposed Canada-EU free trade agreement to national parliaments for ratification. “This was an acknowledgment of the new political reality,” writes Simon Nixon, the Wall Street Journal’s Chief European Commentary. He adds: “Under the EU treaties, trade is an exclusive European competence and deals require ratification only by EU institutions, but in practice, everything to do with trade is now perceived to touch on national sovereignty and so national consent has become politically essential”.
  • World export volumes reached a plateau at the start of January 2015. The same finding holds if instead import volumes or total volume data are measured, according to a July Global Trade Alert report. “Except during global recessions, a plateau lasting 15 months is practically unheard of since the Berlin Wall fell,” the report adds. There were 50% more trade protection measures in 2015 compared with 2014, says the same report.
  • I wrote in early August: “No matter which candidate wins [the US presidential election], the political climate in the US suggests that further trade liberalisation will be difficult”. Both candidates have taken positions against the US-led Trans-Pacific Partnership – a proposed 12-country trade deal. No matter what the outcome of the election, it seems prudent to consider the US growing considerably colder on existing free-trade arrangements.

 

The Trigger For A Trade War

Two weeks ago I discussed one possible trigger for a global trade war – a sharp fall in the value of the Yuan purely as a result of market forces. But this could end up being interpreted as currency manipulation by China.

A more immediate threat is that Europe has until 11 December to decide how to respond to the expiry of special rules on Chinese exports. The rules were applied for a 15-year period after China joined the World Trade Organization in 2001.

At the moment, manufacturers in the West find it relatively easy to win anti-dumping and other trade protection measures against Chinese imports because the special rules mean that China is not classified as a “market economy”.

So a concern is that if this status is granted, there will be a further increase in low-cost imports because of Chinese manufacturing oversupply resulting from its huge post-GFC economic stimulus package.

Why is the market economy issue so important?

China is classified as a “non-market” economy by many trading partners because of the difficulty of assessing production costs due to purported government intervention in the economy. A petition filed against a Chinese company involves looking at the costs of a similar producer in a market economy with a comparable level of economic development – usually India.

If market economy status happens, it will become much harder to prove an anti-dumping case because 0f China’s low production costs. China has tremendous supply-chain efficiencies. And despite the rise in labour costs over the last five or so years, China’s labour costs are still low compared with the West.

Processing petitions could also take longer because of what foreign competitors say is the difficulty in getting financial information from Chinese companies.

But as Simon Nash again writes, failure to grant China market economy status would undermine faith in the international rules-based trading system.

The European Commission is trying to broker a compromise whereby EU trade protection rules would be strengthened without discriminating against China.

But here’s the thing: In July, the US government said China had not done enough for it to be granted market economy status.

“There is little doubt that China’s market reforms have fallen short of the expectations that were held by many members when China joined the WTO,” said US trade diplomat Chris Wilson.

“This is particularly evident in the steel and aluminium industries where China’s pervasive interventions have led to a significant overcapacity of global supply that is threatening the viability of competitive firms in these industries around the world,” he added.

We have come in full circle here. As I said, I see this overcapacity as being the result of the failure of Western policymakers to foresee and so prevent the GFC. They are compounding their error because of their failure to deal with the retirement of the Babyboomers.

In contrast, China’s leaders have long realised and responded to the fact that demographics drive demand. Their economic reforms are built around efforts to escape a “middle-income trap” resulting from a decline in the working-age population. They have also owned-up to the shortcomings of previous policy decisions.

The US political mood suggests to me that there is a good chance that China will not win market economy status in December.

China is today caught in another bind. As it pushes ahead with its reforms, millions of jobs will be lost as manufacturing capacity closes down. The pace of these closures has to, though, be very carefully calibrated in order to prevent GDP growth from suffering too-sharp a decline.

And China has no plans to shutter excess capacity where manufacturing plants have a.) Excellent economies of scale and b.) Are in industrial sectors that are a good fit with the new economic growth model – i.e. they can add long term value to the economy.

This, I believe, applies to some chemicals and polymers – including purified terephtthalic acid (PTA) and polyvinyl chloride (PVC).

A decision not to grant China market economy status could thus push China into a corner and result in a global trade war.

 

Scenarios for PTA and PVC

The charts at the beginning of this blog post show the changes in PTA and PVC trade flows in and out of China since 2009. Several of other chemicals and polymers have seen similarly dramatic shifts.

If China is granted “market economy” status it has the potential to push operating rates higher at its PTA and PVC plants in order to raise exports.

In 2017, ICIS Consulting estimates that PTA local capacity will total 52m tonnes/year versus just 33m tonnes of domestic consumption.

It must be stressed, however, that China’s PTA producers remain very short of paraxylene (PX) feedstock – and where they can source PX it often has to be imported. This weakens cost-per-tonne economics.

PVC is different as most of China’s PVC is made via the carbide or acetylene process, where coal is the starting-point feedstock. China has abundant local supplies of coal, and so coal in China is very cheap.

China will have 34m tonnes/year of PVC capacity in 2015 compared with 17m tonnes of consumption.

What if, though, China doesn’t win market economy status? Then clearly, of course, it will find it difficult to further boost exports to WTO-member countries.

It might instead, though, double down on its strategy of improving mutually beneficial investment and trade flows between itself and countries and regions that have signed-up to its One Belt, One Road initiative.

Greater PTA and PVC exports could thus be targeted at these countries and regions. This might mean that the net effect on global PTA and PVC trade balances will be the same as if China were to be granted market economy status.

Meanwhile, of course, if a global trade war does happen the broader risk to the global chemicals industry is all too obvious. Such a war would challenge the business models of producers heavily dependent on exports who find themselves in the wrong locations.

These type of New Normal risks are nothing short of frightening, which makes them uncomfortable and difficult to think about. When something is uncomfortable and difficult to discuss and plan for, it can quite often be simply ignored.

The right response is to instead accept risks such as a global trade war as too pressing and real to be ignored. They must be built into your short-term contingency planning.

The next step is to change your strategic direction in order to guarantee prosperity in a post-Economic Supercycle world. The way forward is to more actively manage, or create, new chemicals demand by addressing the world’s “basic needs”.

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