Here's Why Trump Is Hiking Chinese Tariffs To 25%

One of the cited reasons behind today's market slide which started in Asia and promptly swept the rest of the globe, is a belated appreciation of Tuesday's news that the Trump administration is now considering more than doubling proposed tariffs on a further $200 billion worth of Chinese goods to 25%, up from an original 10%.

But what exactly prompted Trump to push for the sharp reset in Chinese tariffs?

The answer was actually first given by Trump himself three weeks ago, when in a candid CNBC interview the president said that he was not only watching the US trade deficit with China, but also its currency, which was "dropping like a rock", suggesting that trade war was morphing into currency war after he berated the Fed for hiking rates and pushing the dollar higher (when, as we explain below, Trump should be commending Powell for doing just that).

Fast forward to today, when the WSJ gives some further color, noting that while "the administration didn’t spell out a particular rationale for increasing the tariff.... the reasons include anger over the Chinese government’s failure to approve the merger of U.S.-based Qualcomm Inc. and Dutch chip maker NXP Semiconductors, which forced the companies to scrap a deal aimed at boosting Qualcomm’s reach into new markets."

The WSJ also cites "industry officials who have discussed the move with the White House" and who said that another, perhaps far more important reason for the tariff increase "is to compensate for the decline in the value of the yuan by about 6% over the past two months."

“It’s important countries refrain from devaluing currencies for competitive purposes,” a senior administration official said, and although he didn’t accuse China of acting in that fashion, the implication was clear.

Yet another reason that forced Trump's hand is that as several banks have recently pointed out, the Yuan devaluation to date has effectively offset the adverse impact to Beijing from the $34 billion in tariffs enacted on Chinese goods, mainly machinery and components (to which China retaliated with tariffs on the same amount of U.S. exports, especially farm products).

But whatever the reason, the longer the trade war continues, the more Trump will find himself in a bind: on one hand he wants lower rates and a weaker dollar, on the other he keeps escalating by enacting ever bigger (and higher) tariffs on China, which are sure to prompt a broad inflationary response in the US economy requiring even higher rates, as we discussed previously. Here is the WSJ:

The proposed tariff increase poses big risks for both the U.S. and global economy. A 25% tariff would boost the cost of a range of U.S. imports at a time when inflation has begun to pick up. It would become another factor for the Federal Reserve to consider as it decides how quickly to raise interest rates.

“This gets you nothing,” said Fred Bergsten, founder of the Peterson Institute for International Economics, a Washington, D.C., free-trade think tank. “It adds to inflation pressure and interest rates and [would] strengthen the dollar, which makes trade situation even worse” for the U.S., he said.

Worse, not only are US farmers getting crushed by Trump's tariffs, but domestic companies are starting to feel the burn:

Keith Weinberger, chief executive of Empire Today, a flooring company in Northlake, Ill., said he “might be able to offset” a 10% tariff on his purchases of Chinese vinyl flooring. “But there’s nothing you can do about 25.”

Meanwhile, in corporate America, it appears that there is just one thing executives are talking about: tariffs.

As for China's response, there are two angles: what it says, what it does and what it could do.

Starting with the latter, and continuing the tit-for-tat retaliation in the trade/currency war, higher-than-anticipated tariffs will encourage Beijing to let the yuan slide even more, exacerbating the currency war and potentially making Trump dictate monetary policy to the Fed.

In fact, China can keep devaluing the Yuan until its capital controls "firewall" finally cracks: recall that this was the trigger that prompted a global bear market (from which the US was spared) in 2015/2016 when China lost a total of $1 trillion in reserves to defend its current against an onslaught of capital flight.

Then there is what China says and on Thursday, Beijing urged the United States to "calm down" and return to reason after news that Trump may hike the tariffs from 10% to 25%.

Wang Yi, the Chinese government’s top diplomat, said U.S. efforts to pressure China would be in vain, urging its trade policymakers to “calm down”.

"We hope that those directly involved in the United States’ trade policies can calm down, carefully listen to the voices of U.S. consumers...and hear the collective call of the international community,” Wang, a member of the country’s state council, or cabinet, said in Singapore. "The United States’ method of adding pressure will not, I’m afraid, have any effect," Wang told reporters on the sidelines of a regional forum.

Finally, when it comes to what China does, look no further than the Yuan, whose sharp devaluation started in mid-June, when Trump formally launched the trade war, announcing that new tariffs on $50BN in Chinese products will come into effect, followed just days later with the launch of the next, $200BN round of tariffs.

This is how China has responded so far.

And with the Yuan hitting the lowest level against the dollar in a year overnight, the ball is now in Trump's court. Any further escalation will only accelerate the Yuan devaluation, strengthen the dollar, and - eventually - breach China's capital control firewall at which point 2018 will finally become 2015 all over again.

And the biggest irony: it Trump really wants to defeat China, instead of criticizing the Fed for hiking, he has to encourage Powell to do precisely what he has been doing so far, as Eric Peters explained over the weekend:

"The best way to bring Beijing to its knees is by running a tight monetary policy in the US. China has the world’s most overleveraged, fragile financial system.” In 2008, China’s total debt-to-GDP was 140%. It is now roughly 300%, while GDP is slowing.

The economy is held together by capital controls. If those fail, the whole system fails.” The capital flight in 2015/16 cost the government $1trln in reserves, and that was with ultra-dove Yellen in charge. Imagine what would have happened with Volcker at the helm. “The Chinese are dying to get their money out.”

All Trump has to do, is help them do it and watch as China's economy crumbles from the inside.