What Is Really Going On Behind The Scenes: The Donaldtov-Xibbentrop Pact

Submitted by Michael Every of Rabobank

“I am pleased to report that the U.S. has made substantial progress in our trade talks with China on important structural issues including intellectual property protection, technology transfer, agriculture, services, currency, and many other issues. As a result of these very productive talks, I will be delaying the U.S. increase in tariffs now scheduled for March 1. Assuming both sides make additional progress, we will be planning a Summit for President Xi and myself, at Mar-a-Lago, to conclude an agreement. A very good weekend for U.S. & China!”

With those words from US President Trump, is the trade war over? Nothing is signed yet; US tariffs aren’t coming down, just not going up; we don’t have any details; and any real deal will be impossible for China to stick to. Apart from that, everything is fine! We’ve also previously pointed out USD1.2 trillion of new Chinese imports from the US is gibberish that will mean substituting others’ goods in defiance of WTO agreement, and that the currency stability pledge is also bogus. Even with capital controls, China can’t keep CNY stable as it inflates its money supply to the sky while its FX reserves stay static. The only way it can is to shut itself off from the world completely, or to open up completely to draw in foreign capital. Of course, today will be a day for selling USD and buying CNY and/or CNH. But what are the possible scenarios ahead longer term? Let’s plot them out at a low and high level:

1) Trump genuinely folds (Bloomberg is after all reporting he really wants a deal to support the stock market over objections from USTR China-hawk Lighthizer). As such, Trump agrees the “Mnu-China” deal to sell soy and gas - which China wants to buy anyway; to let Amex and MasterCard do business in China - which they are supposed to be able to do anyway; and for China to keep CNY from collapsing – which it wants anyway. Trump might even drop charges against the Huawei CFO. That deal would shatter Western solidarity vs. Beijing and wallop the WTO; there would be obstruction of justice issues over the Huawei CFO, as well as destroying the idea of the rule of law; and there would be pushback from the Pentagon and US intelligence agencies, which call China “a strategic rival” and an “ideological” opponent respectively. Trump would also be attacked by his Republican base and the Democrats for crumbling, and face potentially-awkward China trade testimony from Lighthizer in Congress this Wednesday. Where is the upside for Trump in doing this when the soy and gas deal was available a year ago?

2) Trump walks away. Tariffs rise to 25% on all Chinese goods. Huawei is banned from the US and prosecution of its CFO proceeds. Markets tank and CNY plummets. Trump takes a big hit on the US economy into the start of 2020 election season. China is furious and becomes aggressive on all fronts as its economy takes a further blow. Any takers for that scenario?

3) Trump and Xi sign a deal showing what China should be doing but isn’t. Beijing buys soy but doesn’t do anything else except keep CNY stable. Trump faces huge pressure from Republicans and Democrats not to backslide, but stresses trade war continues if China doesn’t stick to the deal. Of course, it suits Trump to keep pretending everything is OK into November 2020; and it suits Xi too as he struggles to avoid his own economy imploding. Yet after the November 2020 US election, all bets are off if Trump wins. Indeed, if Trump doesn’t want to start a trade war because markets will sell off, what will he do when markets are selling off anyway? When China does eventually have to let CNY collapse, the US will respond with massively higher tariffs, meaning China cannot export its way out of over-supply, and things will get very bad very quickly. In short, despite talk of friendship and partnership and trade, both sides will use the 21-month period to prepare for the next, more serious round of economic/political conflict. As such, this proposed trade deal sounds like the Nasty-Soviet, or Donaldtov-Xibbentrop Pact. The Nazi-Soviet Pact of 1939 saw Berlin and Moscow agree they both hated the liberal world order more than each other, and the Soviets sell goods including oil, gas, and trans-shipments of soy(!) to resource-short Germany in exchange for low-cost loans and technology. 22-months later, Operation Barbarossa showed what the real game being played was.

Let me be clear: I’m not predicting war. But from a higher level view there is also a spectrum of US-China relation: war/enemies at one end and friends/integrated economies at the other. For decades, the US approach was to encourage China to shift towards the far end of that spectrum. There is now close to US consensus this approach has failed. This trade deal will be the last chance for Beijing to show it can move in the direction the US wants. However, China can’t do as its economy can’t allow it to. Note three recent stories on that front: The South China Morning Post - “The Coming Collapse of China’s Ponzi Scheme Economy”, the New York Times - “China’s Entrepreneurs are Wary of Its Future”, and Bloomberg - “China Deleveraging is Dead as $34 Trillion Debt Habit Roars Back”. That leaves the US with a dilemma. They don’t want war but they can’t get the China they need for economic coexistence. That means divorce and division of the world into spheres of interest (who is going to be the Poland in this Pact?) - which will hurt both sides a lot; or outright US containment of China - which will hurt just as much and risks infuriating China.

In short, in any scenario at some point there is serious pain ahead.

So crack open the Soviet champagne to a Donaldtov-Xibbentrop Pact; but save the good stuff to cheer yourself up on far darker days certain to come. See why central banks are muttering about more QE and negative rates, and one Fed speaker Friday even discussed capping bond yields as a possible new policy tool, as in Japan? They too are can-kicking and steeling themselves for the worst as they realise that very worrying scenarios lie ahead; even Brexit is now potentially being delayed until 2021, it seems to avoid pain now (in which case, that’s a further swathe of angry populists sitting in the EU parliament for sure); but will the EU be in a better position in 2021?!