America First? China Is Dominating Global Technology


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Governance woes behind US trade war


 

Illustration: Peter C. Espina/GT

For now, there is still no end in sight to the brewing trade war between the world’s two economic heavy hitters. Ignoring voices of objection at home, the Donald Trump administration announced that the second tranche of tariffs on $16 billion in Chinese goods will take effect later this month. Though Trump has yet to fulfill his campaign promise to levy a 45-percent tax on Chinese goods, his logic on trade policy refuses to change.

The reason why the US has provoked and intensified the trade war lies in the incapacity of the global system. Specifically, division of labor in the globalized era has led to the exodus of the US manufacturing industry out of the country. Meanwhile, the US claims that China’s “predatory” economy has developed itself into the biggest beneficiary in the system.

That’s why the Trump administration insists on attacking China’s “stealing” practice in the name of “safeguarding US national interests,” regardless of the cost of torpedoing the existing international order.

The robust stock market and economic growth of the US as well as the decline in unemployment have further boosted Trump’s confidence in escalating the trade war. His trade policy has gained more acceptance among Americans. However, the logic behind his trade war can hardly hold water.

The era of globalization has been an inevitable development of human society. As people in the global village are more interconnected, trans-regional flow of finance, technology, information, service and talent has re-optimized global production resources, inspiring the development of countries and regions.

The unprecedented development of productivity and international division of labor has prompted developed countries which boast capital and technology advantages to transfer their low-end industries to other countries where labor and land costs are relatively low. Then a great many multinationals have mushroomed, which has objectively precipitated the growth of developing countries.

Economic liberalism has become a paragon of democracy with which developed nations dwell upon with relish. It’s also an important pillar for the postwar international order. When developed countries sat on the top of the industrial chain to reap benefits, they never complained about the unfairness of the system but instead became its most powerful defender.

Ironically, the US – the founder of the global system – has now become its most proactive opponent. The Trump administration attacks the “unfair” global system and views China as being complicit in bringing about the fall of the US manufacturing industry and loss of jobs. Such rhetoric has led people to believe that the stature of the US has fallen to a third world country’s.

Globalization is not without problem. Apple is a paradigm of a globalized industrial chain, but it’s not a nice story. Developing countries at the low end of the industrial chain can only get disproportionally meager profits while lucrative gains flow to developed nations. In this way, the US deficit is far less than the book figures.

More severely, low-end manufacturing has worsened the environment, putting the health of the public in jeopardy. But the US-led developed world just passed the buck.

Emerging economies like China are resigned to be just a factory of developed countries, so they work hard to develop hi-tech and produce high-value-added products to create a level-playing field with developed countries. This is the law of market economy, which, however, has become a threat to its national security and an enemy of its economy in the view of the US.

The strange logic can hardly justify itself.

Denying others a share of the spoils is not the essence of the era of globalization. If developed countries think there’s something wrong with the global system, they can appeal to international organizations to carry out reform, instead of resorting to short-sighted practices like threatening with tariffs.

Trump’s trade war actually stems from domestic conundrums notably industrial hollowing-out and loss of everyday jobs. The problems are not a result of globalization but of domestic mismanagement. It seems that forcing jobs back home will create jobs, but it can’t last long because it will fail to stimulate the fundamental driving force of industrial development. If Trump can make more efforts at boosting the real economy instead of waging a trade war, he may get closer to “Make America Great Again.”

Credit: By Zhang Tengjun Source:Global Times Published: 2018/8/15
The author is an assistant research fellow at the China Institute of International Studies. opinion@globaltimes.com.cn

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Coming recession in 2020? Possibly earlier


Negative rates: Pedestrians walking past the Bank of Japan (BoJ) headquarters in Tokyo. BoJ’s goal remains
at keeping real interest rates as negative as possible, as long as the economy performs. — Bloomberg

IT’S mid-term review time as the US yield curve begins to flatten.

This curve tracks the relationship between interest rates of US government debt obligations. Normally the yield curve is rising, with long-term bonds having yields higher than short-term obligations.

But occasionally the curve inverts, with long bonds yielding less than short Treasury bills – a historical predictor of future recessions and bear markets in stocks. Recently, the curve has become noticeably flatter, with short rates rising and longer yields remaining stagnant. This has led many analysts to think that the yield curve will soon invert.

But that does not mean a recession is imminent. Just returned from an extended visit back to Harvard. Touched base with my mentors and professors at both extremes of the economic spectrum. They are all split on what this flattening really means. In the event it does invert (the gap today being below 0.3%), recession has almost always (over the past 50 years) followed within a year or so. But few see a recession soon on the horizon.

The first half has come and gone. The ongoing transition to more normal conditions continue in the context of a robust US economy; continued progress in the orderly normalisation of US monetary policy; and re-awakened sensitivities to geopolitical and protectionist risks.

There will be higher interest rates, some inflation concerns and trade tariffs coming-on in the context of markets more readily accepting two to three more rate hikes by the Fed in 2018. The prospect of a global trade war makes everyone very cautious.

Once we start down the road of tariff increases and threats of more to come, the dangers of retaliatory miscalculations are real and very scary. Still even an inverted yield curve should not be on top of our worry list under today’s accommodative monetary conditions.

Synchronised pick-up

The world economy benefitted from four drivers of higher growth: the healing process in Europe, re-bound from slowdowns in Brazil, India and Russia; soft landing in China; and pro-growth measures in US.

To persist, Europe needs to do much more. Also, there is hope that recent tariff tensions would eventually lead to fairer and still-free trade which recognises the inter-dependent nature of global supply chains, and show greater willingness to protect intellectual property rights, modernize trade arrangements and reduce non-tariff barriers. Yes, more rate hikes from the Fed are still on the cards. But the same by the European Central Bank (ECB) and Bank of Japan (BOJ) demand trickier manoeuvring.

This is an area that warrants close monitoring since volatility will likely persist. At least for now, fears of Japan-like deflation in US and Europe are effectively gone. But OECD is worried global growth is not yet self-sustaining. It’s strength in 2018 is largely due to monetary and fiscal policy support – and lacking in rising productivity gains and sweeping structural reforms. In Europe, the “clock is ticking”; without reforms, more populist uprisings will appear as the upswing ages and then fades. US inflation is not only returning to the Fed’s 2% target, but also likely to exceed it. In Europe, consumer prices were last still lower than a year ago – below the ECB’s target of just below 2%. Fear of the spectre of deflation has led BOJ to remain cautious about tapering its monetary easing program. Will just have to wait and see.

IMF warns that the world’s US$164 trillion debt pile (at 225% of GDP) is bigger than at the height of the financial crisis a decade ago. One-half was accounted for by US, Japan and China. What’s needed is for US fiscal policy to be recalibrated to bring down the government debt to GDP ratio (80%) and for China to deleverage its US$ 2.6 trillion private debt. There is no sign either is being done which runs the risk of triggering yet another financial crisis.

Growth will falter

Growth in US can slow considerably when the boosts from last year’s tax-cuts in US fades in 2019 and 2020. IMF now warns that US will grow at about one-half the 3% annual pace forecast by the White House over the next 5 years, reflecting the effects of growing massive fiscal deficit and continuing trade imbalance. For US, sluggish productivity remains a key determinant. In 2Q18, GDP picked-up to rise 4.1% (2.2% in 1Q18) the fastest pace in nearly four years, reflecting broad-based momentum.

But worker productivity advanced 1.3% from a year earlier, consistent with the sluggish 1.2% average annual rate in 2007-2017, well below the better than 2% annual average since WWII. Spending by consumers, businesses and government as well as surging exports all appeared solid in 2Q18. The expansion enters its 10th year this month, building on what is already the second longest expansion on record. Faster growth which has helped to drive the unemployment rate to its lowest level in 18 years, fueled quick corporate profit growth.

Median estimates place GDP growth at 2.8% in 2018, 2.4% in 2019 and 1.8% over the long run. But everyone has growth slowing next year because of falling business and consumer sentiment, reflecting trade disputes with China and many US allies, and uncertainty whether rising business investment is sustainable.

The big concern is the economy overheating – already, it is bumping up against capacity constraints as labour markets tighten. Still, the consensus is that the next downturn will not arrive until 2020. Most economists expect 3% inflation over the next year. What worries me most is the deteriorating global political and strategic environment.

Not so much the economic outlook directly. The world is changing too much, too fast.

So much so, the geopolitical situation is getting worse – open warfare between Israel and Iran, the disgraceful state of Palestine, and uncertainties surrounding Donald Trump and Vladimir Putin, and lack of leadership in Europe. Trade barriers are causing much anxiety. It is as though what’s put in place since WWII isn’t worth a damn anymore.


Europe and Japan

Latest indications from the Brookings-FT Index for Global Economic Recovery (Tiger) show global growth has peaked and momentum has started to fade. Indeed, financial markets are already reflecting mounting vulnerabilities. With weak economic data in 1H’18, Europe and Japan have since cooled. In late 2017, eurozone was still growing at 3.5%: Germany at 4%, France 3%, Italy 2% and Spain 3.5%. But activity slackened to only 1.2% in early April; even Germany recorded a sharp dip – down to only 1%, reflecting waning monetary easing effects and supply-side constraints. The outlook is for a strong above trend upswing for the rest of the year. OECD now expects GDP growth in 2018 to be 2.2% (2.6% in 2017) and in 2019, 2.1%.

For eurozone, the window for reforms is closing – ranging from the implementation of dual currencies for its members to putting European Parliament in charge of economic policy, including the euro-budget. Japanese GDP shrank 0.1% in 1Q18 despite a rise in capital investment. Household spending unexpectedly fell. Still, recovery is expected to be driven by a weak yen brought about by monetary stimulus (BoJ has been buying assets at US$740 billion a year to drive down long-term interest rates). But underlying inflation is stuck at 0.5%. BoJ’s goal remains at keeping real interest rates (after inflation) as negative as possible, as long as the economy performs. OECD forecasts growth in Japan to be 1.2% in 2018 (1.7% in 2017); the same in 2019.

China and BRICS

Many emerging markets (EMs) are still enjoying momentum from 2017, but there is growing concern about rising debt and vulnerabilities to capital flight as interest rates in US rise. For those recently emerged from recession, viz. Russia, Brazil and South Africa, their urge to return to strong levels of activity remains sluggish.

China and India have fewer concerns for their immediate outlook. Still, they need to reform their economies to help raise living standards to catch up. The main challenges will be to execute particular reforms – not just to the financial system but also to SOEs and local governments, including getting rid of corruption.

China’s GDP rose 6.7% in 2Q’18, the slowest pace since 2016. Retail sales held up rather well as did exports. Still, measures to curb rampant borrowing are biting – investments in infrastructure and manufacturing by SOEs and local governments have since slackened. These efforts, in the midst of headwinds from abroad (especially protectionist tariffs), have led to downgrades in growth for the rest of the year. IMF now forecasts GDP growth in China to average 6.5% in 2018 (6.8% in 2017) and about the same in 2019.

Recent depreciation of China’s currency, the yuan, exposes crucial vulnerabilities within the world’s second-largest economy as it faces escalating trade tensions with the US. The currency posted its biggest ever monthly fall against US$ in June (3.4%) and has since lost more ground. This slide marks a departure for the currency often regarded as an anchor of stability for Asia and other EMs.

As Beijing assesses the options, it finds itself between a rock and a hard place because (i) People’s Bank of China (PBoC) intervention means selling its US dollar stash of reserves – which stood at US$3.11 trillion in June; (ii) it could instead raise domestic interest rates, thereby making the currency more attractive which might help to shore up the yuan. But it also risks weakening an already slowing Chinese economy just as the trans-Pacific trade war starts to bite; and (iii) it could impose stricter controls on China’s capital account which will likely spook overseas funds that have rushed into China’s domestic bond and equity markets this year at an unprecedented rate.

However, to internationalise the yuan, China has to keep fund flows relatively unencumbered. The PBoC has sensibly pledged to keep the RMB “generally stable.” In July, China implemented a mix of tax cuts and greater infrastructure spending citing growing uncertainties, as it ramps up efforts to stimulate demand to counteract a weakening economy.

As for India, I wrote extensively on what’s happening there (my July 2018 column: “India: Chugging Along but Needs More Firepower” refers).

What then are we to do

As I see it, China and China-India centred Asia is now the heart of the world economy. Their steady growth has been a source of stability in an otherwise unsteady world.

Of late, developments in China received more scrutiny than usual because of the context: Chinese stock market has since fallen into bear territory, and a growing trade dispute with the world’s largest economy, US. Despite China’s astonishingly sustained expansion, the economy is widely considered vulnerable because growth in output has been underwritten by an even faster increase in debt.

The nation’s gross debt – both public and private – is now estimated at over 250% of GDP. The worry is not just the volume of debt but its quality. China’s domestic policies encourage high savings.

Those savings, held in banks, have been funneled to companies, especially SOEs. The credit quality of the loans is hard to assess but is likely to be uneven. China has since begun to slowly tighten the credit taps, with even tighter rules on shadow banking and more scrutiny for both local government financing and public-private investment projects.

At the same time, a sharp increase in the number of defaults by corporate issuers has revived anxieties about Chinese debt. In my view, it is the tighter credit conditions and defaults, rather than worries about a trade war, that best explain the recent 22% decline in the Shanghai Composite index from its January highs.

Tightening credit policy is also a compelling explanation for the weak macro-economics. Credit growth fell, and growth in fixed investment followed. This appears to be having some effect on consumer sentiment as well.

No doubt, Trump’s tariffs on US$50bil of Chinese imports (and threatens US$200bil more) will have a direct (but unlikely to be catastrophic) impact on growth. But China is now an investment-led rather than an export-led economy.

Still, it is the knock-on effects that are most feared. If the escalation of hostilities leads to a reduction in foreign direct investment in China, the long-term impact could be significant. True, China may be facing a delicate moment economically.

But given China’s deepening role in the world economy, any pain that the US manages to inflict on it would be quickly shared with the US and the broader world – at a moment when Europe’s economy is slowing, and many EMs looking unstable.

On the whole, China’s economy will remain strong and resilient. Whatever happens, I think this won’t change the Chinese situation much.


By Lin See-yan – what are we to do?

Former banker Tan Sri Lin See-Yan is the author of The Global Economy in  Turbulent Times (Wiley, 2015) and Turbulence in Trying Times (Pearson, 2017). Feedback is most welcome.

 

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Trade war’s twrist: US and EU gang up deal against developing countrries?


IN the past few days, there has been a new twist to the global trade war. The United States, which had threatened to impose a 25% additional tariff on European cars, made a deal with the European Union.

US President Donald Trump suspended the automobile tariff plan and may exempt the EU from the earlier US tariffs on aluminium and steel.

In exchange, the EU countries will buy more soybean and energy products from the US, and the two giants will work to eliminate tariffs and subsidies in all industrial pro­ducts traded between them.

Trump and European Commis­sion president Jean-Claude Juncker also agreed to work to reform the World Trade Organisation (WTO), and to tackle China’s market abuse, according to a Reuters report.
“If it holds, the US-EU pact could allow both to focus on China, whose economic rise threatens both,” added the report.

Trump’s economic advisor Larry Kudlow said that, “US and EU will be allied in the fight against China, which has broken the world trading system, in effect”.

Thus, the US-EU deal appears to be both good and bad news. Good because there is a cooling off on one front of the global trade war. Bad because the traditional Western allies may gang up to attack not only China but also the rest of the developing countries.

The US and EU may now jointly pressurise China on various issues. A bigger aim is to hinder China from its Made in China 2025 plan to upgrade its domestic industry in 10 high-tech areas including robotics, autonomous and electric cars, artificial intelligence, biotech and aviation. They do not want Chinese firms to emerge as world-class cham­pions that rival American and European companies.

The US, EU and Japan last December signed an understanding to jointly act against China on trade issues, including steel overcapacity, technology transfer, and the role of subsidies, state financing and state-owned enterprises.

Over the years, the EU has turned to some developing countries as potential allies when it has a conflict with the US but eventually it strikes a deal with the US and then the two Western powers unite and take aim at the developing countries.

This famously happened in the early 2001-2003, when the EU fought the US in the WTO over agriculture subsidies. Then they reached an understanding to protect their own subsidies while pressurising developing countries to open up their agricultural markets.

Today, developed countries continue to spend many hundreds of billions of dollars in subsidies, as well as maintain high tariffs, to keep their farms in business.

The US and EU also flood the world market with their artificially cheapened farm goods, while insisting that developing and poor countries open their markets through lower tariffs for both agricultural and industrial products. This hypocritical practice is at the heart of the imbalances and inequities of the world trading system.

Now, as part of their deal, the US and EU seem to want to continue maintaining double standards. They agreed to cut indus­trial tariffs and subsidies to zero, but to leave alone their agriculture tariffs and subsidies.

Moreover, they agreed to work on reforming the WTO, without spelling out what this means. At the WTO, the US and EU have recently moved to change the way the system has differentiated between developed and developing countries.

Recognising the weaknesses of developing countries, the WTO long ago adopted the principle of special and differential treatment (SDT) for developing countries.

Under this principle, in talks to cut tariffs, developed countries have to cut by a higher percentage than developing countries, and the least developed countries (LDCs) need not reduce tariffs at all. In various rules, developing countries and especially LDCs are mandated to take on less obligations.

However, the developed countries are now challenging the SDT principle.

“Developing and least-developed countries are facing the worst crisis yet at the WTO due to the sustained assault by the US along with the EU and Japan,” according Ravi Kanth in the Geneva-based South-North Development Monitor (SUNS) on July 4.

“Using Trump’s aggressive trade demands as a pretext, some major developed countries such as the EU and Japan have been attempting to deny the SDT flexibilities to deve­loping countries,” SUNS added, quoting a trade envoy from a major developing country.

“The entire system of the WTO is under threat following the Trump administration’s trade initiatives based on reciprocal market access as well as the attempt to foist plurilateral outcomes without multila­teral consensus, and intensified moves to undermine the SDT flexibilities by industrialised countries, particularly the EU.”

Meanwhile, the US actions of unilaterally raising tariffs on alumi­nium and steel, and on US$250bil (RM1 trillion) of Chinese products, violate the WTO’s main principles, threatening the creditability and viability of the organisation itself.

But Trump is not worried or sorry at all. At the beginning of July, he said: “The WTO has treated the United States very badly and I hope they change their ways. They have been treating us very badly for many years, many years and that’s why we were at a big disadvantage with the WTO.”

Said the SUNS article, “In short, the developing and least-developed countries face the prospect of their hard won SDT flexibilities being taken away once and for all to ensure the US stayed at the WTO.”

When the US and EU were locked in a big conflict over auto tariffs, the main enemy of the EU, China and other countries would have been the US.

Now the EU and US have agreed to “reform the WTO” as part of their bilateral deal. It is likely that such an initiative would attempt to reduce the rights of the developing countries, and even to entirely remove the principle of special treatment or even the status of “developing countries” in the WTO.

The trade war could thus have huge collateral damage. All the more reason for the developing countries’ political leaders to pay close attention to what is happening in the trade negotiating and policy­-making arena.

Global Trend by Martin Khor

Martin Khor is advisor of the Third World Network. The views expressed here are entirely his own.
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Benefits of Korean unification likely to be internal


Although there’s still uncertainty over prospects for peace on the Korean Peninsula, it seems that South Korea is highly optimistic about the economic aspect of its cooperation with North Korea.

North Korea has a population of about 25 million. The largest city, the capital of Pyongyang, has about 3.2 million people and other cities generally have populations of about 300,000. The country’s per capita GDP is a mere $530.

By comparison, with a population of 51 million, South Korea boosts per capita GDP of more than $27,500. But South Korea’s economic growth is believed to have peaked, and its export-oriented growth model has run into trade protectionism.

If the hypothesis of merging and unifying North and South Korea were true, South Korea’s population would increase by 50 percent. In light of this, although North Korea’s GDP is a negligible fraction of that of South Korea, there is a chance that South Korea could see a 50 percent rise in its GDP that now adds up to $1.4 trillion. With a GDP of more than $2.1 trillion, a unified Korea would have an economy half the size of Japan’s, or larger than the economies of Brazil, Italy or Canada.

South Korea’s economy is dominated by family-owned conglomerates known as chaebol, with the top 10 chaebol accounting for a hefty part of GDP. Economic growth is seen mainly benefitting big chaebol such as Samsung and Hyundai, which in theory would have the opportunity of maintaining a fairly high rate of wealth growth over the next 10 years.

An assessment of Asia’s economic future based upon the hypothesis of Korean unification indicates that it would be hard for Japan, China and even the US to derive any meaningful economic benefit from such an outcome.

North Korea’s abundant pool of cheap labor and its market eager to see wealth growth will mostly benefit South Korea. In the past, China used to host a certain number of North Korean workers, but that was during an era when North Korea was blockaded by the outside world and could only rely on China for foreign-currency earnings.

If Korean unification, or to be exact the two nations’ economic unification, becomes a reality, the situation will change. In this case, China or Japan will be just onlookers.

China might even find itself challenged by a unified Korea with lower costs in the world market. Japan might fare slightly better, considering its technological advantages and traditional partnerships with South Korean business groups. The benefits the US would get from unification would be limited or nil, taking into account uncertainties about its geopolitical interests.

For the world economy with total GDP of more than $70 trillion, Korean unification is likely to boost global growth by 1 percent. But much is still uncertain if this scenario is to play out.

North and South Korea still face tough obstacles including ideology, capital, nuclear weapons and internal political stability on the path toward genuine unification. The outcome also depends particularly on US political moves. Nevertheless, amid uncertainties there seems to be one certainty: The only way to avoid risk is to have the foresight to make future-proof plans.

By Chen Gong Source:Global Time

The author is the chief research fellow with Beijing-based private strategic think tank Anbound. bizopinion@globaltimes.com.cn

 

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China will impose 25 percent in tariffs on 659 US goods worth $50 billion, including soybeans, cars and seafood.

The move came as a tit-for-tat response to the tariffs announced by the Trump  administration Friday morning. An expert  said the US decision does not aim to tackle the trade deficit with China but to block the Chinese government’s efforts in high-tech development.

Tariffs on 545 US goods worth $34 billion will take effect on July 6, involving agricultural products, car parts and seafood, according to a statement released by China’s Ministry of Commerce (MOFCOM) on Saturday morning. Soybeans, which are China’s biggest import from the US in value, are on the list.

Chemicals, medical equipment and energy products from the US will also be subject to 25 percent tariffs, which will be announced at a later date.

The revised list is longer and involves more categories of products than a preliminary list of 106 US goods published by the ministry in April, but the total value of the products remains at $50 billion.

A Chinese commerce expert found that aircraft were removed from China’s new list, which is noteworthy.

“We need aircraft [from the US]. We have to consider the costs of the countermeasures we plan to take,” Bai Ming, deputy director of the Ministry of Commerce’s International Market Research Institute, said on Saturday soon after the Chinese tariffs were announced.

It’s like acting as a soccer referee who will not call out the offenses and let the play continue when the game still benefits the attacking team even though an attacking player is fouled, Bai further explained.

China is one of the fastest-growing civil aviation markets in the world, and 15 to 20 percent of Boeing’s aircraft deliveries are projected to end in the Chinese market over the next two decades, according to Morgan Stanley.

The US has kept changing their mind and ignited a trade war, which China does not want and will firmly oppose, a spokesperson of the MOFCOM said immediately after US took trade measures on China. “This move not only hurts bilateral interests, but also undermines the world trade order.”

“China and the US still have hopes of negotiating and reaching an agreement, as both the tariffs announced by the two countries will not take into effect until next month,” said Wang Jun, deputy director of the Department of Information at the China Center for International Economic Exchanges.

Wang told the Global Times that the removal of aircraft from the new list can be a signal that China still wants to talk, and also aircraft can be a valuable chip in the next round of trade negotiations.

Meanwhile, Wang said the Trump administration’s newly published list is not so much a solution for the trade deficit problem with China as efforts to hinder China’s technology development.

US President Donald Trump on Friday announced 25 percent tariffs on $50 billion in Chinese goods, containing industrially significant technologies related to China’s “Made In China 2025” strategy.

According to a list published by the office of the US Trade Representative, the tariffs will be applied on more than 1,000 types of Chinese goods, including aircraft engine parts, bulldozers, nuclear reactors and industrial and agricultural machinery.

American industry also opposed Trump’s decision.

“Imposing tariffs places the cost of China’s unfair trade practices squarely on the shoulders of American consumers, manufacturers, farmers, and ranchers. This is not the right approach,” US Chamber of Commerce President and CEO Thomas J. Donohue said in a statement posted on the chamber’s website on Friday.

By Zhang Ye Source:Global Times

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Fed’s big balance-sheet unwind could be coming to an early end

NEW YORK: The Federal Reserve’s balance sheet may not have that much further to shrink.

An unexpected rise in overnight interest rates is pulling forward a key debate among US central bankers over how much liquidity they should keep in the financial system. The outcome will determine the ultimate size of the balance sheet, which they are slowly winding down, with key implications for US monetary policy.

One consequence was visible on Wednesday. The Fed raised the target range for its benchmark rate by a quarter point to 1.75% to 2%, but only increased the rate it pays banks on cash held with it overnight to 1.95%. The step was designed to keep the federal funds rate from rising above the target range. Previously, the Fed set the rate of interest on reserves at the top of the target range.

Shrinking the balance sheet effectively constitutes a form of policy tightening by putting upward pressure on long-term borrowing costs, just as expanding it via bond purchases during the financial crisis made financial conditions easier. Since beginning the shrinking process in October, the Fed has trimmed its bond portfolio by around US$150bil to US$4.3 trillion, while remaining vague on how small it could become.

This reticence is partly because the Fed doesn’t know how much cash banks will want to hold at the central bank, which they need to do in order to satisfy post-crisis regulatory requirements.

Officials have said that, as they drain cash from the system by shrinking the balance sheet, a rise in the federal funds rate within their target range would be an important sign that liquidity is becoming scarce.

Now that the benchmark rate is rising, there is some skepticism. The increase appears to be mainly driven by another factor: the US Treasury ramped up issuance of short-term US government bills, which drove up yields on those and other competing assets, including in the overnight market.

“We are looking carefully at that, and the truth is, we don’t know with any precision,” Fed chairman Jerome Powell told reporters on Wednesday when asked about the increase. “Really, no one does. You can’t run experiments with one effect and not the other.”

“We’re just going to have to be watching and learning. And, frankly, we don’t have to know today,” he added.

But many also see increasingly scarce cash balances as at least a partial explanation for the upward drift of the funds rate, and as a result, several analysts are pulling forward their estimates of when the balance sheet shrinkage will end.

Mark Cabana, a Bank of America rates strategist, said in a report published June 5 that Fed officials may stop draining liquidity from the system in late 2019 or early 2020, leaving US$1 trillion of cash on bank balance sheets. That compares with an average of around US$2.1 trillion held in reserves at the Fed so far this year.

Cabana, who from 2007 to 2015 worked in the New York Fed’s markets group responsible for managing the balance sheet, even sees a risk that the unwind ends this year.

One reason why people may have underestimated bank demand for cash to meet the new rules is that Fed supervisors have been quietly telling banks they need more of it, according to William Nelson, chief economist at The Clearing House Association, a banking industry group.

The requirement, known as the Liquidity Coverage Ratio, says banks must hold a certain percentage of their assets either in the form of cash deposited at the Fed or in US Treasury securities, to ensure they have enough liquidity to deal with deposit outflows.

The Fed flooded the banking system with reserves as a byproduct of its crisis-era bond-buying programs, known as quantitative easing, to stimulate the economy. The money it paid investors to buy their bonds was deposited in banks, which the banks in turn hold as cash in reserve accounts at the Fed.

In theory, the unwind of the bond portfolio, which involves the reverse swap of assets between the Fed and investors, shouldn’t affect the total amount of Treasuries and reserves available to meet the requirement. The Fed destroys reserves by unwinding the portfolio, but releases an equivalent amount of Treasuries to the market in the process.

But if Fed supervisors are telling banks to prioritise reserves, that logic no longer applies. Nelson asked Randal Quarles, the Fed’s vice-chairman for supervision, if this was the Fed’s new policy. Quarles, who was taking part in a May 4 conference at Stanford University, said he knew that message had been communicated and is “being rethought”.

If Fed officials do opt for a bigger balance sheet and decide to continue telling banks to prioritise cash over Treasuries, it may mean lower long-term interest rates, according to Seth Carpenter, the New York-based chief US economist at UBS Securities.

“If reserves are scarce right now, and if the Fed does stop unwinding its balance sheet, the market is going to react to that, a lot,” said Carpenter, a former Fed economist. “Everyone anticipates a certain amount of extra Treasury supply coming to the market, and this would tell people, ‘Nope, it’s going to be less than you thought’.” — Bloomberg

Malaysia and regional equity markets in the red

 

In Malaysia, the selling streak has been ongoing for almost a month. As of June 8, the year to date outflow
stands at RM3.02bil, which is still one of the lowest among its Asean peers. The FBM KLCI was down 1.79 points yesterday to 1,761.

PETALING JAYA: It was a sea of red for equity markets across the region after the Federal Reserve raised interest rates by a quarter percentage point to a range of 1.75% to 2% on Wednesday, and funds continued to move their money back to the US. This is the second time the Fed has raised interest rates this year.

In general, markets weren’t down by much, probably because the rate hike had mostly been anticipated. Furthermore for Asia, the withdrawal of funds has been taking place over the last 11 weeks, hence, the pace of selling was slowing.

The Nikkei 225 was down 0.99% to 22,738, the Hang Seng Index was down 0.93% to 30,440, the Shanghai Composite Index was down 0.08% to 3,047.34 while the Singapore Straits Times Index was down 1.05% to 3,356.73.

In Malaysia, the selling streak has been ongoing for almost a month. As of June 8, the year to date outflow stands at RM3.02bil, which is still one of the lowest among its Asean peers. The FBM KLCI was down 1.79 points yesterday to 1,761.

Meanwhile, the Fed is nine months into its plan to shrink its balance sheet which consists some US$4.5 trillion of bonds. The Fed has begun unwinding its balance sheet slowly by selling off US$10bil in assets a month. Eventually, it plans to increase sales to US$50bil per month.

With the economy of the United States showing it was strong enough to grow with higher borrowing costs, the Federal Reserve raised interest rates on Wednesday and signalled that two additional increases would be made this year.

Fed chairman Jerome H. Powell in a news conference on Wednesday said the economy had strengthened significantly since the 2008 financial crisis and was approaching a “normal” level that could allow the Fed to soon step back and play less of a hands-on role in encouraging economic activity.

Rate hikes basically mean higher borrowing costs for cars, home mortgages and credit cards over the years to come.

Wednesday’s rate increase was the second this year and the seventh since the end of the Great Recession and brings the Fed’s benchmark rate to a range of 1.75% to 2%. The last time the rate reached 2% was in late 2008, when the economy was contracting.

“With a slightly more aggressive plan to tighten monetary policy this year than had previously been projected by the Fed, it will narrow our closely watched gap between the yield rates of two-year and 10-year Treasury notes, which has recently been one of a strong predictor of recessions,” said Anthony Dass, chief economist in AmBank.

Dass expects the policy rate to normalise at 2.75% to 3%.

“Thus, we should potentially see the yield curve invert in the first half of 2019,” he said.

So what does higher interest rates mean for emerging markets?

It means a flight of capital back to the US, and many Asian countries will be forced to increase interest rates to defend their respective currencies.

Certainly, capital has been exiting emerging market economies. Data from the Institute of International Finance for May showed that emerging markets experienced a combined US$12.3bil of outflows from bonds and stocks last month.

With that sort of global capital outflow, countries such as India, Indonesia, the Philippines and Turkey, have hiked their domestic rates recently.

Data from Lipper, a unit of Thomson Reuters, shows that for the week ending June 6, US-based money market funds saw inflows of nearly US$34.9bil.

It makes sense for investors to be drawn to the US, where the economy is increasingly solid, coupled with higher yields and lower perceived risks.

Hong Kong for example is fighting an intense battle to fend off currency traders. Since April, Hong Kong has spent at least US$9bil defending its peg to the US dollar. Judging by the fact that two more rate hikes are on the way this year, more ammunition is going to be needed.

Hong Kong has the world’s largest per capita foreign exchange reserves – US$434bil more in firepower.

By right, the Hong Kong dollar should be surging. Nonetheless, the currency is sliding because of a massive “carry trade.”

Investors are borrowing cheaply in Hong Kong to buy higher-yielding assets in the US, where 10-year Treasury yields are near 3%.

From a contrarian’s perspective, global funds are now massively under-weighted Asia.

With Asian markets currently trading at 12.3 times forward price earnings ratio, this is a reasonable valuation at this matured stage of the market.

By Tee Lin Say StarBiz

Related:

 

PBOC Seen Mirroring Fed With Hike While Keeping Other Taps Open  Bloomberg

  

Foreign investors more willing to hold yuan assets: FX regulator

Reuters ·

 

 Faster Indian Inflation Puts Analysts on Watch for Rate Hike – Bloomberg

Abenomics’ impact fading at sensitive moment for Japanese economy –
Business News

 

Bank Negara governor a short but memorable stint – Business News | The Star Online

Malaysia should first check yen loan terms, advises economist – The Star

 

 

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