What are the implications from the latest review of the U.S.-China Phase One Agreement?

Officials from the U.S. and China spoke over the phone to review the Phase One Agreement signed in mid-January. The tone of the statement by the U.S. Trade Representative office is largely benign, ending the statement with “Both sides see progress and are committed to taking the steps necessary to ensure the success of the agreement”. 

Much has happened since signing of the agreement in January. One thing that has fallen behind is the Chinese purchase of U.S. products agreed during the negotiation. China originally pledged to buy USD 200billion (bn) of U.S. goods and services above the 2017 level over the next two years, which stood at USD 130bn in goods and USD 56bn in services. These pledged amounts are also allocated to different product types, including energy, agricultural products and manufactured goods. In exchange, the U.S. would halve the tariffs it imposed on September 1, 2019, over USD 120bn of Chinese products and postpone tariffs on another USD 160bn of products scheduled to be implemented on December 15, 2019. 

The original targets established in January were very ambitious even during the best of times, but the global recession brought by the COVID-19 pandemic and volatility in commodity prices have made these targets even harder to reach. For the first six months of 2020, U.S. goods exports to China fell by 16% versus the first six months of 2017, significantly below the 49% growth rate required to achieve the Year 1 target. The statement did not show any clear protest from the U.S. on this shortfall, but rather the two sides discussed “the future actions needed to implement the agreement”.

China has also agreed to refrain from competitive devaluation of the Chinese yuan, enhance intellectual property rights protection and improve access to China’s financial services for U.S. companies. The Chinese yuan has strengthened against the U.S. dollar this year. 

Since the Phase One deal was signed, there has been a number of complications in the economic and financial relationship between the two countries. These include the ongoing export restrictions to Chinese tech and equipment companies, scrutiny on Chinese tech companies operating in the U.S. and the warning to de-list Chinese companies in the U.S. if they do not comply with U.S. accounting standards. 

Keeping the dialogue alive may be good enough. Beijing may want to adopt the ‘business as usual’ approach in trade negotiation and not make any assumption on the outcome of the U.S. elections on November 3. Washington may remain tough on China, but reintroducing tariffs as a warning is likely to jeopardize economic recovery and the current buoyant market sentiment. 

EXHIBIT 1: CHINA'S PURCHASE OF U.S. GOODS UNDER THE "PHASE ONE" DEAL HAS LAGGED

Source: Peterson Institute for International Economics, United States Trade Representative. Calculated based on U.S. exports data.
Data available as at 30/06/20.

Investment implications

In coming months, the U.S. could continue to pressure China on a wide range of issues ahead of the elections, including those mentioned earlier. However, we believe the risk of broad based tariffs is modest since President Trump will need to avoid hurting the economy and the booming stock market. This implies more targeted policies towards specific Chinese tech companies or greater pressure on Chinese companies listed in the U.S. For the latter group, we have already seen some opt for a second listing in Hong Kong or China as a contingency. 

Some of these political dramas may not end after the U.S. presidential elections in November. Regardless of who wins the elections, Washington’s pressure on China is expected to remain and some of these policies (tariffs, export restrictions, accounting requirements) are unlikely to be unwound anytime soon. Hence, investors will need to ride with these geopolitical waves and focus on companies that would benefit from the structural growth trends. Greater limits on tech exports to China could see greater investment in research and development on these products in China. 

Meanwhile, multinational companies may opt to diversify their production to avoid getting caught up in these flashpoints. This could imply greater investment in diversifying manufacturing capacity outside of China once the global economic recovery takes hold. Southeast Asia, South Asia and a number of emerging markets could potentially benefit as manufacturers want to produce closer to their customers to mitigate logistics risks due to pandemic or natural disasters, or geopolitical tensions. 

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