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China may be doing more to reduce its trade surplus with the U.S. than Trump

Dion Rabouin

U.S. President Donald Trump grabbed headlines recently by announcing he would place tariffs on up to $60 billion worth of Chinese imports with the goal of reducing the bilateral trade deficit the United States has with China.

However, the man who may really be reducing the trade gap is Chinese President Xi Jinping.

While Trump’s first year in office has so far only seen increases to the U.S. trade deficit with China – and many economists believe his much heralded tax cut and the $1.3 trillion spending bill he just signed will push it higher – China is moving forward with a slate of reforms that will likely reduce the trade gap.

Under Xi’s leadership, the Chinese government has taken a number of steps to open the country’s financial sector to foreign investors, which experts believe could reduce China’s more than $375 billion trade surplus with the United States.

“China is a big country but with minuscule financial markets at this point … If they develop these domestic financial markets and foreigners buy into it, it should definitely put upward pressure on the [yuan] and that’s going to nudge China closer to becoming a high-cost producer,” said Francis E. Warnock, a professor at the University of Virginia’s Darden Business School and head of its global markets and economies area.

A stronger yuan would make Chinese products more expensive

By allowing more foreign capital to come into the country, China’s yuan (CNH) would increase in value because investors would need to buy the currency to purchase the stocks and bonds they want. A more expensive yuan would make Chinese products more expensive to foreign buyers and make them less attractive both at home and abroad.

“That will reduce their trade surplus with everybody,” Warnock said. “Yes, with the U.S. as well.”

Chinese bonds denominated in yuan are set to be added to the Bloomberg Barclays Global Aggregate Index, one of the world’s most followed and highly tracked by fund managers, later this year and JP Morgan is reportedly considering adding Chinese bonds to its Government Bond Index. Goldman Sachs last year estimated that inclusion in such bond indexes could bring $250 billion into China’s bond market.

That’s in addition to index provider MSCI adding mainland Chinese stocks, or “A shares,” to its emerging markets index starting in June, a development investors say could mean $500 billion just from money in exchange-traded funds (ETFs) and other passive trading strategies.

Active fund managers have already begun making their way into Chinese investments. Asha Mehta, an emerging and frontier market portfolio manager at Acadian Asset Management, is leading her firm’s newly unveiled China A shares fund, which she told Yahoo Finance she’s expecting will draw $2 billion of funds.

Acadian was the second asset manager to obtain Renminbi Qualified Foreign Institutional Investor permissions to access the Chinese markets after BlackRock, Mehta said.

Asset manager Acadian details its simulated China A shares portfolio performance.
Asset manager Acadian details its simulated China A shares portfolio performance.

Dec Mullarkey managing director Sun Life Investment Management, said he’s been investing in Chinese debt for some time and plans to continue buying the bonds as they enter various indexes. He expects many other investors will soon join him.

“There will certainly be a demand for it,” Mullarkey said. “Usually when you’ve got an influx of money a lot of that comes from index investors and they are less discriminating.”

China also launched the world’s first oil futures contracts in yuan rather than dollars on Monday, which has received mixed reviews, but could drive more flows into the currency. China is reportedly taking steps to begin paying for crude oil in yuan instead of dollars, a major step toward increasing the international use of the currency.

This new phase of investment in China’s markets looms as the yuan has hit its strongest level against the dollar since August 2015 when China shocked global markets with a surprise devaluation of the yuan, triggering the currency’s biggest one-day drop since the country ended a dual-currency system in January 1994.

Allowing its currency to appreciate and introducing a slate of financial reforms designed to draw capital to the country are two reasons one former top adviser to China’s state-run economic planning commission thinks the country might face a trade deficit in the next five to 10 years.

“The next stage is an open economy that focuses on a balance of trade,” Zhang Yansheng told Hong Kong’s South China Morning Post in January. “Expanding imports is a very significant part of China becoming a big global power.”

A stronger yuan is not a sure thing

But not everyone is sold on the inevitable strength of the yuan. Brad W. Setser, a senior fellow at the Council on Foreign Relations, believes China will maintain its weak currency by offsetting the yuan’s gains from investment with relaxed restrictions on Chinese investors sending their money overseas.

“When money comes into China from the rest of the world or when the central bank worries about the yuan’s strength…it can liberalize and get rid of limits on outflows,” Setser said.

China’s total capital outflow was estimated at $166 billion in 2017, down 67% from $500 billion in 2016 and down 78% from $761 billion of outflows in 2015, according to a report from Pictet Wealth Management.

But Warnock, the University of Virginia professor, argues that accepting a stronger yuan and a smaller trade surplus is part of China’s gradual move to a more market-based economy.

“They’ve realized that there are whole other large portions of the economy that need to be developed,” he said, “and just focusing on those sectors and firms that can export isn’t the whole picture.”

Dion Rabouin is a financial markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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