A flurry of Chinese media reports on Wednesday, including an editorial in the flagship newspaper of the Communist Party, raised the prospect of Beijing cutting exports of the commodities that are critical in defense, energy, electronics and automobile sectors. The world’s biggest producer, China supplies about 80% of U.S. imports of rare earths, which are used in a host of applications from smartphones to electric vehicles and wind turbines.
“China, as the dominant producer of rare earths, has shown in the past that it can use rare earths as a bargaining chip when it comes to multilateral negotiations,” said George Bauk, Chief Executive Officer of Northern Minerals Ltd., which is producing rare earth carbonate from a pilot-scale project in Western Australia.
The U.S. shouldn’t underestimate China’s ability to fight the trade war, the People’s Daily said in an editorial Wednesday that used some historically significant language on the weight of China’s intent.
The newspaper’s commentary included a rare Chinese phrase that means “don’t say I didn’t warn you.” The specific wording was used by the paper in 1962 before China went to war with India, and “those familiar with Chinese diplomatic language know the weight of this phrase,” the Global Times, a newspaper affiliated with the Communist Party, said in an article last April. It was also used before conflict broke out between China and Vietnam in 1979.
“At the negotiating table, the U.S. government has made many arrogant requests, including restricting the development of state-owned enterprises,” the commentary said, according to a CNBC translation. “Obviously, this is beyond the field and scope of trade negotiations, (and) touches upon China’s fundamental economic system.”
“This demonstrates, that behind the trade war the U.S. has launched against China, there is an attempt to violate China’s economic sovereignty, (and) compel China to damage its own core interests, “ the article said.
As trade talks between the U.S. and China increasingly center on Chinese treatment of foreign companies, Beijing says major American complaints about structural aspects of its economy are running up against “core interests.”
The implication: Those matters are not up for negotiation.
Previously, the vague “core interest” term was generally understood as referring to Beijing’s territorial claims, such as those on Taiwan. But a commentary piece published this weekend by state news agency Xinhua emphasized that China will not yield on its prerogative about how to manage its economy.
In January 2018, Xinhua published an English-language commentary piece that said: “Territorial integrity is China’s core interests. Hong Kong, Macao, Taiwan and Tibet are all indispensable parts of China. These facts are beyond doubt and challenge.”
For almost four weeks, the tanker Mendeleev Prospect has been anchored idly off the Polish port of Gdansk unable to discharge a $50 million cargo of crude oil.
After any normal voyage the tanker would quickly deliver its 700,000 barrels of Russian crude into a refinery for processing into gasoline, diesel and other petroleum products. But the Mendeleev Prospect is in limbo, the victim of Russia’s unprecedented contaminated crude crisis that’s been spreading chaos though the European oil market for a month.
Back in April, unusually high levels of the chemicals known as organic chlorides were discovered in the Russian crude flowing through the giant Druzhba pipeline, built in the 1960s to carry crude from the U.S.S.R. to allied countries in Eastern Europe. The chlorides can severely damage oil refineries and on April 24 Russia’s state pipeline operator, Transneft PJSC, halted shipments. Moscow pledged to resolve the issue right away; four weeks later, the flow of Russian oil into Europe is little more than a trickle.
Druzhba usually supplies up to 1.5 million barrels a day of Russia’s benchmark Urals blend into central Europe — more than the total production of OPEC member Libya. The crude goes directly to refineries through two separate pipeline spurs and via tankers from the Ust-Luga export terminal in the Baltic.Click here to download a pdf of this article, Missile.pdf
Rare earths are used in rechargeable batteries for electric and hybrid cars, advanced ceramics, computers, DVD players, wind turbines, catalysts in cars and oil refineries, monitors, televisions, lighting, lasers, fiber optics, superconductors and glass polishing.
Several rare earth elements, such as neodymium and dysprosium, are critical to the motors used in electric vehicles.
Some rare earth minerals are essential in military equipment such as jet engines, missile guidance systems, antimissile defense systems, satellites, as well as in lasers.
Lanthanum, for example, is needed to manufacture night vision devices
The U.S. Defense Department accounts for about 1% of U.S. demand, which in turn accounts for about 9% of global demand for rare earths, according to a 2016 report from the congressional U.S. Government Accountability Office.
Companies such as Raytheon Co, Lockheed Martin Corp and BAE Systems Plc all make sophisticated missiles that use rare earths metals in their guidance systems, and sensors. Lockheed and BAE declined to comment. Raytheon did not respond to a request for comment.
Apple Inc uses rare earth elements in speakers, cameras and the so-called “haptic” engines that make its phones vibrate.
Since 2010, the government and private industry have built up stockpiles of rare earths and components that use them, according to Eugene Gholz, a former senior Pentagon supply chain expert, who teaches at the University of Notre Dame.
Rare earth metals are a group of 17 elements - lanthanum, cerium, praseodymium, neodymium, promethium, samarium, europium, gadolinium, terbium, dysprosium, holmium, erbium, thulium, ytterbium, lutetium, scandium, yttrium - that appear in low concentrations in the ground.
Although they are more abundant than their name implies, they are difficult and costly to mine and process cleanly. China hosts most of the world’s processing capacity and supplied 80% of the rare earths imported by the United States from 2014 to 2017. In 2017, China accounted for 81% of the world’s rare earth production, data from the U.S. Geological Survey showed.Click here to download a pdf of this article, Missile.pdf
Six experts weigh in on what this means for the U.S. stock market.
Ian Shepherdson, chief economist at Pantheon Macroeconomics, says the day’s news isn’t too much of a surprise.
“Chinese trade is $600 billion with the U.S. every year. Huawei is a piece, but it’s not a gigantic piece. I suspect that they thought this was coming at some point, because this talk about the Chinese ability to disrupt European-U.S. networks has been bubbling away for a long time. I can’t imagine it came as a total surprise.”
Scott Nations, chief investment officer at NationsShares, says there are bigger implications to the Huawei story.
“The problem is that the China trade issue is spreading; it’s no longer just a trade deal. It’s now Google cutting off Huawei and Qualcomm, Intel telling their employees they’re not going to sell to the company until further notice. So, I think the market is afraid that President Trump has so many balls in the air when it comes to what’s going on geopolitically that one of them is going to drop.”
Mohamed El-Erian, chief economic advisor at Allianz, says the U.S. can win the trade war but might suffer collateral damage.
“This massive divergence in the U.S. — part of it can be explained that the U.S. is in a better place to deal with higher oil prices and it’s in a relatively better place to deal with the trade tensions. Remember, we win a relative trade war. In absolute terms, we suffer, but we win relative to others, so I think the markets have understood that the U.S. is in a better place than the rest of the world. The question is can we stay there.”
Craig Moffett, founder and senior analyst at MoffettNathanson, says the decision to cut off Huawei also has political consequences.
“I think it’s much more [tied] to national security, but you can’t escape that it also has implications for this narrative that China beating us in 5G is politically a very cogent argument, right? And so, to the extent that we can limit the expansion of the 5G network elsewhere by cutting off Huawei from its suppliers helps that narrative.”
Jim Cramer, host of CNBC’s “Mad Money,” says:
“If you own these [tech] stocks please recognize the risk, because nobody is going to raise numbers here and everybody is going to cut numbers. Every one of those companies that you see, those numbers are too high … There’s some that aren’t related and getting thrown out with the SMH.”
Mark Mahaney, lead internet analyst at RBC Capital Markets, breaks down what this could mean for Google.
“I don’t recall Google ever doing anything like this in the past. It’s probably not material for Google. Google doesn’t really have any exposure to the China market except for Chinese exporters who do look to advertise on Google. Potentially, I don’t look at the phone sector that closely, but for a company if you’re not able to have a full robust suite of Android apps on your phone I don’t know what you have. You’ve got something that’s akin to a brick. The reason people buy these phones isn’t because of communication, it’s because of the functionality embedded in all the Android and Google apps and services. So, there’s a real problem on one side, and it’s a little unclear to me what the issue is going to be for Google moving forward.”
“This is serious,” said Joseph Glauber, former chief economist for the U.S. Agriculture Department. “It’s worrisome to me that you could set prices that would really influence planting decisions, potentially distorting production.”
The administration’s signals on trade aid has sowed confusion and the sense that a $15 billion or even $20 billion program with major ramifications for agriculture and commodity markets is being improvised on the fly.
Last year’s $12 billion trade assistance program broke with more than two decades of American agricultural policy, which has tied payments to farmers’ historic plantings rather than current production. Disparities in the way crops were treated also provoked criticism, particularly a $1.65 per bushel rate for soybeans versus 1 cent per bushel for corn.
Last year’s trade assistance package was announced near the end of the growing season, when it was too late for farmers alter their production plans. This time, much of the crop has yet to be planted. As of Monday, only 30% of the corn crop had been planted and 9% of the soybean crop, according to the Agriculture Department.
“Because of planting, there probably isn’t a worse time for the president to go out and announce a payment to farmers,” said Jonathan Coppess, former head of the U.S. Farm Service Agency, which oversees farm subsidies.
A rainy spring in the Midwest has already created an incentive to shift away from corn to soybeans, which can be planted later in the year, said Coppess, now an agricultural policy professor at the University of Illinois.
“If you’re in Illinois or Indiana or Iowa watching it rain, then the potential of a large soybean payment could be a real factor,” Coppess said. “Last year, U.S. farmers planted close to 90 million acres to corn and almost another 90 million to soybeans, and many farmers in the Midwest rotate on a 50/50 basis between the two crops, so the impact could be millions of acres and hundreds of millions of bushels.”Click here to download a pdf of this article, Missile.pdf
China cut its U.S. Treasuries holdings to the lowest level since 2017 in March amid the trade dispute between the world’s two biggest economies.
It was only a slight reduction -- the stake slipped by $10.4 billion, the first drop since November -- but that was enough to bring the position down to a two-year low of $1.12 trillion, according to data the U.S. Treasury Department released Wednesday.Click here to download a pdf of this article, Missile.pdf
Japan’s three largest banks all reported lower annual profits on Wednesday, highlighting the challenges faced by the banking industry as the world’s third-largest economy looks to be headed for another downturn.
The size of the declines varied - Sumitomo Mitsui Financial Group had a 1% drop while rival Mizuho reported an 83% dive - all three show the difficulty banks have in navigating Japan’s ultra-loose monetary policy.
A government assessment this week showed Japan may already be in recession due to the impact of a U.S.-China trade war and weak external demand. That is likely to drive up bad debt costs for banks as more loans go sour.
“Our core profit fell for a fourth straight year. We had expected this, but the environment is very tough,” Kantesugu Mike, the chief executive of top lender Mitusbishi UFJ Financial Group, told a briefing.
MUFG, one of the world’s largest banks by assets, reported a 12 percent slide in annual net profit, reflecting the squeeze on lending margins. The bank was also hit by a one-time charge from suspending development of a new system at a credit unit, reflecting increased competition from cashless services.
Mizuho, Japan’s second-largest bank by assets, reported an 83% percent decline in net profit, to 96.6 billion yen ($884 million), in the year through March 2019.Click here to download a pdf of this article, Missile.pdf
To be clear, there are well-done studies showing that the recent tariffs have translated into higher prices for U.S. consumers. I am not contesting that research. The question is whether those studies give sufficient weight to all relevant variables for the longer run.
To see why the full picture is more complicated, let’s say the U.S. slaps tariffs on the industrial inputs (whether materials or labor) it is buying from China. It is easy to see the immediate chain of higher costs for the U.S. businesses translating into higher prices for U.S. consumers, and that is what the afore-mentioned studies are picking up. But keep in mind China won’t be supplying those inputs forever, especially if the tariffs remain. Within a few years, a country such as Vietnam will provide the same products, perhaps at cheaper prices, because Vietnam has lower wages. So, the costs to U.S. consumers are temporary, but the lost business in China will be permanent. Furthermore, the medium-term adjustment will have the effect of making China’s main competitors better exporters.
Another risk for China is this: As its access to U.S. markets becomes more difficult, China may be tempted to look to Europe. It remains to be seen whether the European Union will adopt additional protectionist measures, but China must consider that the possibility is more than zero.
To understand another feature of the longer-term perspective, consider that the impact of tariffs can be felt in at least two ways. In highly competitive markets, prices have to match costs, and so a cost-boosting tariff really does translate into higher consumer prices. (This is the case with many of the recent U.S. tariffs on China.) But for profitable branded goods, the economics aren’t the same. If the U.S. puts higher tariffs on Mercedes-Benz, for example, the prices of those cars will still exceed their costs of production. Mercedes, wishing to keep some of its strong market position, will probably decide to suffer some of the cost of the tariffs in the form of lower profits, rather than passing them along to its customers.
China has prominent brands as well, be it Huawei in electronics or other firms in exotic food products, and over time it aspires to climb the value chain and sell more branded goods to Americans. In fact China has an industrial policy whose goal is to be competitive in these and other areas. Tariffs will limit profits for these companies and prevent Chinese products from achieving full economies of scale. So this preemptive tariff strike will hurt the Chinese economy in the future, even if it doesn’t yet show up in the numbers.
There is also a broader reason why a trade war with the U.S. hurts China, and this gets to an important point with trade agreements more generally. A U.S. trade agreement with China would (if enforceable) certify China as a place where foreigners can invest and be protected against espionage, intellectual property theft and unfair legal treatment. That prospect of certification is now suspended. That makes investing in China less desirable for many multinationals, not just U.S. ones. That, in turn, limits Chinese domestic wages as well as long-term learning and technology transfer. A U.S. certification of China might even boost Chinese domestic investment, but again that is now off the table.Click here to download a pdf of this article, Missile.pdf
“Matching the U.S. dollar-for-dollar on the U.S. tariffs would imply raising a 25% tariff on all U.S. imports, including those that go into China’s exports,” Setser said. “China certainly could do that, but it would in many cases damage China directly.”
Simply responding with its own tit-for-tat tariffs isn’t China’s most likely move, said Brad Setser, a former Treasury official who’s now a senior fellow for international economics at the Council on Foreign Relations.
Chinese policy makers could devalue the yuan to offset the impact of U.S. duties on China’s economy. The offshore yuan weakened 5.5% against the dollar in 2018, drawing Trump’s ire and fueling speculation that the country was deliberately weakening its currency. While it has fallen 1.3% this week, the currency rose on Friday after the People’s Bank of China set its daily fixing at a stronger-than-expected level.
However, China’s painful experience with devaluing the yuan in 2015, which prompted capital to flee the nation, is likely to dissuade a similar move, according to Tao Wang, UBS Group AG’s chief China economist and head of Asia economic research. “China doesn’t like the self-fulfilling outflows that come as a result of depreciation, which tend to diminish domestic confidence,” she said. “In addition, yuan depreciation last year angered the Trump administration and led to higher U.S. tariffs.”
China owns $1.1 trillion of U.S. government debt, more than any other foreign nation. If it pared back its holdings in that $15.9 trillion asset class, that could be a potent weapon.
However, China doesn’t really have other good options for where to park its $3.1 trillion in foreign-currency reserves -- the world’s largest stockpile -- making this an unlikely path, according to Ed Al-Hussainy of Columbia Threadneedle Investments.
“Any sharp moves higher in U.S. yields both adversely impact the valuation of their existing Treasuries stock and could spark a dollar rally,” the strategist said. “The financial and FX stability risks of this policy could outweigh the benefits.”
“There are some easy things for China to do,” including withdrawing from soybeans, he said.
Futures on the crop have dropped 11% since April 10.Click here to download a pdf of this article, Missile.pdf
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