"Kee" Points with Jim Kee, Ph.D.

  • Thoughts on China
  • Tariff Burdens

Thoughts on China

President Trump became the first sitting U.S. president to stand on North Korean soil on Sunday as Trump and North Korean leader Kim Jong Un renewed nuclear talks (WSJ). But for markets, the big news was the resumption of trade talks between president Trump and China’s Xi Jinping. China’s growth rate is excessively debated in the media, almost to the point of being inane. Growth in China has slowed and will continue to do so. Part of this is just the law of large numbers, which means it is harder for a large economy to maintain its growth rate than a smaller one. The law of diminishing returns sets in here because economies, even those like China with a large government component, pursue the best opportunities first, and those eventually run out. Think of farming the most fertile acreage first, and eventually having to move on to less fertile land (innovation can work to offset this). Now apply that to every industry you can think of. When applied to growth in this way the law of diminishing returns is referred to by economists as the law of diminishing marginal productivity. By the way, when applied to consumption, it is referred to as the law of diminishing marginal utility (satisfaction). For example, a fourth Mercedes might make you happy, but not as happy as the first one. Back to China, McKinsey & Co., which has an excellent track-record at anticipating China’s economy (having been neither too bearish nor too bullish), argues that another reason for slower growth is tighter credit. They describe China’s policies over the past 10 years as, “eight plus two.” That means China pursued financial liberalization with experiments in debt issuance (loose credit) for eight years, followed by two years (the last two) of trying to reverse it a bit (i.e. tighter credit). Their debt-to-GDP ratio has doubled, going from 120% in 2007 to 253% by Q2 2018. That’s why they are clamping down on credit expansion. According to McKinsey, this clamping down has had a bigger effect on China’s growth rate than trade tensions with the U.S. However, they point out that even with China’s slower growth rate, say 6% instead of the 13% rates achieved a decade ago, China still adds the equivalent of an Australia to the global economy every year! There are some important nuances to China’s growth that we keep track of here at STMM (e.g. auto and phone sales have slowed while internet buying has increased), but keep the big picture in mind: China is slowing and will continue to do so.

Tariff Burdens

Another item worth mentioning comes from an article in yesterday’s (Monday) Wall Street Journal, “My Customers Don’t Pay Trump’s Tariffs.” The author, a consumer-electronics company owner, argues that Trump’s 25% import tariffs on $200 billion of Chinese goods were not passed on to his customers. Instead, he demanded price concessions from his Chinese suppliers, and they all agreed. The author makes a good point, but it is only one of three possible outcomes: Firsttariffs (or taxes) can be passed backward to suppliers in the form of lower payments for their products and services. This is what happened in the author’s case, but other companies in different negotiating positions might pass it backward to domestic workers in the form of lower wages and/or benefits (e.g. healthcare and retirement contributions). Second, barring the ability to take it out of suppliers, some firms will pass the burden on to customers in the form of higher prices. This could mean a higher posted price but it could also take the form of lower quality, like fewer people answering the phone or working the checkout counters, etc., which is an increase in what economists call the “full price.” Third, if companies can’t pass it backward to suppliers or forward to customers, then the tax or tariff has to come out of profits. Since the value of a company’s stock is equal to its current and future (discounted) profits, this means that shareholders would ultimately bear the burden in this third case. And, of course shareholders could include wealthy individuals as well as not-so-wealthy pensioners. So that’s the complete treatment: tariffs or taxes (or other regulatory costs) are payed for by either suppliers, consumers, or shareholders (or some combination of these three). Who decides? Market forces, which are the competitive conditions regarding supply and demand. That’s what economists mean when they say that the market determines who will ultimately bear the true burden of a tax or tariff.