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Despite snag, U.S., China still have strong incentives for deal

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      By Emerging Markets Debt Team, Eaton Vance Management

      Boston: Just one week ago, many media and market pundits were speculating that the U.S. and China would be announcing a trade deal following the Chinese delegation's trip to Washington, D.C. that wraps up today.

      Instead, the U.S. has officially increased tariffs on $200 billion worth of Chinese imports from 10% to 25% as of last night and President Trump has tweeted that paperwork is in the works for 25% tariffs on an additional $325 billion of imports. China has announced that it will retaliate against the U.S. tariff hike, although the details of these countermeasures have not been announced yet.

      How did this negative turn of events happen? Prior to last week, the two sides had agreed to over 150 pages of text for a prospective deal, had spent many hours flying back and forth between Beijing and Washington, D.C. and had many video calls attempting to hammer out the final details of the agreement. The U.S. delegation, led by Robert Lighthizer and Steve Mnunchin, was in Beijing last week for trade talks that Mnunchin himself later described as "productive."

      However, on Friday night a week ago, the U.S. delegation received a revised copy of the agreement from China that had changed large swaths of the document, particularly relating to any changes in Chinese laws. Robert Lighthizer, in particular, has been very critical of any document that does not have transparent enforceability, and, thus, would require changes to Chinese laws.

      It is unclear exactly what caused the Chinese to change their tack. Some reports seem to link it back to President Xi Jinping directly, who may have thought that the Chinese side was conceding too much and that the deal would not be politically palatable at home. While the Chinese can add stimulus to the economy, it is much harder to "stimulate" against political backlash, particularly in a very sensitive year politically in China.

      Both the Chinese and the U.S. seem to think that they are negotiating from positions of strength. While the Chinese economy was fairly weak in 2018, the authorities implemented a variety of stimulus measures and more recent data has surprised to the upside. The Chinese economy is still on shaky footing, but the authorities seem to have been encouraged by the pickup in data. Meanwhile, President Trump is looking at multidecade lows in unemployment and an economy that just posted 3.2% GDP growth in Q1.

      Despite this snag in trade talks, the door has not been completely shut and both countries' leaders still have incentives to come together to strike a deal. President Trump would like get a deal that he can frame as a win while taking tariff pressure off farmers before the 2020 election ramps up. President Xi would like to avoid another shock to the Chinese economy and would prefer to focus on his reform agenda rather than economic stabilization. The two leaders will likely talk on the phone in the near future and will both attend the G20 summit in Japan in June, which could lead to a face-to-face meeting.

      Bottom line: Trade talks have taken an unforeseen and abrupt negative turn that has led to increased tariffs. With both countries of the mindset that they are negotiating from positions of strength, bridging the gap in positions may be difficult. However, the leaders of both countries still have strong incentives to strike a deal, so we remain hopeful that one can be completed in the coming months.