by Bill O’Grady
(NB: To improve readability, we are now linking references to media reports and articles directly in the text via hyperlinks. Footnoting will be reserved for documents to which we can’t link or to provide additional clarity on a topic.)
Since early May, the trade tensions with China have morphed into a broader conflict. Not only is the U.S. trying to change the trade relationship with China, but it is also attempting to change Beijing’s industrial policy. The U.S. has been using two tracks to accomplish this goal. The first uses tariffs to narrow the U.S. trade deficit with China. The second involves various tools, including legal actions and regulations on foreign investment and technology transfers and sales, to affect Chinese industrial policy. The 2018 arrest of Meng Wanzhou, the chief financial officer of Huawei (002502, CNY 3.67), was the opening salvo in the second element of the administration’s policy toward China. Recent actions to limit the sale of technology to Chinese firms is another example to that effect.
China has started to retaliate. It has applied its own tariffs on U.S. exports, which has hurt the U.S. agricultural sector. In response to the technology policy, China is making an implied threat to prevent the export of rare earth products. In a highly publicized tour, Chairman Xi visited a magnet factory that uses rare earth elements in production, highlighting the potential threat. Using rare earths as a form of intimidation is nothing new; China embargoed rare earth metal exports to Japan in 2010 over a maritime dispute.
In this report, we will offer a brief outline of China’s structural economic problems and the U.S. response to provide context for the threatened rare earths embargo. Following this section, we will detail what rare earths are, their importance and discuss the rise of China’s dominance in this area. From there, we will offer our analysis of the likelihood that China follows through with this threat and the probability of its success if implemented. As always, we will conclude with market ramifications.