- Our base case is that the recent flare up in US-China trade tensions will be contained, and the economic impact limited
- With risks lingering, however, we explore two additional negative scenarios, and the macro and monetary policy implications
- In a negative scenario, where threatened tariffs are implemented, central banks will likely remove accommodation more slowly
- In a full trade war scenario, global GDP growth could fall by 2-2.5 pp, and this would elicit a more pronounced dovish response
Trade tensions have flared up since the start of the year. It started with the US imposing import tariffs on washing machines and solar panels, and subsequently steel and aluminium imports. More significantly, both the US and China have since threatened to implement a large number of extra tariffs, conditional upon actions taken by the other party (see box on page 2). In recent weeks, however, both Washington and Beijing seem to have struck a more conciliatory tone, and China has announced measures that directly address some of the US’s main complaints. Financial markets initially took fright at the proposed measures, and various economic confidence indicators declined, despite only a small part of the announced tariffs having been implemented. Markets have since recovered following more conciliatory remarks from both the US and China, but risks to the outlook for trade remain. In this note we discuss our base scenario for the trade conflict, the different contagion channels and the impact on the main global economies and regions. We also discuss two negative scenarios.
Our base scenario is that that protectionist measures will remain limited, and above-trend global economic growth will continue. At present, the solution to the US-China stand-off looks like it will take the form of indirect, face-saving efforts to diffuse tensions and avoid the widespread imposition of tariffs. Recent signals that the US would consider renegotiating TPP (Trans Pacific Partnership) should also be seen in this context. However, we do not exclude the possibility that some of the Section 301 measures mentioned will indeed be imposed by the US, with China retaliating in kind. Our base scenario allows for up to USD70bn of tariffs to be imposed – somewhat more than the initial USD50bn tariff threat, but below president Trump’s counter-retaliation of USD150bn.
As fears over escalation recede, the overall effect on markets and confidence should remain limited. Hence, in our base scenario, we do not materially change our growth, inflation or central bank forecasts. Given different strategic goals, however, tensions will no doubt flare up again in future. Indeed, given US concerns over the competitive threat from the Made in China 2025 goals, we expect more controversial issues to linger for longer.
Below we present two alternative scenarios, where protectionist measures, such as trade tariffs, are more significant. We have estimated the impact on growth, inflation and monetary policy for the most relevant regions, which are the US, China and the rest of emerging Asia and the eurozone. Together, these regions represent around 2/3 of global GDP. Before describing the alternative scenarios, we set out a number of channels through which protectionist measures can impact the economic outlook.
To begin with, import tariffs instantly raise the price of the affected imported goods. As such it can be seen as a negative supply shock to the economy of the importing country, which raises prices and reduces economic growth in that country. In theory, some of the impact on growth and inflation could be moderated by substituting imports with domestic production, or by shifting towards imports from different countries of origin when not all countries implements tariffs. However, these processes take a considerable period of time and are not always possible, for instance if an imported good is of essential importance for a certain production process or there is no alternative country of origin. Consequently, import tariffs in general have an upward impact on production costs and/or consumer prices of the importing country. This will have a negative impact on company profits, fixed investment growth and private consumption growth.
Secondly, the imposition of trade tariffs by certain countries can also have an impact on the economies of countries that are not directly affected by these tariffs, for instance if they play an important role in global supply chains. A lot of Asian countries are exporting intermediate goods to China in order to facilitate Chinese exports to the US. These countries will also be impacted by a US-China trade war. Moreover, when tariffs are imposed on certain good their prices excluding tariffs tends to fall. This means that the import prices of the importing countries that are not directly subject to the tariffs tends to decline.
Thirdly, business confidence can be hit by the uncertainties surrounding the implementation of protectionist measures and its potential impact on economic growth. If these negative confidence effects last for a while, they can spill-over to domestic demand, particularly investment. Cross-border FDI flows will likely also be hurt in case of rising uncertainty. Also, sentiment in financial markets can be hit, resulting in drops in the price of risky assets such as stock prices. This will lead to wealth effects impacting domestic demand and a tightening of financial conditions.
Finally, the impact of trade tariffs on the economy and inflation will also depend on the reaction functions of central banks. Theoretically, the short-term rise in inflation could induce banks to tighten policy. However, this would exacerbate the effects on economic growth. Indeed, a slowing economy would will limit inflationary pressures in the longer term and should induce central bank to ease policy. This would cushion the impact on the economy.
Negative scenario: Deepening US-China trade conflict
In this scenario, we assume that all protectionist measures proposed so far by the US and China are implemented in full, resulting in a real bilateral ‘trade war’ between the US and China. So, the US will impose 25% tariffs on USD150bn of imports from China, and tighten investment restrictions. We assume China will retaliate by imposing 25% tariffs on the USD50bn already mentioned and 30% tariffs on the remaining USD80bn of its imports to proportionally match the US (China’s 2017 imports from the US totaled USD130bn, while the US imported USD506bn from China). With regard to global trade, we note that the trade flows that are directly affected by these tariffs represent just 1.7% of global imports. Hence, the direct effects are small. However, assuming the broader range of contagion effects mentioned earlier, the total effect on global trade will be larger.
The most important results are (see also the table below):
US: We expect a modest upward impact on inflation, but this will be limited by the fact that goods has a relatively small weight in both the CPI and PCE indices. For growth, expansionary fiscal policy should prevent a serious slowdown. Nonetheless, greater uncertainty will likely dampen confidence, and we believe the Fed would decide to hold off from hiking at the September meeting while it assesses the situation.
China/EM Asia: As around 7% of Chinese exports will be affected directly, we foresee a modest negative GDP growth effect (of around 0.2pp) in this scenario, both in 2018 and 2019. We also foresee a moderate upward effect on inflation, as China’s imports will become more expensive. Also taking into account broader contagion channels through global value chains, we expect some negative growth effects on export oriented countries in Asia, driving regional growth down a bit further (by 0.3pp compared to the base scenario). It should be noted that China has a 50% weight in regional GDP, and India (around 20% weight) will likely not be affected much as it is less exposed to global value chains than countries in East Asia. We would expect the Chinese authorities to soften its targeted tightening approach, while leaving the 1-yr lending rate unchanged.
Eurozone: Although in this scenario, the eurozone is assumed to stay outside the trade conflict and no tariffs will be imposed on the EU’s foreign trade flows, there will probably still be a an impact on growth and inflation. The relatively high share of goods exports in GDP (see graph above) implies that any slowdown in global trade will weigh on economic growth. This slowdown in growth will have some downward impact on inflation, which we expect to be reinforced by the fact that the eurozone’s import prices are expected to also decline. The latter because – all else equal – the imposition of trade tariffs tends to reduce the ex-tariff price of these goods. The ECB’s exit from accommodative policies will be even slower.
Worst case scenario: full-blown global trade war
In this scenario, we assume a further escalation of trade tensions between the US and China, and a broadening of protectionist measures versus other countries that have bilateral trade surpluses with the US, which will also retaliate. We would expect a stronger dovish reaction by the Fed, ECB and PBoC.
There is of course an extremely high number of possible scenarios, so to simplify our analysis we focus on the impact of a sharp and generalized slowdown in trade on the global economy, rather than on how we might get there. We assume global trade growth more than halves in 2018, with zero growth in 2019. The figure for 2018 looks still positive because we assume the bulk of the announced tariffs will be implemented in late Q2 or early Q3 so they will only start to have an impact in the latter part of this year. For 2019, there is a more pronounced impact, with trade growth falling by more than 4pp compared to our base scenario. This would be similar to the sharpest slowdowns in global trade growth seen since 2000 (in 2001 and 2008) apart from the 13% contraction in 2009 during the global financial crisis. Such an outcome is comparable to a recent trade war scenario presented by the ECB (see here).
To translate the effects of this into global GDP growth, we have made a rough estimate based on what happened with global GDP during the previous sharp slowdowns of global trade mentioned above (again, excluding for the extreme contraction in 2009). As such, we would see global GDP growth falling sharply, particularly in 2019, by 2-2.5pp. Note that this is an indication of the potential magnitude of the growth impact in this scenario, rather than a precise estimate, as the real impact would depend on highly uncertain confidence and second round effects.
In terms of monetary policy, we would expect both the Fed and ECB to keep monetary policy on hold, and for central bank rhetoric to turn markedly dovish. In the Fed’s case, this would mean interest rates being a full percentage point below where they would otherwise have been (at 2.00% instead of 3.00%), while for the ECB, it means that there will probably be no rate hikes. The room for a further extension of the QE programme seems limited under the current rules of the programme, but the ECB could decide to change these rules (remove the issuer limit or drop the capital key requirement) and continue its purchases through most of 2019. Moreover, the central bank could introduce a new TLTRO programme to support the financial system. In this extreme scenario, we expect the Chinese authorities to counterbalance the effects of the negative trade shock by easing fiscal and monetary policy (including lowering the key policy rate).