Trade war: Fear versus facts

by: Arjen van Dijkhuizen , Bill Diviney

  • The US has become much more hawkish on trade this year
  • China (tech) becoming a key focus of US trade and investment actions
  • While only a small part of global trade is affected so far …
  • … trade tensions have hit global business confidence …
  • … and contributed to a tightening of financial conditions
  • Impact on global economy is relatively moderate so far …
  • … as e.g. CNY depreciation and China stimulus are cushioning factors
  • While there are certainly downside risks …
  • … there could also be winners, and it could accelerate China’s reforms
  • US-China strategic competition probably inevitable: key is how to manage it
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1.     Introduction

In this thematic piece accompanying our Global Outlook for 2019, we will look more closely at the macroeconomic impact of the escalation of global trade tensions that has occurred this year. We have seen a stepping up of trade tariffs, while at the same time the global trade conflict has narrowed to a predominantly US-China one. We will deal with the key macro questions that arise from this. What can we expect going forward? Even more tariffs? How will these tariffs impact the global economy? And what are the key mitigating factors cushioning the impact of tariffs on the global economy so far? Are there only downside risks? Or is there room for some positive outcomes as well?

2. How have US trade measures evolved so far?

After a relatively calm 2017 …

Despite the fiery protectionist rhetoric in his America First presidential campaign, US president Trump refrained from introducing trade tariffs in his first year in office. He kept his electoral promise by withdrawing from the Trans-Pacific Partnership (TPP) immediately after his inauguration in January 2017. He started preparations for building a border wall with Mexico, and threatened Canada and Mexico that the US would exit NAFTA. The US also initiated an investigation on China’s policies regarding technology transfer, intellectual property and innovation under Section 301 of the US Trade Act of 1974. However, as China was needed to contain the risks from North Korea (which rose to a high in the summer of 2017), the US did not impose any trade and investment sanctions at that time. Two meetings between presidents Donald Trump and Xi Jinping held in April and November 2017 even led to a range of bilateral agreements on trade and investment.

… the US has become much more hawkish on trade this year

This year has been different. With risks from North Korea fading, and the US tax plan having been approved, the Trump administration has become more hawkish on the trade front in the course of this year. Starting in January 2018, the US announced a 30% import tariff on solar panels, and 20-50% tariffs on washing machines (these tariffs mainly affected Asian exporters). This was followed in March by import tariffs on steel (25%) and aluminum (10%) for almost all countries (except Australia and Argentina; exemptions for EU, Canada and Mexico lapsed as of 1 June).

China has become key focus of US trade and investment actions

In recent months, the US narrowed its scope on the trade and investment front. Following the truce with the EU over the summer[1], and the revision to NAFTA (USMCA), China has become the US’s key target. This partly stems from the fact that the US has by far the largest bilateral trade deficit with China. US concerns regarding China’s rise as a tech power, the treatment of intellectual property rights, and the way the Chinese government supports and subsidises the development of technology sectors perhaps plays an even larger role. All in all, the US has clearly stepped up China-specific trade tariffs (see table). So far this year, the US has imposed 10-25% Section 301 tariffs on a total of USD250bn of US imports from China. China retaliated by imposing a 5-25% tariff on USD110bn of imports from the US. All of this implies that in total, so far, USD360bn of bilateral trade flows between the world’s largest economies are subject to additional levies. The US also changed legislation and tightened restrictions on foreign (in particular Chinese) investment into the US and on exports of strategic products to China.

Trump and Xi agreed on a 90 day ceasefire in Buenos Aires

At a closely watched bilateral meeting at the margins of the G20 summit in Buenos Aires, presidents Trump and Xi agreed on a 90 day truce in the US-China trade conflict, while the two sides continue talks aiming at a longer term deal. The agreement keeps import tariffs on hold in the coming months. While it is too early to judge whether the US and China will be able to bridge remaining differences of opinion, the US threat to raise import tariffs on USD200bn worth of imports from 10 to 25% (originally planned as of 1 January 2019) is off the cards (for now). Moreover, the US will also not broaden the base subject to tariffs to all imports from China any time soon (that would have entailed broadening the base by over USD 250bn). It hence removes, for the time being, some of the downside risks to Chinese growth as well as upside risks to US inflation.

As part of the preliminary agreement, China looks set to substantially increase agricultural and energy imports from the US, which would help in reducing its bilateral trade surplus. China already took steps to open up its markets by, for instance, liberalising its FDI regime (including that for the financial sector) and lowering overall import tariffs. China has also agreed to lower its import tariffs for US cars back to 15%; those had been raised to 40% as the trade conflict escalated. While it is unlikely China will give up its ‘state capitalist model’, nor its strategy to create ‘national champions’ with a global presence, it is possible that some compromise could be found in the areas of intellectual property protection.

3. What is the macroeconomic impact so far?

Different contagion channels

As we have laid out in one of our previous publications, Trade war scenarios, there are various channels through which protectionist measures can impact the economic outlook. First, tariffs will likely dampen the import and export flows to which they pertain (direct effect). Second, they may lead to higher production costs and/or consumer prices in the importing country. Third, indirect effects result if these measures hit global supply chains. A fourth contagion channel relates to business confidence, which can be hit by the implementation of protectionist measures. This could spill over to domestic demand, particularly (domestic and cross-border) investment. A fifth channel is through financial markets, which could be hit by uncertainty over a further escalation in protectionist measures. This could result in a sharp correction of asset prices and hence to wealth effects and a tightening of financial conditions, which in turn impacts domestic demand. Finally, the impact of trade tariffs on the economy and inflation will also depend on the reaction functions of central banks. We should add that the significance of these contagion channels can differ substantially among countries/regions.

So far, only a small part of global trade is affected …

The tariffs implemented so far this year by the US and in retaliation by others are not yet significant, at least not at the global level. If we focus on the US-China specific import tariffs implemented so far (covering bilateral trade flows of USD 360 bn), around 2% of global imports (2017) would be affected. Still, if we add the US threat to expand the base to all imports from China (2017), over 3.5% of global imports would be affected. That share would rise to around 5%, if we would include other US tariffs already implemented (e.g. steel, aluminum) and US threats like a general rise in import tariffs for cars.

Chinese exports to US still solid, bilateral trade deficit US vs China at record high

So far, the imposition of tariffs has not really affected Chinese exports to the US. It is likely that this is partly explained by frontloading of trade flows to avoid (even higher) tariffs, while CNY depreciation versus USD has been supportive as well. By contrast, growth of Chinese imports from the US has come down sharply in recent months (while China’s overall import growth has remained solid until October). This may be a consequence of China’s retaliation, but also of the aforementioned currency effects. In any case, the result of all of this is that the US bilateral trade deficit with China has continued to rise to record highs, with the 12-month rolling sum surpassing USD400bn last September.

Still, trade tensions have impacted global business confidence

The escalation of trade tensions between the world’s two major powers – combined with other factors (such as the gradual tightening of monetary policy in the US and some other countries, plus perhaps some cyclicality) – appears to have hurt business confidence. Global manufacturing PMIs have clearly come down in the course of this year, both in advanced as well as in emerging economies (although in EMs some bottoming out has taken place). Strikingly, PMI export subindices have fallen sharply this year, which contrasts with the more moderate slowdown (so far) in actual global trade volumes.

 

… and contributed to a tightening of financial conditions

Moreover, in our view trade tensions have contributed to bouts of risk aversion in financial markets, and to a tightening of financial conditions. While stock markets in the US and other advanced economies rallied for much of the year (at least until October), emerging markets have been feeling the heat which has in part been driven by the stepping up of trade tariffs. That is illustrated by the underperformance of China’s stock market. These market developments have also triggered a general tightening of financial conditions, particularly in emerging economies (including emerging Asia). Still, the extent to which financial conditions have tightened so far is not at all comparable to the global financial crisis (or, where relevant, the eurozone crisis).

Impact on global economy estimated to be moderate so far

Under the assumption that tariff measures will not go beyond the threats that have already been put on the table[2], our baseline scenario foresees a further gradual slowdown – not a collapse – in global trade and growth. We expect global trade growth to slow to 3.5% in 2019, down from 4% in 2017. We expect global GDP growth to slow to 3.5% next year, down from 3.8% this year. This is in line with the projections from the IMF, as presented in their recent World Economic Outlook[3]. The IMF expects global growth to stabilise at 3.7% in 2018-19. All this illustrates that despite the build-up of trade tensions, and taking into account the various contagion channels, no sharp deceleration in global growth and trade is expected for the time being.

Still, should the US follow up on all of its threats, the impact on US core inflation could be more significant. Indeed, we would expect a cumulative boost of 30bp over 2019-20. This impact may seem modest, but it reflects a number of factors: 1) that the impact is likely to be blunted by the c.10% fall in the CNY vs the USD over the past year; 2) that core goods has only a 25% share of the core CPI basket (the remainder being services), and 3) that Chinese imports represent around 18% of core goods consumption. It is possible that businesses try to absorb these higher prices, particularly if they do not believe the tariffs are permanent and could be revoked once an agreement is reached between the US and China. As such, there is a high degree of uncertainty over when and how much of the import tariffs are passed on.

While such a rise in US core inflation on the back of import tariffs would no doubt create headlines, it is unlikely to mean very much for monetary policy – except in the unlikely scenario that it boosts inflation expectations. Typically, central banks ‘look through’ such temporary supply-side factors when conducting monetary policy, and we think this instance should be no different in that regard.

4. What is cushioning the macroeconomic impact?

In our view, there are several reasons why the (estimated) impact of the escalation of trade tensions on global growth is relatively modest so far.

Full-blown global trade war has been avoided

A key reason why the macro impact has been contained is the fact that trade tensions have not really culminated in a full-blown global trade war, but rather in a bilateral US-China one. As we laid out in our previous report, Trade war scenarios, the effects on global growth, inflation and central bank policy would have been much bigger in the case of full-blown global trade war (our worst case scenario) compared to a US-China trade war (our negative scenario).

Put differently, as mentioned previously, only 2% of global trade has been affected by import tariffs so far, with the potential for this amount to rise to 7% in case of further escalation and full retaliation. That means that the impact on overall tariff rates will be much less significant than the sharp rises seen during previous waves of protectionism, such as during the Great Depression in the late 1920s In addition, China has announced that it would lower its import tariff rates further (the US would only profit in case of a truce). We should add that comparisons to the 1920s are difficult, as the world is much more integrated and supply chains much more global now.

Tariff rates are not prohibitive

A related factor cushioning the macroeconomic impact from the US-China trade war is that 10% tariffs (or even 25% tariffs) are not prohibitive, in our view. A 10% tariff is a ‘nuisance’ in international trade. Alongside other factors, such as the regular fluctuations of exchange rates (see below), input costs, and the flexibility of both exporters and importers to adjust margins, a 10% tariff would not lead to a complete standstill in the trade of the goods that are being taxed. All of this also depends on the price elasticity of imports and exports.

 

Currency adjustments offset the effects of import tariffs

One significant factor mitigating the impact of trade tariffs has been the adjustment of exchange rates. In economic theory, the effects of import tariffs will be offset by currency appreciation. In case of a small, open economy, the appreciation of the currency fully offsets the direct effect of the import restriction by making other imports cheaper and exports more expensive.[4] In practice, although the US is a large, open economy, US trade policy – combined with the US macro policy mix – has probably contributed to general dollar strength and to a renewed weakening of the Chinese yuan versus the US dollar, offsetting the effects of the initial import restrictions. Since the US announcement to implement China-specific import tariffs, the yuan has weakened by almost 10% versus USD, largely offsetting the effects of the US tariffs so far. This has even contributed to an improvement in China’s overall export competitiveness, measured by the real effective exchange rate. By contrast, US competitiveness has been hit somewhat this year by the generally stronger dollar.

China is taking offsetting macroeconomic measures

In addition to allowing the yuan to weaken (driven by market forces), China is taking other policy measures to offset the downside risks from the trade war with the US. Beijing has started easing fiscal policy and has, for instance, ordered local governments to increase the issuance of special purpose bonds to finance local infrastructure projects. Beijing is also implementing or preparing various tax cuts (personal income, corporates, imports, exports). Meanwhile, the PBoC is tweaking monetary policy (e.g. with further RRR cuts), with a focus on supporting lending to private firms/SMEs, while maintaining the crackdown on shadow banking. These measures are aimed at helping to keep China’s economic slowdown gradual, cushioning the macro impact from the US-China trade war. See our China 2019 outlook here for more details.

Substitution effects

In reaction to the US stepping up trade tariffs and tightening investment restrictions, China is approaching other countries to strengthen cooperation in the areas of trade and investment. In a white paper, Beijing mentioned the goal of concluding or broadening FTAs with the EU, Japan and South Korea, and expressed hope for an early conclusion of the Regional Comprehensive Economic Partnership, a large-scale regional trade treaty including China and India representing trade flows corresponding to around 40% of global GDP. Illustrative for China’s policy shift is the recent thawing of historically complex relations with Japan. Japanese PM Abe’s visit to Beijing last month marked the first formal visit by a Japanese leader to China in nearly seven years.

5. What are the downside risks?

Although the impact of the trade tensions on the global economy is cushioned by several factors, it is clear that these create downside risks to the still rather benign outlook for the global economy. These downside risks could materialise particularly if:

–       US and China raise bilateral import tariffs beyond what has already been threatened

–       US broadens the base subject to tariffs to all imports from China

–       Trade measures ‘go global’ again (e.g. US introduces general import tariff for cars)

–       Trade measures lead to a material disruption of global supply chains

–       US-China conflict spills over into broader ‘cold war’, or even military tensions

Note that in all of these cases, renewed spillovers to business confidence and financial markets are likely to be much larger. Indeed, in the US, while there has been little perceptible impact of trade policy uncertainty in the macro data, there has been a significant degree of anecdotal evidence that trade policy has delayed or halted capital spending decisions. The risk is that these anecdotal reports are a sign of a more widespread impact that has merely yet to materialise in the numbers. In any case, we believe the investment cycle in the US is peaking, but trade policy uncertainty could lead to a sharper slowdown than we currently have in our projections. In the case of China, the clear drop in manufacturing PMIs and PMI export indices suggest we have already seen a clear deterioration of business confidence related to the trade conflict. A further escalation of tensions risks a further weakening of confidence and would pose stronger headwinds to the Chinese economy, even though we expect more policy stimulus and another round of CNY weakening to remain mitigating factors in such a scenario.

6. Is there the possibility of more positive outcomes?

Still, in our view, if the strategic competition between the US and China is managed well, the rise of trade tensions may also bring some positives for the global economy:

Ongoing dialogue guiding the unavoidable strategic competition between US and China

Strategic competition between an incumbent major global power (US) and a rapidly emerging new power (China) is probably inevitable. The question is how to manage this competition in a prudent way. From that perspective, the escalation of trade tensions can have a positive effect, in the sense that they could bring a more meaningful, ongoing dialogue between the US and China serving as a guide with regard to future strategic competition and cooperation.

Acceleration of China’s reforms and opening up

It is unlikely that China will give in to all US demands. We do not expect China to be willing to give up its ‘state capitalist’ model. Nor will it give up its goal to create national champions with a strong global presence. However, trade tensions seem to have to some extent contributed to China’s preparedness to reform in certain areas: the further reduction of import tariffs, the liberalisation of the FDI regime, the opening up of the financial sector and the need to create a domestic level playing field between state-owned and private firms. Although Beijing will refer to these moves as long foreseen structural reforms needed to tweak China’s growth model, it is likely that the trade tensions have hastened this process somewhat.

Trade war may also create some winners

Tariffs – if they remain isolated bilateral disputes – do not necessarily have to reduce trade, but may rather shift it. Disruption to China-US centered global supply chains may create opportunities for other countries/regions, as both US and Chinese importers look for alternative suppliers. According to a recent study of the Economist Intelligence Unit[5], a US-China trade war could create opportunities for Mexico (cars) and Canada, the European Union and some countries in emerging Asia (Malaysia, Vietnam, India, Thailand and Bangladesh in particular) and Latin America (soy bean producers).

[1] The threat of a general tariff on autos remains.
[2] US has threatened to impose a 25% import tariff on all imports from China.
[3] IMF, World Econonomic Outlook, Challenges to Steady Growth, October 2018, Scenario Box 1 – Global Trade Tensions (pp 33-35)
[4] See for instance: Mankiw, Macroeconomics, International Edition, Ninth Edition, 2016, Ch. 13 for an explanation of the IS/LM Model.
[5] Economist Intelligence Unit¸ Creative disruption – Asia’s winners in the US-China trade war, 2018