Trade War Escalation Threatens Global Economy

Key takeaways

• The US has increased tariffs on USD 200 billion of Chinese imports from 10% to 25% and threatened further escalation on all remaining shipments from China
• China has threatened to retaliate
• The longer the dispute continues, the greater the threat to Chinese and US GDP as well as spillover into wider markets
• Unless a compromise is found, the dispute is the greatest short-term threat to the world economy.

First US President Trump engineered a trade crisis, now he has increased tariffs on thousands of China’s imports to the US market, escalating a trade war that endangers a fragile global economy struggling with weak growth and cheap credit.

Trump argues that the US’s record trade deficit is economically damaging and has pledged to reduce it. In 2018, the US had a USD 419.3 billion trade deficit with China and since 10 May is applying a 25% tariff on USD 250 billion of Chinese goods. China retaliated last year with tariffs worth 110 billion, covering almost all of its imports from the US, and has threatened to go further. In November, the US had halted any escalation as the two sides agreed to negotiate.

Talks appeared to be edging toward a deal until last week when, shortly before a scheduled US meeting with Chinese Vice Premier Liu He, the US received an amended draft agreement that changed wording deemed unacceptable to the White House, Reuters reported. While any 150-page trade accord would need amendments once translated into Chinese, the US argued that the changes reneged on planned commitments covering industrial subsidies, intellectual property protection and market access.

“They broke the deal,” Trump told a rally last week, “they can’t do that, so they’ll be paying.” Trump’s statements, often delivered through Twitter, seem designed to make him look tough ahead of his 2020 bid for re-election, while the US president’s agitation probably makes Xi Jinping look strong to the Chinese premier’s domestic audience.

‘No rush’

Estimates of the damage that the tariffs will inflict on the Chinese economy are between 0.5% and 1.5% of GDP, according to the International Monetary Fund, which warns that the dispute threatens the global economy (see our latest investment strategy analysis for more details.)

Markets initially fell in response to Trump’s statements. Then when the tariffs were confirmed, investors took an optimistic view. Because the duties only apply to shipments loaded from 10 May, some still hope that there may be a deal (unlike previous tariff hikes which were implemented immediately) in the weeks before companies and consumers start paying for goods arriving at the US border.

Trump then tweeted on the same day that “there is absolutely no need to rush” to reach a deal as “these massive payments go directly to the Treasury of the US.”

It is worth stressing that this is not how import tariffs work. While the tariff payments end up in the Treasury, it’s US importers paying the customs duties at the port of entry. They then, usually, pass on the additional cost to their customers.

The US president’s lack of urgency is worrying because the longer the dispute lasts, the greater the risks of wider contagion as companies look to replace existing trade routes.

“China deeply regrets this, and we will have to take necessary countermeasures,” responded the Chinese Commerce Ministry within minutes of the US tariffs coming into effect, without spelling out how it plans to retaliate. While China stands to lose more in a straight tariff fight, it could choose to retaliate by making it harder for US companies to do business in China. Indeed, the Chinese government has some experience in non-tariff retaliations with both Japan and South Korea.

Rapid escalation

Much of the positive news around a negotiated settlement was already priced-in before Trump’s initial announcements, and markets fell last week. Any more bad news may quickly undermine markets further.

Frighteningly for businesses trying to ship between the US and China, the lead-time between the first signs that there was a hiccup with the negotiations and the tariff hike has been less than a week. In the past, the Trump administration signalled increases well in advance.

Of course, the dispute is as much about the geopolitical balance of power as trade. China is trying to manage its transition to a more services-led economy along with falling growth, rising wages and the increased social costs that go with an ageing population.

The US argues that China should provide more support and leadership for the global trading system, and that China’s policies distort many industries. In November 2017, U.S. Trade Representative Robert Lighthizer called China’s decade-long plan to modernise the country’s manufacturing capacity “a very, very serious challenge, not just to us, but to Europe, Japan and the global trading system.” (See chart for details of escalation risks)

Breternity

Different trade negotiations continue in London. The two main British political parties are engaged in lacklustre talks to reach a consensus about leaving the United Kingdom’s biggest market. Despite the fractured and partisan discussion, whoever eventually takes over from Theresa May as UK prime minister will likely be left with the withdrawal deal that is already on offer today. And probably then blame May’s legacy and the democratic decision taken under faulty assumptions in June 2016 for the effects that follow.

As we have written before, once a withdrawal agreement is in place, the Brexit negotiations become more technical. And it may become even clearer that every alternative to EU membership in the name of greater independence leaves the UK economy weaker. While destabilising, that relationship does not contain the seeds of a wider threat to international trade.

That is not true for the US-China dispute. China is uniquely dependent on its US exports, which dwarf even its shipments to the eurozone and through Hong Kong (see chart).

As we go to print, Trump has said that “the process has begun” to impose a further 25% tariff on all remaining Chinese imports. Unless the US and China can find face-saving grounds to reach a compromise, this trade row looks like the greatest immediate threat to global economic stability.