The unexpected and predictable consequences of trade wars

Key takeaways

• Despite the impact on the US economy, the Trump administration looks determined to undermine China’s supply chain and rise as a superpower
• The two sides look no closer to a deal and shipments are already finding new routes around the US tariffs via Vietnam, South Korea and Taiwan
• The US has removed preferential tariff treatment from India and Turkey and it is poised to impose tariffs on EU imports over aircraft subsidies
• The US used the tariff threat to reach a bilateral migration deal with Mexico
• Trade remains the most important threat to the global economy

The Trump administration clearly sees the current strength of the US economy as a window of opportunity to counter China’s rise as a superpower. Whatever the short-term cost to the US economy. In order to counter China’s economic rise, the present US administration has weaponised trade with the goal of shutting out China’s supply chain, even if that leaves the American economy and markets reeling to adjust.

When China joined the World Trade Organisation in 2001, the US and Europe expected reforms to create an increasingly western liberal economy. As we mark the 30^th anniversary of the Tiananmen Square massacre, the US tariffs show that the relationship has significantly changed in recent years.

There is no sign that China and the US are any closer to finding common ground in their disputes. On the contrary, the rhetoric has worsened with the US ban on its technology firms from doing business with China’s telecommunications company, Huawei, over security concerns. Formally, the next meetings will be at the G20 Summit scheduled for 28-29 June in Japan, where we don’t expect a breakthrough. In the meantime, China’s President Xi Jinping is signing new agreements in Moscow with his "best and bosom friend" Russian President Vladimir Putin.

Short-term winners, more targets

The US tariffs on China are already disrupting trade flows globally as suppliers and importers find routes around the mutually-imposed tariffs. US imports from Vietnam, South Korea and Taiwan have increased over the past six months while China has increased its exports to those three countries (see chart 1).

In the circumstances, we are watching carefully other trade threats from Trump who has made reducing the US’s trade deficit into a cornerstone of his presidency. The International Monetary Fund has argued that the US/China tariffs will cost USD 455 billion in lost production next year. Tariffs look like the wrong weapon for the wrong target (see chart 2).

In March the US administration announced that it no longer considers Turkey and India as developing countries, which means their exporters will lose their exemptions from US tariffs. The decision, in effect this month, says that Turkey “is sufficiently economically developed” and India has failed to promise that it will give US exporters “equitable and reasonable access to its markets.” The US is India’s biggest trade partner, accounting for one-sixth of exports by value. The US has also investigated the weakness of the Singaporean and Malaysian currencies.

Trump is also targeting the European Union’s trade surplus with the US, affecting German carmakers with a list of imported parts worth USD 53 billion that may be subject to tariffs unless talks can make progress. In July, the WTO will rule whether the US can go ahead with USD 21 billion of tariffs on EU goods related to a dispute over subsidies to Airbus (a similar WTO case may rule against Boeing in 2020).

‘Tariff Man’ pauses

President Trump is increasingly relying on tariffs as a negotiating weapon in its international relations. The US had threatened in May to start a new front in its trade war by applying a 5% tariff on all Mexican imports, with a 5% rate raised in increments at the beginning of each month to a 25% tariff in October. President Trump linked the tariffs with what he had described as “the illegal inflow of aliens” from Mexico.

An agreement reached 7 June between the US and Mexico “consists largely of actions that Mexico had already promised to take in prior discussions with the United States over the past several months,” including deploying the Mexican National Guard and detaining asylum seekers in Mexico while their cases are considered, according to the New York Times. Whether Mr Trump has presented the agreement over border measures following pressure from within his own Republican party, or simply understood the damage they would do, on 10 June he then tweeted that unless the Mexican government implements the agreement, the threatened tariffs would still go ahead.

The danger is that the Trump administration “is trying to use tariffs to solve every problem but HIV and climate change,” Republican Senator James Lankford said last week.

Mexico relies on the US market for nearly 30% of its Gross Domestic Product, so any new tariffs on its exports would erode profit margins and undermine jobs.

‘Massive return of jobs’

From the US’s economic point of view, it may look an odd time to start additional trade disputes. The logic in the Mexico case, according to the White House statement, was that high tariffs on Mexican goods mean “companies located in Mexico may start moving back to the United States” leading to “a massive return of jobs back to American cities and towns.”

If the US hopes to boost domestic manufacturing, it seems unlikely that jobs would necessarily move to the US where the labour shortages may rather raise wages. At 3.6%, unemployment in the US is at its lowest level in 50 years and the sectors most likely affected by any tariffs would suffer the most from any labour shortages. First hit on the target list would be transportation equipment (mostly car parts) which make up more than one-third of Mexico’s exports to the US worth USD 120 billion in 2018, and is the sector which registered the widest trade deficit with Mexico last year.

The tariffs on China are already forecast to increase US inflation as the higher costs of imports hit household spending and businesses’ supply chains. That has knock-on implications for US GDP, which would be compounded by any weakening in equity markets.

The threat of Mexican tariffs also surprised since on 17 May the US agreed with Canada and Mexico to lift tariffs on imports of steel and aluminium and drop their related disputes at the World Trade Organisation. The duties were blamed for stalling the ratification of the United States-Mexico-Canada Agreement (USMCA), signed last November.

Under the still-in-effect NAFTA (North American Free Trade Agreement) between Mexico, Canada and the US, most trade between the three economies is duty-free while globally the US’s average tariff was 1.7% in 2017, according to the World Bank.

Negotiating credibility

Mexico is the largest supplier to the US in vehicle and car parts and machinery, making it difficult for US manufacturers to find alternative suppliers for parts that in the course of their production cross the border multiple times (and so paying a tariff each time).

In addition, unlike Chinese exporters to the US, manufacturers shipping auto parts across the US/Mexican border have fewer options to re-route their business.

These fresh tariff-induced uncertainties have important short-term implications because they undermine the Trump administration’s credibility in negotiations with China. The US is supposed to be close to ratifying the USMCA, but the dispute with Mexico suggest that it can’t be entirely trusted to honour commitments already made with its nearest neighbours. This is damaging the US’s standing as a reliable counterpart in any international negotiations, and leading to increased market volatility.

As the American political calendar moves toward 2020’s presidential election, it looks likely that President Trump wants to be seen by his electorate moving from ‘Tariff Man’ to ‘Dealmaker’. This is a dangerous approach as manufacturing and economic output is dependent on the uninterrupted trade flows established over the past few decades.

While it seems that Mr Trump may be more reluctant to treat his closest economic partners and allies in the same way as China, global trade remains highly sensitive to disruption. As we have pointed out before, it remains the single greatest threat to the world’s economic activity, with an impact that has surprised everyone with its speed and spread.