This article first appeared in The Edge Malaysia Weekly on June 25, 2018 - July 1, 2018

TARIFFS are back...

After months of negotiations the US finally introduced import tariffs of 25% on US$50 billion of Chinese exports on June 15. The total range was smaller than the previously announced package of 1,300 products but still involves 1,102. The tariffs will be implemented in two rounds, the first tranche of US$34 billion (818 products) on July 6, and US$16 billion (284 products) after public consultation.

Notably, the products US levies are on specifically relate to the “Made in China 2025” plan to develop high-tech sectors such as aerospace, ICT, robotics, industrial machines, and (green) cars. In short, unlike US tariffs threatened on European cars or Mexican car parts, these stem from a genuine US perception of national security in terms of its relative dominance of high technology.

Immediately after the announced protectionist measures by the US, China responded it would retaliate with similar measures. The US therefore also faces two rounds of Chinese tariffs on their exports worth US$50 billion. The first round of US$34 billion also takes effect on July 6 and consists of 25% tariffs on agricultural products such as soybeans, corn, wheat, beef, pork, poultry and various types of vehicles. The second round of US$16 billion is assumed to cover the import of chemicals, medical equipment and energy-related products, such as coal and crude oil.

...bigly

There had been worries that rather than the US buckling in the face of Chinese retaliation it would instead increase tariffs further. Market whispers were of a repeat of the threatened US$100 billion increase mooted before negotiations took place and trade tensions seemed to ease. However, the US has raised the ante in this poker game even more “bigly”. President Donald Trump released a statement that: “China has determined that it will raise tariffs on US$50 billion worth of US exports. China apparently has no intention of changing its unfair practices related to the acquisition of American intellectual property and technology. Rather than altering those practices, it is now threatening US companies, workers, and farmers who have done nothing wrong...

“Therefore, today, I directed the United States Trade Representative to identify US$200 billion worth of Chinese goods for additional tariffs at a rate of 10%. After the legal process is complete, these tariffs will go into effect if China refuses to change its practices, and also if it insists on going forward with the new tariffs that it has recently announced. If China increases its tariffs yet again, we will meet that action by pursuing additional tariffs on another US$200 billion of goods. The trade relationship between the US and China must be much more equitable.”

Needle and the damage done

In short, another US$200 billion of 10% US tariffs loom, and if China responds again, that will become US$400 billion.

Together with the existing US$50 billion in measures already in place, and tariffs on steel and aluminium, we potentially have in excess of US$456 billion of goods with tariffs put in place against China — against total exports to the US of US$505 billion in 2017 according to US data. That means around 90% of Chinese goods could soon face a tariff. That surely moves this from a trade spat to a full-fledged bilateral trade war.

One can take the view that for now this is still just a US threat — an attempt to “needle” China into opening up its markets. However, what will be the damage done even from the existing US$50 billion of measures that we can already analyse more concretely.

Calculating the macroeconomic impact

In terms of the direct economic impact of protectionist measures by both China and the US, ideally one would like to use world trade models which have incorporated all tariffs and non-tariff barriers for different product groups, such as the Global Trade Analysis Project (GTAP).

As these calculations tend to be very time-consuming, alternatively, we use export elasticities by Jean Imbs and Isabelle Mejean (2010). Although there are some drawbacks to this approach, it is sufficient to get at least a quick and dirty indication of the economic impact.

•    Our calculations show that the duties on US$34 billion worth of goods that will be imposed on July 6 on either side will shave off 0.15 of a percentage point and 0.1ppt of Chinese and US GDP, respectively;

•    If we add the tariffs on the additional US$16 billion worth of goods that are planned to be implemented after public and business consultation, as well as the protectionist packages already in place on both sides, the total direct economic damage would end up being -0.24ppt of GDP for China and -0.14ppt for the US.

This relatively mild impact is not actually surprising, as exports constitutes only a small proportion of the total economy in both countries (19% in China and 12% in the US). By contrast, smaller and more open economies are more likely to bear the brunt of protectionism.

Nonetheless, there are possible second-order effects. It is hard to see how business confidence in both countries won’t suffer an impact — although it will be interesting to note any dichotomy between the reaction of small US firms, which are generally not trading internationally and/or which face increasing “China price” competition in the domestic market, and US multinationals, who are far more exposed to global trade tensions.

We will also have to track how financial markets react — though so far in terms of both benchmark US equities and the VIX volatility index, there has been no panic selling similar to that seen in Europe during the recent standoff over the formation of the Italian government, for example.

Yet that may change rapidly now that we are looking at a potential US-China trade war.

Calculating the agri market impact

Although the total hit to Chinese and US GDP under the existing US$50 billion bilateral tariffs that are proposed is quite small, as shown, the same cannot be said for the Chinese or US agri markets. Indeed, the imposition of a 25% tariff on soybeans, as just one example, has enormous implications for various industries.

Raboresearch F&A team covering China has undertaken an extensive analysis of the impact of the steps already announced to date, which will be published soon. It underlines how much disruption can be hidden beneath a small change in aggregate national GDP. Our Agri Commodities Market Research team will also be releasing their analysis of the outlook for the US agri markets on June 21.

How bigly in response?

The key issue now becomes what China will do in response. One thing is clear: it cannot act on tariffs alone proportionate to the US because it does not import anywhere near as much from the States as the US buys from it — only around US$105 billion per year. Indeed, that is what the US is partly complaining about!

As such, what are China’s non-trade options? They have several — and yet none of them are either painless or without serious side effects.

China has an enormous stock of around US$1 trillion US Treasury holdings and thus to some extent finances the US current account deficit by buying US government debt with the dollars it receives from trading with the US.

If China were to decide to diversify into non-US assets (that is, by selling these securities) this could potentially exacerbate a rise in US interest rates, which would hurt the US economy. There are suggestions that part of the spike in 10-year Treasury yields above 3% recently was helped by aggressive Russian diversification away from US Treasury holdings in its foreign exchange reserves. Perhaps the threat of rising rates might force the US to change policy position? However, there are several counterarguments to that view:

•    First, the value of China’s US$3.1 trillion of forex reserves would naturally be hit should China sell off its Treasuries, pushing yields higher and the Treasury price lower.

•    Second, what else could China buy instead of US Treasuries? As noted above, China buys these assets as the counterpart of its trade surplus with the US. If the trade surplus is reduced ahead, so will Treasury buying in lockstep. But until that happens, China needs a liquid, safe home for its vast forex earnings. European government markets are suffering from a shortage of supply; Japanese government bonds are likewise being rapidly bought up by the Bank of Japan; and emerging-market government bonds and developed-market corporate bonds, and equities, are all too volatile for Beijing to invest in. In short, China has no real viable options but the US.

•    Third, a mass dump of US assets would result in further upward CNY/CNH pressure. This would lead to even lower exports through higher export prices, and thus a deterioration of the competitiveness of Chinese exporters on top of the hit from US tariffs.

Perhaps in biglier dimensions?

As such, if China needs to find another way to respond in this poker game it arguably needs to look elsewhere. Not only will US agri exports now be hit, but likely a far broader range of US goods and services. One can draw up a short list of the key US brand-name products and firms that will suddenly see problems with customs clearance, or with local bureaucracy. or with “spontaneous” consumer boycotts. China is already threatening “qualitative” assessments of US firms as a non-tariff barrier.

China is also likely to adopt a US services boycott. Tourism inflows to the US, where there is a hefty US surplus of course, would rapidly dry up, for just one example; furthermore, any time there would a Chinese choice between a US and another foreign service provider it would be clear who would win the battle.

Another potential option to offset the loss of competitiveness due to US tariffs would be to devalue the CNY against the US dollar. Ironically, China could do that under the guise of allowing market mechanisms to function freely. All that it would take for a serious market-led CNY/CNH depreciation would be for the People’s Bank of China to announce that from now on, the currency is free-floating and that it will let the market set its value and/or perhaps to remove capital controls. We have already seen how the market has tried to test towards USD/CNH 7.0, and that would no doubt be achieved in short order. Indeed parity with USD/HKD at 7.75, and beyond, would not be unrealistic.

However, this is surely still a last resort. It would risk a collapse in forex reserves, a US dollar crisis, and financial instability. The key Belt and Road Initiative would also be impacted as its local currency price tag would rise dramatically. Moreover, it might trigger an even more aggressive US trade response. Even though CNY/CNH would be trading freely, it seems unlikely that the US would refrain from accusations of currency manipulation that harms US interests, and even higher tariffs in response.

So what other areas does China have to explore if it wants to raise the ante? Potentially, geopolitics. There will be an attempt to build an anti-Trump trade coalition with the EU — such overtures are already being made. However, who in Europe trusts China on trade? And who in Europe is willing to risk the loss of the US defence umbrella?

More pertinently, the recent Trump-Kim Jong-un summit happened with Chinese help. Is detente there, as Trump proclaims, or might China swing Kim back towards a more belligerent stance that would make Trump lose face and be forced to contemplate the ruinous expense of military action? Kim is about to visit Beijing. One wonders why. Yet, perhaps he successfully played China off against the US and is no longer a strategic tool for Beijing. In that case China might raise geopolitical tensions elsewhere to ask the question of the US, “Are electronics goods worth that fight?”

Different logics

Traditional economic analysis sees all trade wars as harmful — and this one is unlikely to be an exception. In case this winds up into a global trade war, with a general 20% import tariff in the US versus all other countries, and a retaliatory tariff of 20% by all US trading partners, not just China, scenarios run with our macro econometric model (NiGEM) show serious, negative outcomes.

In such a case, the global economy would lose out on 2.5ppt of economic growth over five years in total. The US would end up in a recession in 2019 and the economic damage would be substantial in the first five years: -6.3ppt of growth loss compared to a situation where trade tensions would be absent. We are talking about massive amounts here, up to US$1,000 billion of lost economic growth, something which is, ironically, the same amount Trump vowed to invest in infrastructure over the next 10 years during his campaign.

For China, the negative impact of a global trade war would also be substantial (-1.6ppts over five years’ time), but far lower than in the US. This is due to the fact that China would have the opportunity to step up trade with the rest of the world, as their relative competitiveness vis-à-vis the US increases.

Let’s not forget though that there is always the possibility that the US cranks up political pressure to force its trading partners and political allies, like the EU, to implement protectionist measures against China as well. If other countries followed up on US demands to “tackle China” with tariffs, the economic impact on Asia’s giant would be much more substantial. Could even expected Chinese domestic stimulus compensate? It is doubtful it could for long. As such, this is a very high-stakes game of poker.

So, back to the future, then

Against that backdrop one has to ask why we are still seeing escalation and not de-escalation at this stage. Perhaps because the underlying logic here is the peculiar strategic, not economic one.

The US wants to change China’s economic model; China doesn’t want to change it. If one sees this is as about trying to impose a painful change of behaviour then the logic is hopefully clearer: only by imposing the threat of a crippling cost can one hope to dissuade an opponent from fighting back.

That is the same strategic logic for having a nuclear defence option even when we all know that nuclear weapons are something nobody actually wants to use. (For doubters, consider if Trump would still have been meeting in Singapore with Kim if North Korea didn’t now possess nukes!)

As such, not only are US tariffs back, but a strategic logic says the US threats of US$450 billion, not just US$50 billion, in tariffs on China may be real. For China, the same strategic, not economic, logic points to upping the ante in any number of ways too, rather than backing down — even if that creates other global risks/volatility. And the same strategic logic says we are back to the issue of US versus China trade wars as part of a larger fight over whether it will be a US- or China-led economic future. The economy itself appears to be just a bystander.

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