Trade wars have finally begun. After exchanging several threats over the last few months, both the United States and China have imposed a tariff of 25% on imports worth $34 billion. This marks the official beginning of what China dubs as “the biggest trade war in economic history”. While this trade war is far from the biggest the world has seen, it has the potential to cause some significant damage to the world economy. US President Donald Trump, who began the year by imposing tariffs on imported solar panels and washing machines, has vowed to possibly tax all Chinese imports into the US, which last year added up to a little over $500 billion. President Trump’s tariffs against China will likely resonate with voters who believe in his “America First” campaign and perceive the trade deficit with China as a loss to the US economy. China, not surprisingly, has responded by targeting American exports like soybean and automobiles, a move that could cause job losses in American states that accommodate Trump’s voter base. Other major US trading partners such as the European Union, Mexico and Canada have also slapped retaliatory tariffs on various US goods.
The ripple effects and the future of global economy
On July 06, the Trump administration imposed sweeping tariffs on $34 billion worth of Chinese goods, including flat-screen televisions, aircraft parts and medical devices. The goods marked for tariffs will now face a punishing 25 percent border tax when they are imported into the US. The Trump administration initiated these tariffs after concluding an investigation into some of China’s ‘controversial trade practices’. The new trade barriers are designed to penalize China for doing things like forcing foreign businesses to hand over their most-prized technology to Chinese companies – many of which are state-owned – in exchange for access to their market.
China immediately accused the US of starting “the largest trade war in economic history to date” and responded by imposing 25 percent tariffs on $34 billion worth of US goods, including soybeans, automobiles and lobsters. Minutes after the US tariffs went into effect, a spokesperson for China’s ministry of commerce said, “China promised not to fire the first shot, but in order to safeguard the country’s core interests as well as those of the people, it is forced to fight back … the US will be opening fire on the whole world and also opening fire on itself.” The state-run Global Times wrote, “If what the US wants is to escalate a trade war with China, then so be it. A little fighting may be the only way the Trump administration clears its mind and allows everyone to sober up.”
The aggregate amount of trade affected is moderate relative to the US and Chinese economies, but for the US, this is the most extensive import protection since the disastrous Smoot-Hawley tariffs in the 1930s. President Trump has threatened a 10 percent tax on a further $200 billion of imports from China.
1. On Global Economy
The trade war carries a major risk of escalation that could weaken investment, depress spending, unsettle financial markets and slow the global economy. According to analysts, the warfare could spread to other countries and to areas beyond trade. A prolonged conflict and the disruption of global supply chains can have a ripple effect on the global economy. Many of the products facing American tariffs have components and assemblies that are made in third countries which would be affected as well. Indeed, given the way supply chains work, the US consumer could well end up paying higher costs for products. An all-out trade war could lead to a collapse of global trade and shove the world economy towards a recession.
2. On Chinese Economy
China is in a fairly good position to weather this storm. Its economy is less dependent on exports in general, and exports to the US in particular, than just a decade earlier. The value added in its exports to the US is less than 3 percent of its economy. This reflects the fact that China is at the end of many global value chains, which include inputs from the US, Japan, South Korea and Taiwan. Some of the pain from the US tariffs will hit these other economies, not China.
Still, the trade war comes at a bad moment in China’s cycle. The authorities have been tightening financial conditions and trying to rein in financial risks, so that the economy is slowing, even before it takes a hit from trade. The Shanghai stock market is in bear territory, down 23 percent from a recent high in January. This reflects a combination of the de-leveraging campaign and worries about trade.
In the past two months, the Chinese currency has depreciated 4.3 percent against the dollar. This is a natural market reaction to the US protectionism. Over the same period, the dollar has appreciated about 5 percent against a basket of major currencies.
This is one of the ironies of the US which is trying to use trade taxes. They create uncertainty in the world and one result is that capital flows out of other economies to the US. In the short run, this raises the value of the dollar and largely undoes the protection.
Historically, when the US introduces protection, it has typically not led to an improvement in the trade balance, rather the opposite. In the case of US-China trade, 25 percent tax means that about $50 billion of imports will be more expensive, and the US is likely to import less.
But the other $500 billion that the US imports will be modestly cheaper because of depreciation and the US will import more. History suggests that the net effect on the trade balance will be minor. This is one reason that the direct effect on the Chinese economy is likely to be minor.
3. On US Economy
The US economy is humming along because of fiscal stimulus from tax cuts plus expenditure increases. Net job gains in June were above 200,000, the pattern of recent months.
In general, the trade war will destroy some jobs in export sectors and create some jobs in import-competing ones. This is a bad tradeoff because export jobs are generally of higher productivity and pay.
The job churning is also disruptive — the lost jobs are likely to be in agricultural states and southern states with auto plants, whereas job gains are probably elsewhere. The Trump White House is betting that, given the overall strength of the economy, some localized pain will be tolerable and the get-tough policy toward China will be a political winner for the midterms.
Economically, both the United States and China would lose from a trade war. Punitive tariffs would push up import prices, dent exports, cost jobs and crimp economic growth, so both sides would do best to avoid an outbreak of hostilities.
In this trade war with China, President Donald Trump wields one seeming advantage: the US could ultimately slap tariffs on more than $500 billion in imported Chinese goods. Beijing has much less to tax: It imported just $130 billion in US goods last year. Yet that hardly means China would be powerless to fight back once it ran out of US goods to penalize. It possesses a range of other weapons with which to inflict pain on the US economy. Here is a look at some of the options China has in this war:
1. Target American Companies
China’s state-dominated and heavily regulated economy gives authorities an arsenal of tools to disrupt US companies by withholding licenses or launching tax, anti-monopoly or other investigations. Also open to retaliation are services such as engineering and logistics in which the United States runs a trade surplus.
China’s entirely state-controlled media have encouraged consumer boycotts against Japanese, South Korean and other products during previous disputes with those governments.
Last year, Beijing destroyed Korean retailer Lotte’s business in China after the company sold land in South Korea to the Seoul government for an anti-missile system opposed by Chinese leaders.
Beijing closed most of Lotte’s 99 supermarkets and other outlets in China. Seoul and Beijing later mended their relations but Lotte gave up and sold its China operations.
2. Financial Leverage
Nationalists point to China’s $1.2 trillion holdings of US government debt as leverage. Beijing might suffer losses if it sold enough to influence US debt financing costs – but such sales might become necessary. In addition, China’s yuan has sagged against the dollar this year, which might require the central bank to intervene in currency markets. To get the dollars it needs, the People’s Bank of China might become a net seller of US Treasury. Punishing the US Treasury market is, thus, one of the tactics China has available to retaliate against unilateral US tariffs.
3. Diplomatic Pressure
Beijing can appeal for support to US allies that are miffed by Trump’s “America First” approach and the US withdrawal from the Paris Climate Agreement. Trump’s unilateral actions have allowed China to position itself as a defender of free trade despite its status as the most-closed major economy. That could help Beijing win over governments that have criticized Trump for acting outside the World Trade Organization.
Chinese leaders have tried – so far without a major success – to recruit European and other governments as allies. More broadly, Chinese commentators have suggested Beijing also could disrupt diplomatic work over North Korea’s nuclear and missile programmes or other initiatives. But political analysts say that would risk setting back work Chinese leaders see as a priority.
The trade conflict is unlikely to de-escalate with in 2018. If the US identifies further imports to be taxed, there will be a 60-day comment period, which provides one window for negotiation. China, however, is unlikely to change its basic offer: It is willing to buy agricultural products, energy and high-tech manufacturing if the US is willing to sell.
It is gradually opening up more sectors of its economy, such as automobiles and financial services. If the US persists in the trade war, then American firms are likely to be shut out as China opens up. By 2019, the negative effects of the protection are likely to be stronger while the influence of the fiscal stimulus wanes.
In a globalized world, no country can hope to impose tariffs without affecting its own economic interests. Apart from disadvantaging its consumers, who will have to pay higher prices for certain goods, tariffs will also disrupt the supply chain of producers who rely on foreign imports. So both the US and China, which have blamed each other for the ongoing trade war, are doing no good to their own economic fortunes by engaging in this tit-for-tat tariff battle. The minutes of the US Federal Reserve June policy meeting show that economic uncertainty due to the trade war is already affecting private investment in the US, with many investors deciding to scale back or delay their investment plans. China, which is fighting an economic slowdown, will be equally affected. The ongoing trade war also threatens the rules-based global trade order which has managed to amicably handle trade disputes between countries for decades. It could also isolate the US, which has refused to settle differences through serious negotiations, as other global economies strike trade deals on their own. In March, for instance, 11 Asia-Pacific countries went ahead to sign a Trans-Pacific trade deal while leaving out the US, which had pulled out of the Trans-Pacific Partnership in early 2017. If global trade tensions continue to simmer, it may not be too long before countries resort to other destructive measures such as devaluing their currencies to support domestic exporters. The world economy, which is on a slow path to recovery, can do without such unnecessary shocks.
However, do not be surprised if in 2019 the US takes the offer that has been on the table, dressing it up a bit in order to declare victory.