U.S.-China Trade Tensions Now A Key Risk To Growth

Timing is everything

U.S. tariffs have been an ongoing theme since the March announcement on steel and aluminum, but the scale and risks associated with recent action can no longer be minimized within the economic outlook for 2019. Initial tariffs were broadly applied and affected most countries, including traditional U.S. allies and NAFTA partners.

However, these amounted to a mere $10 billion tax on American business inputs, which could mostly be absorbed. The next layers of tariffs have largely been leveled against China, and in grand fashion. We had little concern regarding the first tranche, which reflected roughly U.S. $50bn in “technology” imports, or products included as intermediate or capital goods. These ultimately raise costs for U.S. businesses, but again were relatively small in economic scope (see Chart 1). That view is now changing. On September 24th, Phase 2 ramped up the pressure on businesses, with $200bn in Chinese imports incurring 10% tariffs until year-end, rising to 25% thereafter. It is the latter 25% tax-hike that offers the greatest concern; particularly should it be coupled with a potential Phase 3 for an additional 10-25% tariff on $267bn in Chinese imports. This increasingly targets consumer goods, which would directly raise prices for American consumers alongside already-rising pressures among a broader range of American businesses.1

China has not sat idle, choosing to retaliate in a strategic fashion. China’s Phase 1 response focused import tariffs on cars (classified as other in Chart 2), as well as agricultural products like soybeans and pork. These are goods often produced within states where constituents tend to vote conservative. Phase 2 retaliation amounting to 5-10% tariffs on $60bn in U.S. products has shifted to include intermediate inputs and capital equipment. The lower 5% tariff is likely a nod by Beijing in recognition of the additional cost to be borne by Chinese importers on key components, particularly since the domestic currency has depreciated by 8% since the trade war heated up in March.

The latest tit-for-tat trade spat is expected to have negative economic repercussions for both the U.S. and Chinese economies. Model simulations suggest that a 10-25% tariff on $200bn in Chinese goods import could hit U.S. GDP growth by between 0.1 and 0.4 ppts in a little over a year’s time, depending on whether the U.S. administration follows through on applying the 25% tariff in the New Year. Implicit in this estimate is an assumption that sentiment among consumers and businesses is impacted, accounting for more than a third of the drag on U.S. economic growth. If these impacts fail to materialize, the drag to economic growth falls to the lower end of the range. However, we think it’s a leap of faith to assume equity markets would not recalibrate to lower earnings growth potential. Although there is always uncertainty embedded in forecasts calibrated on historical relationships, it’s a hard case to make that the negative effects on domestic income and consumer purchasing power will be completely skirted. It’s not realistic to presume that firms can fully substitute away from more expensive imports to domestically produced goods, particularly given the large scope of products captured in the latest tariff round. The end result will lead to less efficient supply chains, and by extension, higher production costs and less competitive domestic firms than the status quo.

Since China has retaliated by imposing 5-10% tariffs on $60bn of U.S. goods, there is an ever-present risk that the U.S. follows through on its threat to up-the-ante with an additional 10-25% tariff on the remaining $267bn in Chinese goods imports. This move could endanger an additional 0.4 ppts of U.S. GDP growth (Chart 3). Adding it all up, further escalation could reduce U.S. economic growth by up to 0.8 ppts over the next eighteen months or so, and is consistent with a loss in 250k jobs relative to the counterfactual of our baseline forecast (+0.15 ppt increase in the civilian unemployment rate, with the impact possibly larger depending on the total amount of goods targeted by tariffs).

Since more consumer goods were included in the current round of tariffs, higher consumer prices are all but guaranteed. Model simulations suggest a peak impact on inflation a year from now of about +0.1 to +0.3 ppts in the case of U.S. tariffs of 10-25% on $200bn, and the inflation impact could rise to +0.6 ppts if the U.S. were to impose a 25% tariff on an additional $267bn in Chinese goods imports.

The potential impacts of the tariffs already in place may not sound notable in an economy trending close to 3% growth. But, due to waning fiscal impulse and tighter financial conditions, our recent forecast has growth slowing towards 2% by early 2020 – when the peak impact from the tariffs would occur. Regardless of whether the U.S. follows through with Phase 3, the tariff-induced impacts may already produce a more anemic growth outlook.

No Surprises In China’s Response

The U.S. market for imported goods is $2.4tn, and home to some of the world’s wealthiest consumers. This gives the U.S. much of the leverage in trade negotiations with other nations. Chinese imports of $505bn comprised about one-fifth of total U.S. imports in 2017, representing a mix of intermediate and finished goods. Therefore, tariffs do not just make imported goods more costly for consumers, but also raise costs for U.S. industries that rely on global supply chains, threatening to make them less competitive overall.

Chinese authorities recognize that the U.S. has the upper-hand in negotiations, and have been careful in their response in order to mitigate any potential damage to their economy. In response to U.S. tariffs on Chinese goods this year, China has levied tariffs on about $113bn (or 73% of the total).

Although the U.S. maintains the upper-hand on having less trade dependence on China than vice-versa, it’s important to keep in mind that China has strategic levers at hand. For instance, shortly following the Phase 2 U.S. tariff imposition, Chinese authorities announced intentions to reduce import duties broadly for all nations, pushing China’s effective tariff rate down to 7.5% from 9.8% last year.2 Technically this was already in the works as part of China’s intent to pursue market reforms via trade deals with partner countries, but the timing may now have been accelerated. This has a couple implications for American companies. First, it can reinforce a first-mover advantage for companies from other countries into a $12.2 trillion economy, which has a clear advantage of rising incomes coupled with a large population base. Second, if China were to lower tariffs, in general, for countries, the U.S. would qualify under WTO’s most-favored-nation (MFN) rules. But, that benefit would now be obstructed as long as retaliatory tariffs remained in place. It also requires the U.S. to remain in the WTO to receive this benefit, which the current administration has placed into question. We doubt China would be quick to implement these changes, but they have clearly signaled market direction, and will ensure their path remains in alignment with their Made in China 2025 strategy, irrespective of U.S. policies,

China was open to ongoing dialogue with the U.S. administration, but has openly stated they would not negotiate under threat. So it was not altogether surprising that China pulled out of scheduled talks once the U.S. announced they would proceed with the tariffs targeting $200bn Chinese products. But, authorities have stated that they remain amenable to talks in late October or a November trade summit.3

So there we have it. Both countries have moved closer to intractable positions. This was reinforced by China earlier this week when they published a whitepaper stating its position on trade with the U.S.4 This document highlights mutually beneficial aspects of China-U.S. trade cooperation, but also addresses that the ‘America First’ attitude of the new U.S. administration has “abandoned the fundamental norms of mutual respect and equal constitution that guide international relations”. Moreover, the document highlights the importance of China and U.S. in the global economy, and that current trade tensions threaten to slow global growth.

Chain Reaction: Global implications

Certainly further escalation may start to impair global supply chains, risking a material slowdown in global trade, investment, and ultimately economic growth. A slowdown in Chinese economic growth from the current 6.6% pace may put in peril the growth outlook in its East Asian trading partners (Chart 4) that together comprise about 10% of global economic activity. However, the China trade spat may provide opportunities for these same trade partners to gain more Chinese business at the expense of U.S. firms. Nevertheless, since much of the value added in Chinese exports is generated abroad, these tariffs may exacerbate the economic slowdown already underway in China that has been orchestrated by authorities to wean the economy off its overreliance on debt. As such, supply chain partners outside of Asia, such as Europe, are also likely to be negatively impacted. For example, we estimate that a 1 percentage point level shock to Chinese output relative to our baseline would result in a loss of up to 0.2% in European output. In turn, softer European income and demand could compound the drag on U.S. output from tariffs, where Europe makes up more than 18% of U.S. shipments (Chart 5).5 This narrative gets replicated dynamically throughout the globe.

Although there remains hope that dialogue will provide a resolution to the current tit-for-tat trade dispute, there is reason to be worried that this is only a battle amidst a long cold trade war with China. It’s difficult to see how a new trade deal or global trade paradigm will satisfy both the U.S. demand for fairer trade, and China’s longer-run ambition of becoming a global economic and military power in the next few decades. This means that trade frictions between the two economic powers are likely to escalate in coming months, and that thicker borders between the two nations may provide a significant headwind to global growth beyond our estimated 0.3ppt drag.

End Notes

1. Based on analysis by Chad P. Bown et al. “Trump and China Formalize Tariffs on $260bn of Imports and Look Ahead to Next Phase” September 20th, 2018. https://piie.com/blogs/trade-investment-policy-watch/trump-and-china-formalize-tariffs-260-billion-imports-and-look
2. For further details see: https://www.scmp.com/news/china/politics/article/2165880/china-cut-tariffs-some-big-ticket-imports-it-braces-trade-war
3. For more details see: https://www.wsj.com/articles/china-cancels-trade-talks-with-u-s-amid-escalation-of-tariff-threats-1537581226?mod=searchresults&page=1&pos=8
4. A good summary of the whitepaper is available here: http://www.globaltimes.cn/content/1120652.shtml
5. Based on simulations in Oxford Economics Global Model, September 2018 baseline.