China has much more to lose than the US in a further escalating trade war

A long version of this study can be read here.

This week the G20 summit will kick-off in Argentina, but the meeting that will really catch the eye is the expected meeting between Trump and Xi Jinping on trade. Trump has hinted that a deal between both countries could happen, but this was not confirmed by Larry Kudlow, the director of the National Economic Council (see here). Given the reluctance of China to give in to US demands, we are sceptical that a deal could be wrapped up during the G20 and trade tensions will de-escalate. There even is a chance that early December President Trump will announce a new round of tariffs targeting all Chinese imports.

The question is: what is at stake economically? Many economists have made an economic impact assessment of the current situation and a further escalation of the conflict (see, for example, IMF, 2018a). Rabobank also has made some initial attempts to calculate the impact of this trade war mainly by focusing on export market share losses (see, for example, here). With relatively small volumes of trade being targeted at the beginning of the year, a partial analysis was sufficient to get an indication of the economic impact. However, as Trump has raised the stakes by targeting USD 250bn of Chinese exports to the US (followed by Chinese retaliation), a more thorough analysis is required. Therefore, in this report we have re-assessed the impact of the trade war using more advanced methodologies. For an extensive overview of the assumptions, methodologies, technicalities, limitations and detailed results of this scenario analysis, we refer to our background report.

Trump already referred to China’s unfair trading practices during his election campaign back in 2016, but it took a year before his administration translated his anti-China rhetoric into policies. Figure 1 shows a timeline of the most important steps in the US-China trade war. Initially, measures were relatively limited and not solely focused on China. However, after these small protectionist packages it became clear that the Trump administration was turning its protectionist focus towards China. And China took the moral higher ground vowing to fight back at any cost against any US protectionist policy directed towards them.

After failed talks between the US and China in May, the US tightened the screws in June by implementing tariffs on USD 50bn worth of exports from China to the US, which again was retaliated by China (Figure 1). In the most recently installed package by the US of USD 200bn introduced in September, three phases are evident (Figure 1). After the 'first' round of 10% tariffs on USD 200bn, the levies will be increased to 25% as of 1 January. If China retaliates, the US is also prepared to impose levies on another USD 264bn worth of Chinese exports, which in effect makes all export from China to US shores subject to a 25% tariff.

As China imports far less from the US than the other way around, it has less options. China has taking countermeasures for the USD 200bn package by targeting USD 60bn of US imports, which means that after the previously targeted USD 50bn, 87% of the total US exports to China are now subject to higher tariffs (Figure 1). Because China’s limited ability to match new US tariff packages by similar countermeasures, we foresee that they will use so-called non-tariff barriers (NTBs) as well. Finally, China can choose to be less cooperative as a mediating party in the conflict between the US and North Korea.

In our analysis, we define two trade war scenarios and compare the economic effects to a benchmark scenario in which a trade war would not have occurred. In our first scenario we take account protectionist measures that either have already been installed of have been announced[1]. In a second scenario we assume a further escalation of the trade war, where both countries decide to levy tariffs on all their bilateral imports. For the US this means a 25% tariff rate on an additional USD 264bn USD, and for China a 25% rate on another USD 50bn of imports from the US. Furthermore, we assume that China will increase non-tariff barriers (NTBs). For more details on the assumptions in both trade war scenarios and the benchmark scenario, we refer to our background report.

Methodology

In order to examine our trade war scenarios, we use the National Institute Global Econometric Model (NiGEM). The advantage of using NiGEM is that the model allows us to assess the impact of rising relative prices due to the protectionist measures on key economic variables in the short to medium term, such as the trade flows, investment and private consumption, something we have not been able to do in the partial analyses on trade wars that we carried out before.

Many studies have shown that trade is an important conduit for economies to benefit from international knowledge spillovers, which are an important determinant of a country’s ability to accelerate labour productivity growth. However, technological change in NiGEM is more or less exogenous. Therefore, we have calculated the technology shocks in our trade war scenarios separately and impose these shocks ex post in NiGEM. In order to do that, RaboResearch has developed two dynamic productivity models for both the US and China (see our background report). To our knowledge we are the only scenario study covering the trade war that also includes dynamic productivity effects.

[1] The announced measures are the American proposed tariff increase on 1 January 2019 from 10% to 25% on USD 200bn of Chinese goods, and the assumption that China will also raise their tariff rate from 7% to 25% on USD 60bn of American goods.

Here we present the results of our scenario analysis. Our two scenarios (scenario 1: current & announced protectionist measures, scenario 2: escalation to a full-fledged trade war) are compared to our benchmark scenario (no trade war).

Impact on the US

Figure 2 shows the impact on the US economy. In scenario 1, the US economy would miss out on 0.9ppts of growth in 2030 (cumulative) compared to our benchmark scenario. In case of a further escalation, the US would miss out on 1.6ppts of economic growth in the long-term, which is still relatively mild.

In absolute terms, the calculated effects imply that each US citizen in 2030 will miss out on USD 600 of cumulative wealth (Figure 3) and in case of a further escalation (i.e. scenario 2), this price tag could be almost as high as USD 1,100 per capita. As US GDP per capita currently is as high as 55,000 per capita, the costs of the trade will be relatively easy to bear. Then again, we also have to keep in mind that these are average effects, whereas we know that the impact is distributed unevenly. A banker in Manhattan will feel the pinch of the trade war to a far lesser extent than a cranberry or soybean farmer in the Mid-West.

Explanation

Figure 4 and 5 illustrate that US export growth is taking a beating, especially in scenario 2. This is the result of higher export prices due to the tariffs and non-tariff barriers implemented by China and the appreciation of the US dollar. The impact on private consumption due to higher inflation (Figure 6) caused by the US tariffs is mitigated by the strengthening of the US dollar. This alleviates the negative impact of higher import prices on their purchasing power. The impact on private investment growth is also relatively mild. For the US, the development of domestic demand is much more important than foreign demand. This explains why the US economy does not experience a large adverse shock in both our trade war scenarios.

Roughly one-fifth of the calculated negative GDP effects in the US are due to lower dynamic productivity effects. The damage of the trade war on the supply side of the economy is limited, as US firms do not heavily rely on Chinese technologies. Of course, lower import competition from China will alleviate the competitive pressure on US firms somewhat, which leads to less incentives for these firms to innovate and increase operational efficiency, but also these negative productivity effects are marginal at most.

Impact on China

For China, the trade war comes with a much heavier price tag than for the US. Our calculations (Figure 7) show that under the current circumstances (scenario 1), China would lose out a cumulative 1.5ppts of economic growth in 2030 compared to the benchmark scenario. In case of a further escalation (scenario 2), i.e. Trump would decide to target all of China’s export to US shores, GDP losses could end up being as high as 5.7% in the long-term.

In absolute terms, the calculated effects imply that each Chinese citizen (1.4 billion) in 2030 will miss out on USD 400 of cumulative wealth under scenario 1. In case of a further escalation, this price tag could be almost as high as USD 1,500 per capita (Figure 8). Given these numbers, one also has to keep in mind that GDP per capita in China (currently USD 15,000) is about 30% of US per capita income. The average Chinese citizen suffers much more from the trade war than the average American.

Explanation

The impact on the Chinese economy in our first scenario is more or less in accordance with findings in other studies, but in case of a further escalation we find much larger effects. This is due to a number of reasons. First, we expect the CNY to depreciate quite profoundly if Trump would announce another round of tariffs on all Chinese exports, as it will raise the pressure further on the CNY due to an expected liquidity response by the central bank and more pressure from capital outflows. This will deteriorate the terms of trade of Chinese households and weigh additionally on their purchasing power, besides higher consumer prices caused by tariffs and non-tariff barriers (see Figure 9). This inflationary impact reduces Chinese private consumption (Figure 10), which cumulatively is almost 10ppts lower in the second scenario compared to a trade war-free world.

Secondly, due to lower trade with the US (Figure 11), the Chinese economy will benefit less from technological knowledge developed in the US. This would consequently weigh on productivity growth in China going forward, which would have been much higher in case a trade war would not have occurred.

We did not incorporate any fiscal response from China in case of a further trade war escalation Such a response from the Chinese government is not unlikely. However, the room to manoeuvre is becoming more and more restricted, as we have emphasized before. Especially in the area of monetary policy, the Chinese government has to weigh its options carefully, given the already high and increasing debt levels. There is some more room on the fiscal side, but this stimulus needs to be focused on productive (non-SOE) investments.

Impact on F&A

So far, we limited ourselves to the macroeconomic impact of the trade war. Nevertheless, our colleagues from Food & Agri Research (FAR) have studied its impact on various industries in the F&A sector. Read more on the implications of the trade war on the global soybean industry[VS(1] , global soybean trade, China’s import pattern, the soybean processing industry inChina, theUS, andelsewhere, as well as on thelivestock sectorand onUS fruits and nuts. In Box 1, we briefly discuss the far-reaching impact of the current trade war on the global soybean market.

In our model, it is possible to assess the second-order impact on third countries spilling over from the direct confrontation between the two largest economies in the world. First, however, we have to address the caveats here. First of all, we have mainly focussed on the US-China relationship in our scenario analysis and have formulated detailed assumptions to calculate the impact of the trade war to the best of our ability. We have not included specific detailed assumptions for other countries. Furthermore (as stated earlier), one of the limitations of NiGEM is that it does not take export substitution and the impact on integrated global supply chains fully into account.

Market opportunities versus lower global growth

There are two effects in third countries that work against each other. First, relative export price levels in these countries decline vis-à-vis the US and China, which enables exporters in third countries to increase their global market share. This consequently would result in a positive impact on net exports in these countries due to substitution away from Chinese and US products in favour of products manufactured in these countries. Second, what is weighing on exports of third countries is less global trade and economic growth, which ends up 0.7ppts (cumulative) lower in scenario 1 and 2.0ppts lower in scenario 2 (Figure 12). This second effect is dominating, which leads to the conclusion that virtually every third country ends up with lower growth than in a situation where a trade war would not have occurred.

Another effect that is weighing on growth in third countries is the fact that firms that use intermediate goods from the US or China will be faced with more expensive products, which will be partly incorporated in their own prices. So higher inflation in the US and China will partly feed into higher inflation and lower private consumption in third countries as well.

Euro Area and the Netherlands

In the Euro Area, the US-China trade war would shave off 0.25-0.5ppts of growth in total up to 2030. This suggests that as long as the Euro Area won’t be directly involved in the trade war, the impact on the European economy will be limited. However, some European countries are affected more than others. The Netherlands, for instance, is a very open economy and also has relatively strong trade ties with the United States. Therefore, the current string of events weighs more heavily on Dutch economic growth (see Figure 13) compared to countries that are relatively less dependent on foreign trade, such as France.

Cumulatively, the Dutch will lose out on 0.4ppts of economic growth at the peak of the trade war in 2021 in scenario 1 against our benchmark scenario, with a long-term effect of -0.3ppts in 2030. In scenario 2, however, the total adverse effect in 2021 is -0.9ppts with a long-term effect of -0.7ppts. In absolute terms, the price (in terms of missed economic growth) each Dutch resident pays at the peak of the trade war in 2021 is cumulatively 170 euros in scenario 1, whereas a further escalation would more than double that price (380 euros).

In this study we made a re-assessment of the economic impact of US-China trade war. Compared to earlier Rabobank studies on this topic we adopt more advanced methodologies. Besides examining the direct impact on economies, we also assess the impact on labour productivity development, given the fact that trade is an important conduit to benefit from knowledge developed abroad.

Our first trade war scenario is the most realistic one and includes all protectionist measures currently in place, or announced. In the second scenario we assume that the trade war is taken a step further and the Trump administration will target the remaining Chinese exports to the US of USD 264bn (and China will retaliate). Both trade war scenarios are compared with a benchmark scenario in which a trade war would not have occurred.

Our findings show that trade wars in general will only lead to economic losses, most of which end up in the countries directly involved (the US and China), but also negatively affects third parties. In our first trade war scenario, global economic growth will (cumulatively) be 0.7ppts lower in 2030 than in a trade war-free world. In our escalation scenario, global economic growth will be 2.0ppts lower in 2030.

Given these losses, however, our scenario analysis also shows that China disproportionately is bearing the brunt of the US-China trade war. China would miss out on 1.6ppts of economic growth (400 USD per capita) in 2030 in our first scenario, and 5.7ppts (1,500 USD per capita) in our second scenario against the benchmark scenario of no trade war. The US will have to absorb economic losses of 0.9ppts (600 USD per capita) under the first scenario, whereas in the escalation scenario these effects will be 1.6ppts (1,100 USD per capita). Given these numbers, one also has to keep in mind that GDP per capita in China (currently USD 15,000) is 3.5 times as low as in the US. This underlines that the economic pain from the trade war weighs much heavier on the average Chinese than on the average American.

Our results for the US are largely in line with finding in other studies, but we find a much larger impact on China in case of a further escalation (scenario 2). This is for two reasons. First, we expect that the Chinese currency will depreciate quite profoundly if Trump would announce another round of tariffs on all Chinese exports. Secondly, due to lower trade with the US, the Chinese economy would be restricted in its capacity to benefit from technological knowledge developed in the US. This would consequently weigh on productivity growth in China going forward, which would have been much higher in case a trade war would not have occurred.

We have shown in this report that the stakes are high. In the short-run, any trade deal could ease tensions somewhat, but our expectation is that the tensions between both countries will continue for over a longer period of time. This study provides a clear picture of what the detrimental potential economic effects would be in that case.