The US-China trade war in the rerun

On Friday morning, the US raised import tariffs from 10% to 25% on 200bn worth of Chinese goods shipped to US shores. The unexpected move had been ‘announced’ in a tweet by President Trump on Sunday evening. Moreover, in that tweet Trump also suggests that the US administration is willing to slap duties on an additional 325bn worth of goods later on, which, effectively, would imply that all Chinese exports to the US would be subject to higher tariffs.

The list of goods that are targeted in this decision range from F&A products, such as fish and rice, to furniture and boats. Companies may find some temporary reprieve in the fact that the US government has confirmed that goods in transit will be exempt. The notice provides that “products of China that are covered by the September 2018 action and that were exported to the United States prior to May 10, 2019, are not subject to the additional duty of 25 percent, as long as such products are entered into the United States prior to June 1, 2019. Such products remain subject to the additional duty of 10 percent for this interim period.” This means that companies will not immediately be hit by higher import costs. Moreover, it also gives the US and China a few extra weeks to continue negotiations and work out their differences before the threatened sanctions start to bite in earnest.

Rather unsurprisingly, China has responded with a statement that it is now forced to retaliate. However, so far it is unclear exactly what kind of tit-for-tat response China has in mind. That only reinforces the notion that China felt that they might be able to get away with the amendments they had made – not fully expecting the US to react in this manner.

Why did the US raise tariffs?

The Trump administration cranked up the pressure as Chinese negotiators were accused of backtracking on agreements already considered carved in stone by US negotiators.Reuters reports that last Friday Chinese diplomats arrived in Washington with substantial edits made in the 150 page draft agreement, which would remove the Chinese commitment to change laws on more structural issues that the US administration had raised earlier, such as forced technology transfer, violation of Intellectual Property (IP), subsidies for Chinese state-owned enterprises and currency manipulation. China’s refusal to commit itself to changing laws reaffirms that Beijing is concerned this would undermine China’s legal and policy sovereignty.

Moreover, the South China Morning Post said that: “some government advisors believe it would be better to accept higher tariffs than make ‘suicidal’ changes to country’s economic model.” This of course directly relates to the US’ demand to phase out excessive subsidies to Chinese large state-owned enterprises (SOEs). Registering a private sector debt of more than 200% of GDP, Chinese companies are far more leveraged than their EM counterparts and are probably not able to weather increased foreign competition. Keep in mind that these SOEs provide employment to millions of people and if a large proportion of these firms were to go belly up, this does not bode well for social stability in China.

The Trump tweet on Sunday caught market participants and analysts by surprise, igniting considerable volatility on financial markets across the globe, with Chinese stock markets taking the biggest hit. Chinese stocks had already tumbled in the last week of April on concerns that economic stimulus plans by the government would not be sufficient to kickstart growth and the CSI300 index had lost another 8% since the market opened after the Golden Week holiday (this morning’s rebound in the CSI appears mostly driven by Chinese state interventions to stop the sell-off). But in contrast to late April, the impact on markets has been much broader this week, with both US and European equities suffering as well. Flight to safe-havens has brought 10y Bund yields firmly back below zero again, whilst risk premiums have jumped. In European markets this has been most notable in higher spreads on Italian government bonds and on high-yield corporate bonds.

What’s more, it seems that the market is suddenly taking the risk of retaliation by China more serious now, with the Chinese renminbi coming under heavy pressure. Since 3 May, the currency has lost nearly 2% in offshore markets already. We have often highlighted this depreciation risk, because China simply will not be able to find the sufficient amount of import goods from the US through which it can retaliate with higher tariffs. And this is happening against a backdrop of a Chinese economy that is structurally sliding into slower growth and – as a result – is trying to rev up its growth engine by stimulating CNY borrowing, which raises the risk that it will at some point lack sufficient dollars to match. We note that the playing out of the current trade war scenario has been baked into our bearish base-case for CNY for some time now. Hence, a further weakening of the CNY remains on the cards and, without a political change of heart from China, a test of the 7 level for USDCNY would seem imminent in our view. Such a development could also trigger fresh accusations by the US that Beijing is manipulating its currency. A weaker CNY would also mean that other Asian currencies would have to depreciate for those countries to maintain their competitive advantage.

Looking at this from a broader perspective, the rise in risk perception in financial markets indicates that this week’s developments have served as a wake-up call for market participants, although it remains to be seen whether financial markets at this stage have already priced in sufficiently the downside risks stemming from a further escalation of the trade war. After all, equity prices are still significantly higher and risk premiums significantly lower than where they started the year. The more benign policy outlook for the major central banks may have offset growth concerns that had already emerged over the course of 2018 but with many central banks stuck with an ‘empty toolbox’ it is doubtful whether they are ready to fully address the materialization of the much-warned-for downside risk scenario. Against this backdrop, we would argue that – from a market perspective – the main risks going forward are:

Against a backdrop of slowing global economic growth, an anticipated US recession and the financial market risks highlighted above, the current string of events could easily aggravate the downward trajectory. In November 2018, Rabobank published a scenario study in which we assessed the economic impact in two trade war scenarios against a benchmark scenario where a trade war would not have occurred. We have calculated these effects by combining the global econometric trade model NiGEM with two dynamic productivity models for the US and China. For more information on the methodology, see here.

Two scenarios

In our first scenario, we take into account the protectionist measures that currently are installed or have been announced.[1] For a complete overview of all protectionist packages in place, see Figure 3. 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, we refer to our background report.

[1] We assume that China will also raise their tariff rate from 7% to 25% on USD 60bn of American goods.

Global economy

Due to lower global trade and investment, economic growth ends up 0.7ppts (cumulative) lower under current circumstances than the benchmark of no trade war. In case of a full escalation, this would even be as large as 2.0 ppts of missed GDP growth.

Impact on the US economy

Figure 5 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.

US export growth would take a beating, especially in case of a full escalation of the trade conflict (Figure 6). 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 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.

China

For China, the trade war comes with a much heavier price tag than for the US. Our calculations show that under the current circumstances, China would lose out a cumulative 1.5ppts of economic growth in the long run compared to the benchmark scenario (Figure 7). In case of a full escalation, i.e. if Trump decides 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.

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 the Trump administration were to announce another round of tariffs on all Chinese exports, as it will raise the pressure further on the CNY due to higher 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 (Figure 8). This inflationary impact reduces Chinese private consumption, 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, 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 for 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.

A downside risk in the trade war is that another round of uncertainty caused by the US tariff hikes will induce foreign companies to speed up plans to move their Chinese activities overseas, with other more stable low-wage Asian countries such as the Philippines, Vietnam and India being the usual suspects. The knock-on effect of a drain on manufacturing activity from China is something we could not assess directly, but the impact could potentially be substantial.

The Netherlands

There are two effects in countries that are not directly involved in the US-China trade war that work against each other. First, relative export price levels in these third countries decline vis-à-vis the US and China, which enables exporters in these 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. 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.

Cumulatively, the Dutch economy 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.

The official announcement of the rise in tariffs took place amidst talks between the US administration and Chinese vice premier Liu He, who currently is in Washington to talk about the trade deal on Thursday and Friday. He had dinner with US Trade Representative Robert Lighthizer and other US officials just hours before tariffs kicked in. It was not only awkward but likely also deliberate. It thus remains to be seen whether Chinese and US negotiators are able mend a trade deal in the coming days in an environment that is perhaps best described by ‘broken trust’.The latest news is that President Trump received a ‘beautiful’ letter by President Xi Jinping and both leaders may speak on the phone. Trump quoted Xi in the letter: “Let’s work together let’s see if we can get something done.” Then again, the SCMP reports that President Xi Jinping is not willing to make concessions: “Sources said President Xi Jinping earlier vetoed extra concessions proposed by his negotiators. “Xi told them ‘I’ll be responsible for all possible consequences’,” one of the sources said.”

So whilst there is still the outside possibility that both leaders will move quickly to restore the relation by reversing their recent actions, we would actually see two routes as being the most likely going forward, with the first option still our base case.

Option 1: a weak deal

The first option is that both countries will go ahead to agree to a weak deal. Given the current circumstances, this would be the ideal scenario for China. China is walking a tight rope: on the one hand it is not willing to give in to measurable and enforceable agreements in the deal on structural issues that the US has difficulties with, such as violation of IP, forced transfer of technology and subsidies for state-owned enterprises. On the other hand, a full escalation is not ideal for China as well: we have shown in this study that China has much more to lose under this scenario than the US. In fact, such a scenario could result in a potential USD liquidity shortage and, eventually, a balance of payments crisis in China, given its large and growing stock of short-term external debt.

The US may be willing to accept a weak deal, as President Trump is obviously not keen to tank the global economy as well as dragging down the equity markets in the run-up to the presidential elections next year. Moreover, disruptions to US supply chains operating in China are real and significant, and the tariffs might backfire as time progresses. If the US agrees to a weak deal, it will likely demand some sort of open-end vague phrases in the final deal about China implementing reforms, as to able to frame the deal as being strong and solid. As a weak deal would lack a concrete enforcement mechanism, the US would most likely keep current protectionist tariffs in place to keep pressure on the lid against China. This has been and still is our base scenario.

Option 2: full escalation

Having said that, we deem the second option, a full escalation of trade war caused by a complete disintegration of trust on both sides, as almost as likely. For one, Trump might see the rapid decline in the US trade deficit with China in March as evidence of the success of his protectionist policy agenda, not taking into account that this might well be the result of a cooling Chinese economy.

Moreover, the Trump administration seems to realise that the US has the upper hand in the current trade conflict, something which our scenario study acknowledges. The New York Times indeed reports that: “The Trump administration has done projections on the effect of the additional tariffs on the economy and believes that the negative effects will be minimal and pale in comparison to those facing China, an administration official said.”

If this is the case, the US won’t agree to a weak deal. Trade Representative Robert Lighthizer will also make sure that a weak deal won’t happen, as he has vowed as such before Congress. Crucially, his hardline view seems to outweigh that of the louder, more dovish voices of Steven Mnuchin and Larry Kudlow heard in the financial press.

A no deal outcome would have Rabobank revise its economic forecasts. But the stakes are much higher than solely economic consequences. China could escalate beyond tariffs - and beyond economics. North Korea just test fired two missiles again; the US and Japan, the Philippines and India all just sailed through the Taiwan Straits in unison; and the US and Iran are at real loggerheads. In short, the geopolitical context in which all this is happening, could amplify the impact of the trade war on other fronts as well.