By Mickey D. Levy
Trump's proposed new tariffs on $200 billion of imported goods from China escalate the U.S.-China trade conflict and intensify the debate about the economic and political implications of trade negotiations. Clearly, the tariffs will be costly to some U.S. industries, but they also put China in a bind. Also, markets are speculating that China may devalue its currency as a retaliatory measure. These issues are more complex on many dimensions than they seem on the surface.
Several critical points frame the escalating U.S.-China trade feud. The starting point is not free trade or fair policies. Global leaders tout the benefits of free trade while supporting policies that protect their favored national industries. Most find the current uneven array of trade policies workable and are willing to keep things roughly the same and work through official channels like the World Trade Organization (WTO) to achieve minor adjustments that take years to negotiate.
China's several decade-long boom in export-related manufacturing and rise as an economic powerhouse has been facilitated by trade and investment policies widely considered in violation of commonly-accepted standards of fair trade. Until recently, foreign nations and companies have accepted China's high costs of compliance and practices in order to gain access to its large and booming markets.
President Trump recoils at the U.S. enormous bilateral trade deficit with China and China's trade policies, and is aggressively pursuing corrective action outside the normal establishment channels like the WTO. China relies heavily on trade with the U.S., its largest trading partner. While Trump faces intense U.S. political opposition to some of his trade strategies, the leaders of China's command and control government also face intense economic and political pressures.
Chart 1: China Exports and Imports of Goods and Services
Source: China's State Administration of Foreign Exchange and Berenberg Capital Markets
China is now the world's largest exporter and importer of goods (Chart 1). The bulk of its exports are machinery and transportation equipment and manufactured goods. China's export-related manufacturing sector relies heavily on imports of durable goods equipment and energy products, particularly from South Korea, Japan, Taiwan, and the U.S., and an array of emerging nations for crude materials and energy.
The United States imports $506 billion of Chinese goods (22 percent of total) and exports $130 billion goods to China. The U.S. bilateral goods trade deficit with China is $375 billion, five times larger than the U.S. bilateral trade imbalance with any other nation. In recent years, the United States has become increasingly reliant on imports from China while China has become less reliant on imports from the United States. The primary flows of goods between the United States and China are more fully analyzed in a longer report we published as a reference for considering trade policies ("Visualizing global trade: rising volumes, multilateral flows," April 25, 2018).
China's export-related manufacturing has been the primary engine of its economic growth, which has lifted it from a poor emerging nation to the world's second largest economy, and a critical driver of global growth and trade. Underlying this dramatic economic rise was China's blatant mercantilist policies, including an artificially low currency peg through 2006, augmented by an array of centrally-controlled trade and investment barriers and practices that advantaged and protected Chinese producers and gave them access to the intellectual property of international competitors (through legal and other means).
In recent years, Chinese leaders have shifted policy gears toward increasing reliance on domestic consumption and services. In response, while its exports have continued to grow, rapid increases in domestic consumption and services have reduced Chinese exports as a percent of GDP to 19 percent (Chart 2). Nevertheless, China continues to rely heavily on export-related manufacturing, and the U.S. is its largest trading partner. This puts Chinese leaders in a difficult situation.
Chart 2: China Exports as a Share of GDP
Source: China Customs, China National Bureau of Statistics and Berenberg Capital Markets
Trump's proposed 10 percent tariff on an additional $200 billion of Chinese imported goods would raise the share of Chinese imports subject to new tariffs toward 50 percent. This would lift to roughly 10 percent the portion of total U.S. imports ($2.4 trillion) facing new tariffs. Tariffs and other barriers to trade impose economic costs, and this is not good. If these new tariffs stick, and nothing else changes, they would impose costs on U.S. consumers and producers.
However, the net aggregate effect of the new U.S. tariffs and China's retaliatory tariffs are expected to be relatively modest - the effect on GDP growth and inflation would be small, both barely enough to register in tenths - but the effects will vary widely by industry. Two points of caution: these new tariffs may be temporary, as they have been imposed as bargaining tools, and may be rescinded in future negotiations; and simple estimates of the macroeconomic effects based on multiplying the 10 percent tariff times the aggregate dollar value of the goods and guessing business or consumer responses are likely to be inaccurate.
New tariffs on goods that are easily and cheaply substitutable will have little net effect, while new tariffs on durable goods involved in complex supply chains that are critical to production efficiencies and not easily substitutable would impose larger economic costs. Also, whether the higher cost of an imported good is passed on to the end user as a higher price or absorbed in the margins of the importer depends on product demand and will vary by industry.
Consider the effect of China's retaliatory 25 percent tariff on imports of U.S. soybeans. China's demand for soybeans has not declined, so it needs to import the same amount. So far, China has cut its imports of U.S. soybeans by 20 percent and filled the gap by increasing imports from Brazil and other sources. U.S. exports of soybeans to Brazil and a few other nations have jumped to offset its reduction in exports to China. The net economic effect is much smaller than the U.S.-China bilateral trade flows suggest. In contrast, new tariffs on some durable goods used in complex supply chains that are not easily replaceable will be disruptive and involve higher transition costs and negative effects.
The bigger economic risk to global and U.S. economic performance is if Trump's escalation of trade barriers elicits more and more retaliatory measures by a broadening array of global trading nations and/or the ongoing negotiations lead to a sharp decline in confidence that would severely damage U.S. economic performance.
The probability of ever-escalating trade wars remains low, despite all the saber-rattling and scary media headlines. Every major economic power in the world relies heavily on trade, and while most global leaders would like to maintain the status quo and loath Trump's aggressive and bullying tactics, ultimately, our strong hunch is they will be willing to negotiate lower barriers that facilitate ongoing trade flows between global businesses and consumers. This is particularly true of China, which has benefited the most from trade and investment policies that have favored their economic boom while violating global standards of fair trade and investment practices.
We believe strongly in the benefits of free trade and disagree with Trump's tilt toward protectionism to reduce bilateral trade deficits, but believe that his aggressive and erratic negotiating tactics will force China to reduce some of its onerous trade barriers. For more detail, see "Trump's chaotic trade negotiations will likely result in lower barriers, but at a cost," April 4, 2018.
This week's tense NATO negotiations and outcomes are illustrative of how global leaders who had wanted to maintain the status quo grudgingly gave into Trump's aggressive urging on NATO cost-sharing. Feathers were ruffled and hatreds reinforced, but the establishment was changed. Another insight from the NATO meeting was Trump's vision and tactics blend a wide array of global security issues (NATO, Russia, North Korea, Syria and Iran, China, etc.), trade policies and economics (including oil and gas flows). Ultimately, we expect trade negotiations to involve diplomatic issues, with some very interesting outcomes.
A higher probability risk is if the trade negotiations jar confidence, which, from such elevated levels, would harm business production and investment, and dampen U.S. consumer spending. So far, confidence surveys have remained elevated, but they deserve close scrutiny.
Concerns about the effects of new tariffs on U.S. consumers are likely to be offset by strong gains in jobs and personal incomes and the 2018 tax cuts. These positive trends may also offset some trade-related concerns of businesses that face new tariffs on imported consumer goods, and provide some flexibility to raise product prices. On the other hand, while corporate tax reform and the easing regulatory environment also provide an offset to businesses, business confidence likely is more vulnerable to a sustained escalation of trade negotiations.
There are limits to this expectation that Trump's tactics will lead to negotiated reductions in trade barriers. If Trump were to actually impose a broad 20 percent tariff on imported European autos (rather than just threaten them), the economic and confidence effect would be significantly more damaging and our assessment of potential trade policy outcomes would become more negative. Building a stronger coalition between the U.S. and Europe makes more economic sense and would be a much more favorable strategy for gaining trade policy adjustments by China. Congress has stepped up pressure on President Trump, passing a resolution that it would have a role in imposing trade barriers. Insofar as Trump's threats of auto tariffs may hinge on the Administration's designation of large auto imports as a national security issue - which is a stretch - this official Congressional pressure may be a constraining factor on Trump.
The option for China to devaluate its currency is seemingly small, constrained by the economic reality that devaluation would be harmful to China's economy and inconsistent with the broader objective of increasing reliance on domestic consumption and services. An administered devaluation would reduce the operating costs of Chinese firms relative to foreign competitors in yuan-denominated terms, but would reduce the purchasing power of Chinese consumers who would face higher costs of imports.
It would also raise the costs of durable goods, materials, and energy imported by Chinese companies. The People's Bank of China manages its currency to the U.S. dollar.
Devaluing the yuan to the USD would generate an appreciation of the currencies of other nations that are some of China's biggest sources of imports, including South Korea, Japan, and Taiwan, accentuating the upward pressure on prices of China's imports. Also, Hong Kong, which is a very large destination (and transshipment channel) for China's exports, maintains an absolute peg to the U.S. dollar.
Presumably, China's leaders understand this economic reality and will limit the use of currency devaluation as a retaliatory tool.
These U.S.-China trade negotiations are expected to heat up and persist and get more rancorous rather than abate anytime soon, despite economic risks on both sides and mounting political pressures globally and in the United States. Trump is a persistent negotiator and not driven by ideology. He is concerned by China's enormous bilateral trade surplus with the United States and his perception that some of its trade and investment practices and strategies threaten U.S. security. Despite being an economic powerhouse, China wants to keep in place the trade and investment policies that facilitated their booming growth. Eventually, these issues will be resolved - we believe China will eventually agree to modify some of its onerous trade barriers and Trump will back off from some of his demands - but not on the near-term horizon.