President Trump signed an executive memorandum on Thursday, 22 March, instructing the US Trade Representative (USTR) to consider imposing tariff increases on Chinese goods. The memorandum is the direct outcome of the Section 301 investigation of China’s practices related to technology transfer and intellectual property, which the USTR believes undermine “the value of US investments and technology and weakens the global competitiveness of US firms”.
The memorandum also instructed the Treasury Secretary to propose actions that would impose restrictions on Chinese firms seeking to invest in US companies that operate in industries or are developing technologies deemed strategically important to the US.
The US trade tariff announcement has sparked investor concerns about a potential trade war that could also inflict collateral damage on a broader set of economies, impact global growth and inflation, and increase geopolitical tensions. As such, the announcement roiled global markets, with the S&P 500 index falling by 2.5% the day of the announcement, major Asian stock markets registering similar declines the following day, Treasury yields declining and haven currencies strengthening against the dollar.
Tariffs against China – likely products and economic impact on the US
Since the move was based on the results of the USTR Section 301 probe of China’s intellectual property practices, the tariffs could likely focus on Chinese electronics/tech exports, such as communication equipment, computers and data processing machines. Other products may include auto-parts, home appliances, furniture, clothing and toys. All these are the key products that make up the immense US trade deficit with China.
At this point in time, it is difficult to assess the impact of these measures on US growth and inflation. On the surface, the impact should be quite small as the tariffs are limited in scope – on up to USD 60 billion-worth of annual goods imported from China. The value of US goods imports in 2017 totalled over USD 2 trillion, hence tariffs would be placed on less than 3% of US imports and on about 10% of total imports from China.
Of course, any growth impact could be compounded if there is significant retaliation from China (see below) and, looking ahead, if simmering trade tensions between the two countries weigh meaningfully on risk assets and business confidence. As for any inflation impact, in addition to the limited scope of the tariffs, potential substitution effects and the willingness of Chinese firms to absorb the costs of tariffs through margin compression (perhaps supported by government subsidies) would also limit the extent of feed-through to consumer prices.
Not only are the tariffs limited in scope, but they will not take effect immediately, suggesting the possibility that any progress in negotiations with Chinese authorities over intellectual property practices could lead tariff implementation to be delayed further or scaled back. Following a 15-day period during which the USTR may propose tariffs, there will be a 30-day comment period and then a briefer period during which the USTR will make a final determination on tariffs. Thus at the very least, implementation of any tariffs against China – and implementation of any retaliatory measures by the Chinese government – appear to be at least six weeks away, providing space for negotiations to continue.
The broader context – US trade agenda raises risks of further tensions
Setting aside the specifics of this tariff action, it is useful to step back and view the announcement within the broader context of the administration’s trade agenda. Since its earliest days, President Trump and his trade advisors have been clear on pursuing an 'America First' policy aimed at reducing the US trade deficit and revitalising the US manufacturing sector, by challenging international trade norms and renegotiating trade agreements.
Renegotiating the North America Free Trade Agreement with Canada and Mexico started fairly quickly last year, but investors may have seen the delay in tariff measures as indicative of the administration’s bark being worse than its bite. In reality, though, the administration was following a legal process so that it could use specific authorities granted to the President under the Trade Act of 1974 and the Trade Expansion Act of 1962. Only in recent months has that process progressed to the stage of decision-making on tariffs.
The 'America First' agenda suggests that protectionist measures may not end with the Section 301 action against China. Indeed, there are reasons to suspect that the risks are tilted towards additional measures going forward.
- First, measures to date will have no meaningful impact on the US trade deficit, in aggregate or with individual countries. In fact, an increase in US growth fueled by fiscal stimulus implies scope for the trade deficit to widen further. Given the importance that the President attaches to the trade deficit as an indicator of the health of the US economy, a lack of improvement or worsening of the deficit could lead to further protectionist measures.
- Second, Trump ran on a campaign pledge to boost manufacturing jobs, and he and his advisors see protectionism as a means to that end (and generally see the benefits of such measures as outweighing the costs). In addition, the recent reshuffling in Trumps’ cabinet has resulted in a suite of advisors who are likely less willing to push back on Trump’s policy instincts, including on trade.
- Finally, the President and his main advisors believe that the size of the US economy and the large trade deficit provide significant leverage over China and other trading partners in trade policy negotiations. The administration may also believe that the short-term costs of a trade war are bearable compared to the cost of continuing to support international trade norms that it believes discriminate against US firms. As President Trump said recently, “Trade wars are good, and easy to win.”
Despite these factors that suggest risks of further trade skirmishes ahead, there are a number of mitigating factors that should serve to prevent a significant escalation in tensions with major US trade partners. For example, the administration’s recent trade policy measures are noteworthy for their lack of concrete details, a penchant for delayed implementation, and flexibility in application. This suggests that the administration may be pursuing a strategy of using the threat of tariffs as a negotiating tactic. If this is indeed the case, any progress in negotiations could serve to delay tariff implementation.
In addition, President Trump places great weight on stock market performance, viewing it as a referendum on his presidency. This could serve as a natural disciplining mechanism on trade policy, preventing more extreme outcomes that could lead to an equity market correction that rattles household and business confidence. It is also possible that Trump’s base could come to view the administration’s policies as harmful on balance, especially if retaliation by trade partners against US exports becomes more severe.
Finally, any movement by the administration to a broader set of tariffs (or unilaterally withdrawing from NAFTA) risks Congress taking action to amend trade laws to claw back power that has been ceded to the executive branch during the post-war period. The threat of such action (as well as any threat by Congress to block the administration’s legislative agenda) should limit the risks of significantly adverse trade policy outcomes. And the risk of Congressional action to limit the administration’s trade authority will likely increase next year, given the results of recent elections and polls that suggest the potential for a significant Democratic 'wave' in the Congressional mid-terms.
Prospects for retaliation from China
China reacted within hours by announcing tariffs on USD 3 billion-worth of US imports, including 15% on US fresh/dried fruits, nuts, wine, American ginseng, and a 25% tariff on pork and processed agricultural products. But this reaction was more of a lagged response to the steel and aluminium tariffs that Trump announced in February and just went into effect last Friday. Further tit-for-tat retaliation may include tariffs on major US exports such as aircraft, more agricultural products and autos. China could also hit back at US investments in China, which could hurt the Americans more than Trump could hurt Chinese investment in the US because there is a lot more US FDI (Foreign Direct Investment) in China than Chinese FDI in the US.
China’s retaliation strategy will likely focus on hitting those US exports that are politically sensitive. i.e. that could do more harm on US domestic politics, notably agriculture. Nevertheless, China’s reactions to any product-specific tariffs will likely remain restrained and proportional to avoid escalation. Beijing may even react constructively by voluntary export restrictions on selected products, better enforcement of intellectual property rules, easing requirements on technology transfers in selected sectors and further opening its services industries, as Premier Li Keqiang alluded to at the closing of the National People’s Congress on 20 March.
Economic impact on China and other countries in the supply chain
As long as the tariffs are product specific, which is currently the case, the macroeconomic impact on China is limited. The targeted USD 60 billion of Chinese exports are about 15% of annual Chinese exports. Research shows that a permanent 25% of tariffs on this amount of Chinese exports will trim 0.1ppts from China’s GDP growth. Separately, if Chinese exports to the US were to fall by a permanent 10%, that would cut Chinese GDP by about 0.3ppts. But all this impact can easily be offset by domestic infrastructure spending and/or an increase in Chinese exports to other markets under the Belt & Road initiative.
Thus, in our view, it is not worth Beijing’s while to use renminbi depreciation to fight the US trade tariffs. The costs of a large devaluation to counter the effect of the 25% tariffs will overwhelm the uncertain benefits for Chinese exports. China may even allow bigger renminbi appreciation against the US dollar (especially if the dollar remains on a weak trend) at the margin to soothe trade tensions. Nonetheless, there is an offsetting pressure on the renminbi’s potential strength by further serious US trade actions against Chinese exports. China is also unlikely to dump US Treasuries in retaliation, because doing so will only hurt its FX reserve valuation and there are no alternative assets into which the Chinese can switch their massive US Treasury holdings in the short term. Still, the threat of adjustments to Treasury holdings could provide China with significant leverage in trade negotiations.
While the damage to China should be rather limited, there are certainly risks on those Chinese stocks and bonds issued by the affected industries/firms. Broker research shows that those A-share sectors with 30%+ export exposure include electronics, computers, home appliances, machinery, hardware and semiconductors.
But there is the potential for collateral damage on other economies that supply parts and components to China. This effect can be estimated by stripping out the foreign value-added content in China’s gross exports and reassigning them back to its original source countries to assess their ultimate export exposure to the US. Of the top ten most-exposed countries to the US, six are in Asia. And of the most-US-exposed Asian countries, the industries that could be hit by US trade measures are textiles, leather and footwear in Vietnam, computers and electronics in Taiwan and Malaysia and chemicals and petroleum products from Singapore. This has risk implications on portfolio management and asset allocation.
Long-term risks stemming from on-shoring
As we argued recently, the longer-term risk is that both China and the US seem to be striving for on-shoring the globalised production chains built over the past three decades, with China doing it through import substitution to minimise the foreign share of its industrial base and the US via 'America First' policies. Even partial success of these initiatives could be worrying. Firstly, the breaking up of the global supply chains will likely bring back inflation by reversing the disinflationary forces brought about by globalisation. Secondly, cross-border production chains are a force for peace and stability as they raise the cost of armed conflicts. Reverting back to national production structures raises the possibility that big countries would try to settle their differences by force.
With contributions by Chi Lo and Steven Friedman More on US trade related topics