Trump’s Trade War Is Getting More Serious

Trump’s trade war is following a familiar script — the age-old story of tit-for-tat retaliation leading to ever more escalation. In responding to U.S. tariffs however, China is at a disadvantage.

Chinese options

It is important to note that China’s tit-for-tat opportunities are limited because of the huge imbalance between American imports from China and vice-versa. If China wanted to retaliate and keep the pressure on the United States, it will have to find non-tariff methods once it has dealt with $130 billion of imports, and or subject some U.S. goods to much higher new tariffs.

Some observers have expected China to devalue the Renminbi or seen some of its holdings of U.S. Treasury bonds. These actions are “old chestnuts” and most unlikely.

The latter would be self-defeating because Chinese reserve asset values would drop. The former would risk reigniting capital flight at a highly sensitive time for the Chinese economy, and destabilizing Asian and global markets — in which China has no interest.

Rather, China should be expected to target or discriminate against U.S. companies operating in China, making it more cumbersome or expensive for them to do business relative to say, EU or Japanese companies.

The government could delay or block licenses and approvals for U.S. companies in China, and subject U.S. investment in and imports to China to administrative delays, inspections, and general awkwardness.

Further, it could simply confirm the operational management difficulties about which foreign firms complain, by insisting that state-owned enterprises and other Chinese firms continue to benefit from special regulatory and commercial treatment, and make life difficult for U.S. firms.

China’s track record

China has form when it comes to targeting foreign firms. In March 2017, it restricted tourists wanting to go to South Korea as a protest against Seoul’s adoption of a controversial U.S.-supplied missile shield. Previously, in November 2016, angry about the visit of the Dalai Lama to Mongolia, it imposed punitive fees on the country’s commodity exports.

In 2012, the Chinese government encouraged anti-Japan protests and actions against Japanese companies as tensions rose over the disputed Diaoyu or Senkaku Islands, and it also curbed tourism to and banana imports from the Philippines over the disputed Scarborough Shoal in the South China Sea.

In 2010, China acted against imports of Norwegian salmon over the Nobel Prize award to Chinese dissident, Liu Xiaobao, and implemented a rare-earth export embargo against Japan and other western nations, partly related to an earlier dispute over the Senkaku Islands.

So, if it wanted to, Beijing could target companies where the domestic effects might be negligible, and or where there are alternative foreign suppliers. It could, for example, cancel orders for aircraft built by Boeing, whose China sales generated about 12% of the company’s global sales in 2015.

Airbus provides a ready substitute. It could target semiconductor manufacturers such as Qualcomm and Broadcom, most of whose revenues come from China. It could penalise U.S. companies with big China operations, such as Apple, General Motors, WalMart and Starbucks, all of whom do big business there and are looking to expand.

A risky strategy

Yet, this sort of policy could become highly risky for China, threatening not only Chinese jobs and the livelihoods of citizens, but also the remnants of whatever trust existed between the United States and China. That is a price China may simply be unwilling to pay, except in extremis.

China will, therefore, have to give serious thought to how to respond to Trump. It may have not taken Trump’s trade policy seriously enough at the outset, and under-estimated the impact that an escalating trade war might have on the export sector and wider economy that is experiencing slowdown pressures, regardless.

So far, China has not acted disproportionately. Its latest responses include state rhetoric about refusing to be bullied, instructions to state media to down-play trade war coverage and reports about the Made in China 2025 strategy.

China has also shown a willingness to work with the EU and Japan directly and in the WTO to counter American trade policies, and a preparedness to offer U.S. and other foreign companies more liberal terms regarding entry into and ownership structures of specific sectors, such as autos and finance.

The German chemicals giant, BASF, moreover, was revealed last week to have been allowed to proceed with a major Guangdong project in which it would be the sole owner. And BMW learned that from none other than Premier Li Keqiang that it “could” become the first foreign auto company in China to be allowed to become a majority owner in its joint venture (with Brilliance Auto Group).

Effects

So far, most commentators and financial markets have been relatively unperturbed about this escalating trade war. The Chinese equity market is an exception, having dropped sharply to flirt with levels last seen in the 2015-16 crisis, but this has more to do with what’s going on in China rather than what’s being done to China.

From what we know today about the scale of the trade war, the effects will be harmful to global growth, but not critically so.

International institutions and global banks think the impact might be limited to about 0.25-0.5% globally over 12 months, and push inflation up by perhaps 0.25%. The effects on the United States and China would be rather larger, but still not enough to provoke a recession.

Where will it end?

The trouble is that no one knows where this will end. There will be second-round effects as supply chains become disrupted, investment flows and business confidence weaken and multiplier effects across countries as lower output and higher prices get passed around.

These trends are then likely to re-enforce additional protectionism, impair competition, and foster bad blood among nations. This is an environment in which downside growth risks loom a lot larger. Further, the cycle of trade responses could intensify, with the United States, for example, upping new tariff rates to well above 10-20%.

Under these circumstances, we should expect the global consequences of a trade war to become much more serious.

One major investment bank, UBS, has suggested that in a more aggressive trade environment, the world economy could become as “recessionary” as it became after the Lehman crisis, with a hit to U.S. and Chinese growth of between 2.25-2.5%, and to the EU of about 1.5%.

It is questionable whether global markets are discounting properly the cumulative effects of a trade war on the scale that we can discern today. It is certain that they haven’t even begun to contemplate the effects of an escalation in the trade war.

What happens next depends on how this war is going to be fought. The United States alone can’t fight a war if the rest of the world doesn’t play ball by retaliating. But by not retaliating, it will appear weak and willing to be bullied. Trump will doubtless oblige, and so we should expect this trade war to get worse first.