Trade tensions - the US ups the ante

Tensions are escalating rapidly between China and the US. Threatened US tariffs due to come into effect on 6 July met with promises of a reciprocal Chinese response. This in turn saw US President Trump order his officials to draft plans for tariffs on a further $200 billion of Chinese imports.

Though a smaller tariff (10% rather than 25% on the original $50 billion), this marks a significant intensification of hostilities and a more substantial macroeconomic impact, with total targeted Chinese trade now 10% of Chinese exports – consensus estimates place the economic damage at around 0.2% of economic growth. We believe China is likely to retaliate, having warned of “strong countermeasures”.

Chinese retaliation – possible non-tariff responses

China’s options for tit-for-tat retaliation become limited at this stage. Whilst the US imported just over $500 billion of goods from China in 2017, China only bought $130 billion from the US. In our view, China will instead be considering non-tariff options.

China may have more leverage in financial markets, where it is one of the biggest holders of US Treasury bonds, for example. Selling these holdings has been mooted as a potential response by China with the aim of forcing up US bond yields and increasing the cost of US government borrowing. However, the result would be a Pyrrhic victory. The subsequent downturn in the US would significantly reduce demand for Chinese imports.

Another channel might be through the currency by devaluing the renminbi (RMB). Whilst this would help offset the costs of US tariffs, periods of weaker RMB have been associated with market volatility and concerns over capital flight from China. The People's Bank of China (PBoC) seems to be ruling out such a move at present, preferring to build a reputation for a stable currency.

If tariffs or financial measures are not to be used then what options does China have? We would look at the recent experience of the Lotte group who operate 99 supermarkets in China. The Japanese-Korean company was targeted by China after it provided land for the installation of the THAAD missile defence system in South Korea. China subsequently embarked on a strict enforcement of fire regulations at the companies' stores and whilst the authorities may have had in mind the safety of Lotte customers, the result was that the stores became unable to operate. According to the Financial Times, of its 99 hypermarkets, 87 have been closed since February last year, often on grounds of fire-code violations. Lotte is now in the process of pulling out of China.

The US has significant operations in China: since 1990 foreign direct investment from the US to China has totalled $256.5 billion, with over 70% going into greenfield sites. As a result US companies are directly exposed to the China market. For example, Apple generates around 20% of its total sales in China, Boeing around 12% and Nike 15% of its revenue.

China could of course also consider an asymmetric tariff response, levying double the US tariff on all imported goods, or even higher tariffs to a range of goods calculated to target Trump’s supporter base, as with the original $50 billion tariff proposal. We do think that as US tariffs grow in macro damage (Trump has threatened another $200 billion if necessary), the chances of a stronger Chinese response rise; currency devaluation is likely to become a more widely speculated prospect.

Collateral damage

We recently attempted to estimate which economies are likely to be most affected a Sino-US trade war, and the analysis is still relevant under the latest threats.

We utilise data from the OECD on trade in value added (TiVA). This data looks at the origins of the value within each tradeable good, capturing information about global supply chains with the aim of reflecting the fact that although a good may be exported from China to the US, most of the components within it actually originated elsewhere. In the charts below, we extrapolate from TiVA data (which only runs to 2011) to obtain a rough estimate for 2017 of value added as a share of US-China trade for the most exposed economies.

For Chinese trade, about 65% of the value added in exports to the US originates in China, leaving significant scope for damage to other economies from tariffs on those goods. For the US, domestic value added is closer to 85%, according to the TiVA data. Japan is the most exposed developed market economy, though the value added is still small at 0.65% of GDP. On this measure, emerging market (EM) economies, such as Taiwan, Malaysia, Singapore and Korea, are more vulnerable.

For further trade war analysis, please see the May Economic & Strategy Viewpoint.