United States: Trade war escalates, amplifying downside risks and reducing likelihood of a deal
May 23, 2019
The trade war between the United States and China dramatically escalated on 10 May when President Trump raised the existing tariff rate on USD 200 billion of Chinese imports from 10% to 25%, while also threatening to impose new 25% levies on the more than USD 300 billion of Chinese imports currently unaffected by the dispute. The move indicated a breakdown of bilateral talks—which took analysts by surprise as negotiations had seemed to have progressed in the weeks prior—due to reported backtracking on previously-agreed commitments by the Chinese side. This latest development will likely have a limited impact on the U.S. economy for now, but has sizably increased the risk of a further, more painful tariff escalation in coming months, as well as the likelihood that at least some tariffs will stay in place for longer than previously anticipated.
As the current product list affected by tariffs has been designed to limit their impact on American consumers, the latest tariff hike should have a modest impact on price pressures and economic activity. According to economists at Goldman Sachs, current tariffs will increase core PCE inflation by about 0.2 percentage points (pp), peaking this summer before fading by end-2020. This would in turn drag GDP down by about 0.1-0.2 pp by the end of this year.
Nevertheless, according to economists at Goldman Sachs, if new tariffs on all Chinese imports are applied, which they forecast has slightly less than 50% chance of occurring, it could lower GDP by 0.5% overall. The team at Goldman Sachs also noted that, “if trade tensions sparked a major sell-off in the equity market the growth impact could worsen considerably”. As for core PCE inflation, the impact could increase to 0.6 pp in this scenario. Nomura researchers broadly concur with this assessment, and project that the new tariffs would lower GDP growth by 0.3 pp from late 2019 to 2020, while increasing core PCE inflation by about 0.5 pp. However, they estimate the likelihood of this scenario to be 65%. While the U.S. trade representative (USTR) has already begun the process to apply these new tariffs, the administration will likely wait at least until 28-29 June to act. This is when the next G20 summit is set to be held, which will provide an excellent opportunity for Presidents Trump and Xi to rekindle talks and pave the way for a deal.
On top of the U.S. tariffs, retaliatory measures from China also need to be accounted for. The increase of tariff rates on USD 60 billion of U.S. goods will likely have a relatively minimal impact, especially as the U.S. administration has enacted a USD 16 billion aid package for affected farmers. Nevertheless, the U.S. economy, and companies operating in China particularly, are more vulnerable to non-tariff retaliation measures. For instance, a recent survey from the American Chamber of Commerce in China showed that nearly half of its members now suffered from administrative pressures, ranging from government inspections, slower customs clearance and slower approval for licensing and other applications.
Moreover, China could resort to the “nuclear option” of restricting exports of rare earth minerals to the U.S., which would have a significant effect on the country’s industrial sector. Tellingly, the latest list of tariffs drafted by the USTR includes almost all Chinese imports, but excludes these rare minerals. Despite a recent veiled threat from Xi Jinping, such a move remains highly unlikely and is more likely to be used as a deterrent to further U.S. escalation.
Overall, our panelists still appear reasonably confident that a trade deal can be hammered out in the coming months. That said, many expressed concerns that the situation could get worse before it gets better, and some—like Nomura—now see further tariff escalation as their baseline scenario. Our most bullish panelists, such as CIBC and Scotiabank, believe domestic political dynamics may rein in Trump, especially if consumer prices flare up and equity markets weaken. As summarized by Brett House, VP and deputy chief economist at Scotiabank, “a 25% increase in the prices of smart phones, tablets, and computers heading into the 2020 vote has never struck us as a winning electoral strategy.”
On the other hand, some of our more bearish panelists see a further escalation as likely if not inevitable. For example, Allan von Mehren, chief analyst at Danske Bank, noted: “We worry that the two sides are ‘digging in’ and that Trump believes he can push China into more concession with his ‘maximum pressure’ tactic. We struggle to see a trade deal coming until there has been another round of escalation and sell-off in the markets that creates the needed pressure for both sides to meet each other halfway. We do not expect a trade deal until H2 with the highest probability mass in late Q3.”
All in all, the consensus view among our panel can best be expressed by Joyce Chang, global head of research at JPMorgan, who remarked that “although our baseline view remains that a US-China trade deal will be successfully negotiated, the risks are binary, and we prepare for more downside in the near-term as it could prove difficult to bring bilateral talks back on track.”
Author: Joffrey Simonet, Economist