We continue to go in circles on trade policy. Following the initial 301 tariff threat, ZTE sanctions, and a reported ‘truce’, tariffs are again back on the table. And not just any tariffs, US$450 billion worth of potential tariffs. So once again, the question vexing markets is whether or not this is brinksmanship and can be negotiated, or part of a longer-term strategy aimed at restructuring the US/China economic relationship. The answer, while crucial, is not clear.
If brinkmanship, a Chinese offer to buy more US products could likely resolve the tariff problem (even if investment restrictions are expected to stay). However, if part of a broader plan to hurt China by reducing their competitiveness and redirecting supply chains while accepting the costs to the US economy, then tariffs will proceed. We suspect the Washington bureaucracy has shifted and is prepared to take a more confrontational strategic approach to the China relationship, especially now that the business community has also shifted towards a more hawkish stance advocating for more pressure on unfair Chinese policies.
Trump himself, however, remains the question mark and, in trade matters, the President matters the most. Unlike broader foreign policy which can be influenced and shaped by Congress and civil servants, on trade policy, after years of ceding authority to the White House, Congress has little ability to influence the outcome. So, what Trump wants ultimately matters.
Assuming tariffs are implemented, how could the situation develop? There are two broad potential outcomes – a one-round fight or multiple rounds. Most trade conflicts have been ‘one round’ i.e. tariffs are implemented, retaliatory tariffs are implemented, and then both countries negotiate an outcome. This conflict could follow that path — China does not want tariffs adding stress to an economy already weakening, and the US does not want consumer distress in an important election year. But, if both leaders assume they have the upper hand, and due to domestic pressures, the situation could quickly escalate.
If one round, the economic impact would be minimal: US$50 billion in tariffs on China is a drop in the bucket compared to the size of China’s economy. However, if the US escalates with a 10 percent tariff on an additional US$200-400 billion of imports, 90 percent of China’s total exports of goods to the US would be affected, likely resulting in significant economic disruption. How would China respond? Three broad options stand out: a) restrict US business activity in China; b) depreciate the currency; and c) sell US Treasuries. We deem options A and/or B as the most likely.
China’s response through the trade channel is limited, forcing the use of other measures to retaliate. Owing to the fact that US businesses derive a significant portion of either overall sales or sales growth from China, we deem it likely that China will retaliate either formally or informally against US corporates.
While the economic impact on the US is unclear, revenue disruption and resulting equity volatility could achieve similar negotiating leverage. The next effective option would be currency depreciation. A 10 percent depreciation could offset the additional tariffs at a 10 percent rate, although not without significant risks, including exacerbating outflows. There are no costless options, but hopefully we don’t reach that point.
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