Insight & Analysis

US-China trade war: fresh scenarios open up after Trump’s sudden about-turn

Published: May 2019

President Trump wrong footed many by suddenly escalating the trade war with China and his new, more aggressive stance has suddenly created several scenarios for how the dispute will evolve.

Against expectations, President Trump has escalated the trade war with China and while the odds remain high that Trump and Chinese President Xi will soon come to terms, the fresh impasse has suddenly made a number of other scenarios seem possible, even one in which the US, China and global economy suffer a recession.

The sudden about-turn by President Trump triggered an increase on the US tariff for US$200bn in Chinese imports from 10% to 25%. An additional US$50bn in Chinese imports already have a 25% tariff. In response, China says it will retaliate in early June with higher tariffs on many imported US goods.

According to Mark Zandi, analyst at Moody’s Analytics, the higher US duties will impact more than 5,700 different Chinese goods imports but will not apply to goods already in transit to the US, only those that left China on or after 10th May. It can take more than a month for ocean freight from China to reach the US, effectively providing a grace period for further negotiations.

It is unclear what prompted Trump to up the ante with the Chinese. His administration has suggested to media that the Chinese were backtracking on some provisions of the deal, most notably around subsidies provided to their large state-owned enterprises. But Zandi believes it may be that Trump is engaging in some sort of brinkmanship, as he appears emboldened by the resilient US economy and stock market to extract more concessions from China.

Whatever the precise reasoning behind Trump’s volte-face, Zandi is clear that it has suddenly opened up a number of scenarios whereas before a settlement had almost universally been expected.

The good

Given the difficult progress in the discussions up to now, the costs to the US economy and stock market if the war drags on, and Trump’s innate desire to deal, Zandi believes the odds are good that some type of arrangement will be struck by the end of the grace period in mid-June. Moody’s is attaching a 60% probability to this “baseline scenario”.

However, this baseline scenario also assumes Trump does not open a new trade-war front involving vehicle imports into the US, says Zandi, pointing out that the Commerce Department has ruled that vehicle imports are a national security threat, giving Trump the ability to increase tariffs.

He adds: “The president has long been upset with the large US trade deficits with Germany, Japan and Korea, due in large part to the imports of vehicles and parts from these countries, but he will likely table this fight for another day.

Under Zandi’s baseline assumptions, the economic outlook will not change meaningfully. US real GDP growth is expected to come in at 2.5% in 2019 and unemployment is expected to slowly but steadily decline throughout the year. Chinese growth is also not impacted, with real GDP growth of 6.3%, and the global economy continues to grow at close to its 3% potential.

The bad

Zandi’s “alternative scenario” is that Trump can’t find a way to shake hands with President Xi, and the higher 25% tariffs remain in place for longer, say through the end of the year. If longer than that, the trade war and its economic fallout would threaten to become a prominent part of next year’s presidential elections.

“The higher tariffs will have a meaningful impact on the US, Chinese and global economies. Global businesses can navigate around the impact of a 10% tariff — they can reduce their profit margin, pass along some of the higher costs to their customers, and source their imports from places not facing tariffs — but navigating around a 25% tariff will prove impossible. Global supply chains will be disrupted, hurting business investment and manufacturing output.”

Moody’s is assigning 30% probability to this alternative scenario and reckons it would reduce US real GDP growth this year by nearly half a percentage point to closer to 2%, potentially leading the Federal Reserve to cut interest rates, given the uncertainty and weaker growth. However, Moody’s is assuming the Fed won’t go that far as US growth remains close to potential and unemployment is stable and low.

Chinese real GDP growth will be reduced by approximately the same amount to just less than 6% this year under the scenario, although Chinese authorities may choose to ramp up their economic stimulus to offset the trade war’s ill effects.

The ugly

For Zandi “a much more serious, worst-case, and increasingly plausible scenario” is that Trump engages in an all-out trade war, following through on most of what he has threatened to do. This would include putting a 25% tariff on all Chinese imports to the US, which comes to some US$520bn for the past year, about one-fifth of all imports into the country.

“In this dark scenario, Trump also goes all-in on the 25% tariffs on vehicle imports and parts. The rest of the world doesn’t take all this lying down, and retaliates in-kind to the US actions. The Chinese could jack up tariff rates on all of the just over US$100bn in US imports to their country, but more likely China will have a non-tariff response.”

China could also make it more difficult for US businesses to obtain regulatory approval for various business activities or delay the time it takes for US goods to clear customs. It could even allow the yuan to depreciate further in value, as it did last year when the trade war first broke out. He adds: “An even more extreme step by China would be to altogether stop buying US goods— like the Apple iPhone. The Chinese boycotted Japanese cars a few years ago in a spat with that nation.

Moody’s is assigning 10% probability for this full-blown trade war scenario: “It would be a recipe for a US, Chinese and global recession later this year. The Fed will attempt to cushion the economic blow by cutting rates, and the Chinese will pump up monetary and fiscal stimulus, but these efforts will fall short.

“The length and depth of the downturn will depend on how long it takes Trump to call a truce, but given the fast-approaching presidential election, it is difficult to imagine he would allow the war to continue much into next year.”

Zandi concludes that while there is good reason to engage China on its questionable trade practices and generally poor behaviour in international commerce, Trump’s trade war “is a costly and likely ineffective way of getting China to reform…the economic costs of a war are potentially too high.

“There is a general consensus that Trump won’t push it too far. Once it does show up in lower stock prices and weaker US growth, he will relent. This makes sense, but it is important to carefully consider alternative scenarios.”

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