China: a trade war with the US is not imminent, but risks are rising

On the 22nd March, United States (US) President Donald Trump’s administration announced that it was imposing tariffs on USD 60 billion of imported Chinese goods. The move comes on the heels of tariffs on imports of washing machines and solar panels in January, and steel and aluminium products in February. Mr Trump has frequently said that such measures are necessary in order to protect manufacturers in the United States (US). However, he had so far refrained from pointing fingers at China, the country with whom the US possesses the largest trade deficit, equivalent to USD 350 billion in 2017 – two thirds of the total deficit. The move also constitutes a break from Trump’s previous rhetoric in the sense that it targets a broad basket of products. These include: consumer electronics, telecommunication equipment, shoes, clothing, and toys, amongst others. A full list of products will be announced in fifteen days, and there will be a 30 day consultation period once the list is published. On the 23rd March, China retaliated by announcing tariffs on a proposed list of 128 US products worth USD 3 billion. The basket includes some of the main US exports to the country, including: a 25% tariff on US pork and recycled aluminium; as well as tariffs on agri-food imports such as soy, vegetables, fruit and wine. While a full-fledged trade war between the US and China is not yet imminent, risks are certainly on the rise.

Why are both sides ramping up protectionist rhetoric?

The new measures come amid the 301 Investigation, led by US Trade Representative Robert Lighthizer, into China's potentially unfair trade practices with the US. Mr Trump seeks to reprimand the Chinese state for both its investment policies that make technology transfer a precondition for doing business with China, and as retribution for intellectual property theft from US businesses that operate in the country. The announcement comes after a year of tough rhetoric and very little in the form of action, which has seen Trump’s popularity decline ahead of the important November mid-term elections.

The announcements come after a year of tough rhetoric and very little action

With the October Communist Party Plenum and the National People’s Congress out of the way, Chinese authorities understand that the onus of the bilateral relationship has shifted to the US political calendar. Mr Trump knows this as well, meaning that Xi Jinping will likely make some concessions on trade. For starters, a 25% tariff on USD 60 billion worth of Chinese imports will not cost China USD 15 billion, as price elasticities (a measure of how sensitive demand for exports is to changes in prices) are lower than one. The “cost” for China will be lower, and the same is true for Beijing’s proposed tariffs on USD 3 billion worth of US imports. Moreover, the US has proposed tariffs on a broad set of sectors, some of which are well integrated into global supply chains that are dominated by US firms. Tariffs will likely only target Chinese companies, further reducing the cost. At this juncture, both countries can afford the tariffs, but other factors offer cause for concern.

Both countries can afford the tariffs, but other factors offer cause for concern

Xi Jinping cannot appear weak during his first challenge after announcing last week’s constitutional changes, which enable him to remain in his role for longer because he has ostensibly proven to be an effective leader. Beijing will likely tighten its grip in other areas, such as aspects related to security and cross-strait relations. For this reason, bilateral relations between China and the US are expected to deteriorate further in 2018.

What are the main risks?

1) Worsening bilateral relations, weaker investor sentiment and some outflows: it is hard to imagine how investor sentiment can remain buoyant in the context of worsening relations. Confidence indicators will also likely decline, acting as a manageable but noticeable drag on the economic outlook through investment channels. Capital flows to the region are expected to remain positive, but if Friday’s knee-jerk reaction from global markets is anything to go by – the Hang Seng Index fell by 3%, while the Shanghai Composite fell by almost 4% on Friday – the coming year will be difficult.

2) Chinese exporters will be impacted: some Chinese exporters will experience a decline in orders once the final list is approved. Cancellations and amends to long-term contracts are possible. Coface estimates that products for which the US possesses the largest deficits with China will be affected the most. Likewise, Beijing will likely retaliate on products where the US has a largest surplus with China (see chart above). However, rather than boosting “jobs in the US”, more expensive Chinese imports will likely be substituted by cheaper equivalents: Bangladesh, Cambodia, India and Vietnam could gain market share in textile and shoes, while Korea, Philippines, Taiwan, Thailand and Vietnam, will probably gain in consumer electronics, and other machinery and equipment. In the longer term, China has more to lose as exports to the US account for 5% of its GDP in 2016 (versus 0.5% for the US).

Beijing’s retaliatory measures will hurt the Chinese economy

3) Beijing’s retaliatory measures will hurt the Chinese economy: the US tariffs were met with resistance from local business, as they increase the cost of intermediary goods, in turn eroding profits. The same is true for China. US imports of soybeans and pork can be substituted with imports from other markets (Brazil and Uruguay for soybeans; Germany, Spain and Denmark for pork). However, with larger market share comes more bargaining power. Food prices were a major drag on Consumer Price Inflation (CPI) last year (1.5% YOY). Low base effects are already exerting upside pressure on CPI. Higher input prices will amplify these pressures and lead to imported inflation. This is credit negative for the agro-food and retail sectors. Indirectly, higher inflation may trigger authorities to tighten monetary policy faster than expected, with repercussions for heavily-indebted enterprises across the board.

4) More protectionist measures could follow: negotiations are likely to commence soon. For example, Brazil and the European Union clashed over steel and aluminium prices in February, but US tariffs were finally exempted on 22nd March. While a full-fledged trade war has not yet manifested, things could take a turn for the worse if no agreement is reached.

Carlos Casanova Coface's Asia Pacific Economist, based in Hong Kong

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