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Fallout from US-China clash

Trump's tariff tactics could backfire if China decides to go on the offensive and erode US power and influence.

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US President Donald Trump and China's President Xi Jinping at a news conference in Beijing last year. If the tariffs on Chinese imports are permanent, the US will suffer an efficiency loss.

US PRESIDENT Donald Trump believes that "trade wars are easy to win". Many observers and investors agree with him as the US economy is recovering strongly while the Chinese economy is slowing down with the emerging markets (EM) being caught in the crossfire. How about thinking out of the box about the opposite: The US will be hurt while EM will benefit, with China playing a role in all this?

Classical trade theory of comparative advantage argues that limiting imports reduces both consumer welfare and productivity growth in the long run. So no one wins in a trade war. Macroeconomic conditions determine who gains and who loses in the short run, but such analysis does not seem to have gained much attention in the political debates on President Trump's tariff tactics against China.

US-China growth divergence

From a Keynesian perspective, the outcome of a trade war depends on whether the players are experiencing full-employment conditions or demand deficiency. In recessionary times, tariffs can boost domestic demand and employment by eroding the substitution effect of imports, albeit at the cost of long-run efficiency and welfare. But in a full-employment situation, tariffs merely boost inflation and impoverish the consumer.

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The robust US economy today is clearly close to, or even beyond, its sustainable production possibility frontier. US businesses will not only have to hire extra workers to boost output to displace Chinese imports, but they will also need to invest in new capacity. But the lack of spare capacity suggests that this new investment will have to come at the expense of other investments that were more profitable and productive before tariffs.

If the tariffs on Chinese imports are permanent, the US will suffer an efficiency loss as the comparative advantage theory argues - goods that could have been bought cheaply from China may use up resources that displace more profitable activity where the US has a comparative advantage.

Higher costs on domestically produced and imported goods will also reduce the US consumer surplus. This outcome is more likely if the US imposes tariffs more broadly to prevent production from shifting to other low-cost producers from China.

If the tariffs turn out to be temporary, the investment in capacity for displacing Chinese imports will become obsolete later, as their output will be undercut again by cheap, tariff-free Chinese goods. In fact, anticipating that tariffs may be temporary, US businesses may not invest or hire new workers to replace imports from China.

Add in the Chinese

If the Chinese suppliers also know that US businesses will not invest in import substitutes in response to what might be temporary tariffs, they will not necessarily cut their export prices to the US despite the tariffs.

This means that US importers will be left to pass the extra cost of tariffs onto the US consumer, or accept a reduction in their retail margins, or a combination of both. Hence, the tariffs will simply act as a tax on the US consumer instead of a penalty on Chinese exports.

US household well-being will also decline as a result of reduced hiring in sectors that face margin pressure exerted by the tariffs. There would also be little offset via increased hiring in sectors protected by the tariffs if indeed US firms choose not to expand production in response to what might turn out to be temporary protectionism. And as US importers pass on the tariff cost to the consumer, that will drive up US inflation and interest rates, ceteris paribus.

Impact on EM

To the extent that US tariffs do price China out of the US market, other EM producers may replace the Chinese exports unless the US imposes tariffs on all other imports. In this case, America's overall trade deficit will still remain but with a different geographical import composition.

In particular, US imports of low-end goods such as shoes, toys and textiles may shift to Vietnam, India, Bangladesh and Indonesia, while imports of higher-value goods such as electronic equipment and machinery may shift to Mexico, Turkey or South Korea.

Contrary to the conventional wisdom of the Sino-US trade conflict hurting EM, US tariffs may end up helping EM by boosting their exports to displace Chinese goods.

Meanwhile, if China increases its domestic stimulus to fight the trade war, it could also increase imports from EM. The combined trade diversion and Chinese demand effects will help offset some of the collateral damage on the region that the Sino-US trade conflict will bring.

The strategic implications

To the extent that President Trump wants to use tariffs to force US MNCs to cut their investments in China so that the interdependence of the two rival economies can be reduced, the strategy may backfire on US national security.

This is because since World War II, America's commitment to open markets through trade and investment has fostered an economic boom in Asia, which has created a benign economic interdependence between nations. This interdependence, in turn, has raised the cost of military conflict.

China has benefited from this system and, thus, should have an incentive to maintain stability and order. But if the US abandons its post-war economic engagement strategy, by corollary, it will reduce economic interdependence, lower the cost of armed conflict and possibly increase China's incentive to become more aggressive to erode America's power and influence. This should be seen by the Trump administration as a threat to US national security.

  • Steven Friedman and Chi Lo are senior economists at BNP Paribas Asset Management.