THE threat of a full-blown trade war has escalated in the last few weeks with the G7 meeting ending in disarray over US tariffs on imports of steel and aluminium from its allies. More importantly, Donald Trump threatens tariffs on (so far, at least) US$450 billion of imports from China, and China threatens to retaliate. Our base case remains that a negotiated solution will ultimately be reached, but the pain threshold in the US is clearly higher than initially thought and the risks have increased.
A trade war is when countries raise significantly the barriers to trade, each motivated to "protect'' domestic workers - sometimes with a "national security" as a front. The most notorious trade war is that of 1930 where average 20 per cent tariff hikes on most US imports under Smoot-Hawley legislation led to retaliation by other countries and contributed to a collapse in world trade.
A basic concept of economics is comparative advantage: If countries A and B are equally good at making product X but B is best at making product Y, then it's ideal if A makes X and B makes Y. Simply put, free trade leads to higher living standards and lower prices, while restrictions on trade lead to lower living standards and higher prices. The trade war of the early 1930s is one factor that put the "great" in The Great Depression. As RBA Governor Philip Lowe observed: "Can anyone think of a country that's made itself wealthier or more productive by building walls?"
Mr Trump is threatening tariffs to "right" what he regards as unfair trading practices. He wants better access for US exports to China and stronger protection of US intellectual property. His comments at the recent G7 meeting, where he proposed completely free trade, suggest that he secretly supports free trade.
Trade war fears
Fears of a global trade war were triggered in early March, with Mr Trump announcing a 10 per cent tariff on aluminium imports and a 25 per cent on steel. US allies except China were initially exempted, but exemptions for Canada, Mexico and the European Union expired on June 1. Tariffs on steel and aluminium imports are minor, at around 1.5 per cent of total US imports, but there is a risk of escalation as the affected countries retaliate.
The main focus remains China. On March 22, in response to the Section 301 intellectual property review (alleging theft by China), Mr Trump proposed 25 per cent tariffs on US$50 billion of US imports from China and restrictions on Chinese investment in the US. At the same time, the US lodged a case against China with the World Trade Organisation. China then announced "plans" for 25 per cent tariffs on US$50 billion of imports from the US, with a focus on agricultural products. Following that, Mr Trump threatened tariffs on another US$100 billion of imports from China.
These tariffs were put on hold after a May 19 agreement between the US and China, under which China agreed to import more from the US, reduce tariffs and strengthen laws to protect intellectual property, with negotiations on the details to come. Mr Trump initially cheered the outcome, but after domestic criticism, announced that the US$50 billion in imports from China would be subject to a 25 per cent tariff which would be finalised by June 15, and that investment restrictions would be finalised by June 30. The 25 per cent tariff was set to start on July 6, for US$34 billion in imports.
After China called off the May 19 deal and said it would match the US tariffs, Mr Trump revised the tariff on US$100 billion to 10 per cent on US$200 billion of imports. He also threatened to add on another US$200 billion to the list if China retaliates. This brings the tariffs on US imports from China to US$450 billion, which covers 90 per cent of America's total annual imports from China. Along the way, Mr Trump has also announced consideration of possible car tariffs.
Clearly the escalating tariff threats have added to the risk of a full-blown trade war between the US and China, and between the US and its allies if there are further escalations. The initial steel and aluminium tariffs and the proposed tariff on US$50 billion of imports from China amount to 3 per cent or so of US imports, or just 0.5 per cent of US GDP. This is hardly a trade war.
But if there are tariffs on US$450 billion of imports, it's about 18 per cent of total US imports and will have a bigger impact. On this scale, it's inevitable that consumer goods will be impacted. And with China importing only US$130 billion from the US annually, its proportional retaliation to US tariffs will have to move into other areas like tougher taxation and regulation of US companies operating in China and selling US Treasury Bonds (although this will only push up the yuan and make things worse for China).
Of course, with US allies preparing retaliation against US tariffs on steel and aluminium, there is a danger of a conflict escalating as the US counter-retaliates. And there's the potential car tariffs.
There is the danger of Mr Trump's uncertainties over policies and that whoever has been handling the US negotiations has damaged Mr Trump's and America's credibility.
The negative economic impact from a full-blown trade war would come from reduced trade and the disruption to supply chains. Modelling by Citigroup of a 10 per cent average tariff hike by the US, China and Europe showed a 2 per cent hit to global GDP after one year, with Australia seeing a 0.5 per cent hit to reflect its lower trade exposure and Asia facing supply chain disruption. At present, we are nowhere near an average 10 per cent tariff hike (the average proposed tariff on US$450 billion of Chinese imports is 12 per cent, which works out to 2 per cent across all US imports)
It might also be argued that the US is poised to withstand a trade war because it imports from others more than they import from the US, and the negative impact from the proposed tariffs (about US$60 billion in tax revenue out of the economy) is swamped by the US$300 billion in fiscal stimulus boosting the US economy. Mr Trump also feels empowered because of domestic support in the US - especially among Republicans - for taking a tougher stance on trade, and his approval rating has risen to 45 per cent - the highest in his presidency.
US vs China
The current situation mainly involves the US and China, so the goods flowing between the two countries can be replaced by goods from countries not subject to the tariffs to reduce the impact.
What we are seeing is not a trade war, but more of a trade skirmish. The tit-for-tat tariffs are trivial in size. All the other tariffs are just proposals and the additional tariffs on US$200 billion of imports from China plus another US$200 billion would take months to implement, much like the initial tariffs on US$50 billion. Mr Trump is clearly using his "maximum pressure" negotiating approach with US Trade Representative Robert Lighthizer, saying "we hope that this leads to further negotiations".
Had the US no intention to negotiate, the tariffs would have been implemented long ago. And while Mr Trump is riding high as he stands tough for American workers, a full-blown trade war with China will not be in his interest come the November midterm elections. This would mean higher prices at Walmart and hits to US agricultural and manufacturing exports, both of which will hurt his base and drive a much lower US share market which he uses to measure his success. US Congressional leaders may also threaten intervention if they feel his tariff escalation is getting out of hand.
So negotiation is still the aim and China, given its May agreement, is presumably still open to negotiation. Our base case is that after a bit more grandstanding for domestic audiences, negotiations recommence by early July and delay the July 6 tariffs, ultimately leading to a resolution before the tariffs are implemented. Share markets might rebound in response to this.
But given the escalation in tension and distrust of Mr Trump, we will attach only a 55 per cent probability to this. The other two scenarios involve:
- A short-lived trade war with the tariffs starting up on July 6 and maybe some more, but with negotiations resulting in their eventual removal (30 per cent probability). This will likely see more share market downside in the short term before an eventual rebound.
- A full-blown trade war with China with all US imports from China subject to tariffs and China responding in kind, triggering a deeper 10 per cent decline in share markets on deeper global growth worries (15 per cent probability).
Watch for a return to negotiation between the US and China by the end of June. The renegotiation of Nafta and proposed retaliation from the EU against US steel and aluminium imports are also worth watching.
- The writer is head of investment strategy and chief economist, AMP Capital
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