The US has raised tariffs on Chinese imports and China has responded in kind. However, the mood has improved lately, raising hopes of a deal between the two countries which we believe is president Trump's aim ahead of the mid-term elections in November.
China is more limited in its scope to raise tariffs, but that does not rule out a host of measures it could take to make life difficult for US companies. Furthermore, China might be able to stick out the pain that a trade war would bring for longer than the US. It has more potential for fiscal support and, of course, President Xi's communist party will not be facing elections in the near future.
How might a US-China trade war play out?
It has been said that China has not responded to the latest threat from the US because it is limited in its ability to extend tariffs as a result of its much lower import bill. Whilst the US imported just over $500 billion of goods from China in 2017, China only bought $130 billion from the US. Adding in services increases the total but the point remains that China will struggle to match the US' threatened tariffs on $150 billion of imports. Perhaps that is why President Trump has said that ‘trade wars are easy to win’.
However, such thinking assumes that China can only respond by raising tariffs. China may have more leverage in financial markets, where it is one of the biggest holders of US Treasury bonds, for example. Selling these holdings has been mooted as a potential response by China with the aim of forcing up US bond yields and increasing the cost of US government borrowing. However, the result would be a Pyrrhic victory. The subsequent downturn in the US would significantly reduce demand for Chinese imports.
Another channel might be through the currency by devaluing the renminbi (RMB). Whilst this would help offset the costs of US tariffs, periods of weaker RMB have been associated with market volatility and concerns over capital flight from China. The People's Bank of China seems to be ruling out such a move at present, preferring to build a reputation for a stable currency.
If tariffs or financial measures are not to be used then what option does China have? We would look at the recent experience of the Lotte group who operate 99 supermarkets in China. The Japanese-Korean company was targeted by China after it provided land for the installation of the THAAD** missile defence system in South Korea. China subsequently embarked on a strict enforcement of fire regulations at the companies' stores and whilst the authorities may have had in mind the safety of Lotte customers, the result was that the stores became unable to operate. According to the Financial Times, of its 99 hypermarkets, 87 have been closed since February last year, often on grounds of fire-code violations. Lotte is now in the process of pulling out of China.
The US has significant operations in China: since 1990 foreign direct investment from the US to China has totalled $256.5 billion, with over 70 per cent going into greenfield sites. As a result US companies are directly exposed to the China market. For example, Apple generates around 20 per cent of its total sales in China, Boeing around 12 per cent and Nike 15 per cent of its revenue.
An easy win?
To conclude, a trade war is not our central case. Should the situation deteriorate this would not be a trade war in a conventional sense, such as in the 1930's when there were widespread increases in tariffs. China is more limited in its scope to raise tariffs, but that does not rule out a host of measures it could take to make life difficult for US companies. Furthermore, China might be able to stick out the pain that a trade war would bring for longer than the US. It has more scope for fiscal support and, of course, President Xi's communist party will not be facing elections in the near future.
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