The tug-of-war between positive economic fundamentals and the protectionist policies that threaten to undermine them has dominated the macroeconomic story so far this year. Regrettably, this narrative is likely to continue unabated for the remainder of the year.
Following the synchronised upswing of 2017, the global economy stuttered at the beginning of the year. Global growth lost momentum in the first quarter, in part reflecting special factors such as the impact from adverse weather conditions.
In recent months, economic growth has rebounded to levels that prevailed last year, when global growth came in at 3.7% (see Chart 1). What’s more, global growth has become less synchronised: the US economy has continued to accelerate, while economic growth has slowed in the rest of the world. This creates a fragile backdrop, in which trade tensions – that are likely to continue to brew in the run-up to the November US mid-term elections – could become a catalyst for a sharp and broad-based slowdown.
Chart 1: the global composite PMI bounced back in Q2 following a wobble in early 2018
Source: International Monetary Fund (IMF) and JPMorgan/Markit as at June 2018
Opening up markets to international trade
Current trade tensions are probably the result of long-standing trends that were amplified by the global financial crisis. In the last few decades, the share of income that goes to labour has declined across most developed countries. More recently, productivity growth in developed countries has also slowed. In other words, the main source of improving living standards has faltered, while the distribution of the economic pie, which is growing at a slower pace, has shifted to the detriment of labour. These developments have probably fuelled public disillusionment with the political establishment and the prevailing economic policies, which have gained traction since the global financial crisis.
Globalisation has become one of the prime targets of criticism. From a global perspective, the net effect of free trade has been positive, but that is not universally obvious, as opening up markets has produced winners and losers.
In developed countries, free trade has created losers in regions and sectors that are less technologically advanced and more exposed to international competition. Indeed, a recent study by the Federal Reserve Bank of New York shows a positive correlation between trade openness and the dramatic rise in household debt experienced in the US in the run-up to the global financial crisis1.
At the same time, China has enjoyed remarkable economic progress since its entry into the World Trade Organisation (WTO) in 2001: it has increased its share of international trade more than threefold, exceeding that of the US recently (see Chart 2). For that reason, trade tensions between the two countries were almost inevitable. Indeed, support for China’s containment is broad-based and bipartisan in US Congress. And should the current US-China trade tensions subside, a more confrontational relationship between the two countries is likely to persist going forward.
Chart 2: China’s share of international trade has exceeded the US's share
Source: IMF as at April 2018
In this context, the fact that the current wave of protectionism stemmed from the US was not fortuitous. US President Donald Trump has long-held an inherently negative view of the US trade deficit (see Chart 3), which appealed to voters during the 2016 presidential campaign. And after exhausting the fiscal aspect of his economic agenda by delivering significant tax cuts late last year, Trump has now stepped up his efforts to advance his protectionist ambitions.
Chart 3: The US trade deficit of goods has more than quadrupled over the last 20 years – and China accounts for half of it
Source: US Census Bureau as at May 2018. Note: the above breakdown of the US trade balance figures are 12-month rolling sums ($bn).
The Trump administration’s policy initiative to raise tariffs has advanced quite quickly. That’s because Trump has exploited particular legal provisions that allow him to adjust trade policies unilaterally and bypass the usual legislative process:
Drawing the battle lines: tariffs on trade
The trade measures – and the corresponding retaliatory measures – implemented so far are quite limited. In total, the value of affected trade now amounts to about $150bn globally, or 0.8% of overall world exports. These measures include:
Hitting the retaliation button
With further trade measures in the pipeline, the list of tariffs is likely to lengthen. Adding up all of the measures currently under discussion and assuming impacted countries retaliate commensurately, the amount of targeted trade could quickly rise to more than $1tn, or 6% of global exports.
The two main measures under discussion – both initiated by the US administration – focus on autos and Chinese trade. Recent developments have been mixed: while the proposal concerning auto tariffs has been put on an indefinite hold, the pressure on China remains high.
The imposition of higher tariffs on US auto imports would be a significant step towards a fully-fledged trade war: it would affect a large share of US imports ($300bn or 19% of total imports) across a number of regions and probably result in a broad-based retaliation. It is therefore good news that Trump and European Commission President Jean-Claude Juncker agreed to put any new tariffs, including Trump’s threatened 20% tariff on US imports of cars and parts, on hold while talks proceed. In May, the US Commerce Department initiated an investigation to determine whether imports of autos and parts were damaging the US industry4.
The focus has now shifted to alternative solutions, most notably the negotiation of a new trade deal between the EU and the US. The new approach requires time and considerable diplomatic efforts, and its chances of success in the medium term are unclear. Nevertheless, it has defused short-term tensions, probably reflecting domestic opposition to higher auto tariffs in the US.
China, however, remains in the spotlight. On 10 July, the Trump administration said it would seek to impose a 10% tariff on a further $200bn of imports from China. The list proposed by the US trade representative Robert Lighthizer targets multinationals that source materials and components from China including automotive parts, food ingredients and construction. In addition, it includes a 23% share of consumer goods, which means that if the new tariffs are imposed they would have a bigger impact on US consumers than the first tranche of tariffs, which focused on manufacturing components (see Chart 4)5.
Public hearings on these potential new tariffs on Chinese imports are scheduled to take place at the end of the month, which could clear the way for their implementation in September, at the earliest.
Chart 4: Proposed US tariffs on Chinese imports will significantly impact consumer goods
Source: US International Trade Commission and the Peterson Institute for International Economics (Chad Brown) as at July 2018
Rhetorical skirmishes between the US and China have continued unabated in recent weeks. On 20 July, Trump suggested that he is ready to target as much as $500bn of Chinese imports, i.e. all US imports from China. Chinese authorities have adopted a more conciliatory tone, acknowledging that a trade war would be in nobody’s interest. However, China has also made it clear that, if pushed, it would not be afraid to escalate its fight.
China’s retaliation could assume non-conventional forms as its ability to target trade is limited. Indeed, in 2017, China exported about $500bn of goods to the US, while it imported about $130bn from the US. Therefore, China has already suggested that it would resort to non-tariff barriers to trade, such as regulatory restrictions on US exports to China and higher scrutiny on US businesses operating in China. In addition, Chinese authorities might consider some extreme levers: they could devalue its currency and sell-down its official US Treasury Holdings. As both tools present potential drawbacks, China will probably deploy them with caution. Chinese authorities have already allowed market forces to work: the Chinese renminbi (RMB) has depreciated by 8% against the US dollar since April. This offers some relief to Chinese exporters, making up for the pain from the recent US tariffs, while also acting as a warning for the US. Going forward, Chinese authorities will probably try to stabilise the Chinese RMB near its current levels of 6.8RMB against the US dollar in the short term. As evidenced in August 2015 and early 2016, an abrupt depreciation of the RMB can lead to capital outflows and financial instability, which would eventually harm the Chinese economy. While there are capital controls in place, abrupt foreign exchange moves could provide an incentive to find ways around them. As for US Treasuries, it is unlikely that China will dump its holdings, which amount to $1.2tn and are held by the State Administration of Foreign Exchange – the investment arm of the People’s Bank of China (see Chart 5). However, it may avoid buying additional Treasuries at a time when the net supply of Treasuries will increase, reflecting higher funding needs which are set to increase to about $2.1trn in 2018-2019.
Chart 5: Chinese authorities currently hold $1.2tn of US Treasuries – 6% of the total outstanding amount
Source: US Department of the Treasury as at 2017
The macroeconomic impact
The trade measures implemented so far have been fairly limited. As such, their aggregate macroeconomic impact should be marginal, amounting to differences akin to rounding errors in terms of global growth.
In addition, the implemented trade measures primarily concern the US and China, large economies which should both be in a position to weather them well. The implemented US tariffs impact less than 1.5% of overall Chinese exports, and they are worth less than 0.1% of Chinese GDP. Similarly, the Chinese response affects just over 2% of overall US exports of goods and it is worth a negligible proportion of US GDP.
The implementation of the additional measures proposed against China would inflict further pain. Higher US tariffs would impact about 10% of overall Chinese exports, and they would be worth less than 0.3% of Chinese GDP. However, these small aggregate numbers would mask the disproportionate impact on some regions, sectors and firms across the globe.
An escalation of trade tensions is the biggest risk for the world economy going forward as it could evolve into a fully-fledged trade war. Most macroeconomic models predict that the impact of a trade war would be significant, but manageable. It would act as a supply shock resulting in lower global output and temporarily higher inflation. According to some recent estimates6, a fully-fledged trade war would result in a 2-3% reduction of world GDP over a few years, depending on the assumptions on tariffs. In particular, the Organisation for Economic Cooperation and Development (OECD) estimated that a 10 percentage point increase in trade costs (due to higher generalised tariffs) would reduce global output by 1.5% over a few years7. The OECD scenario does not seem that far-fetched. Assuming all measures under discussion are implemented, and based on 2017 data for US imports and duties, US duties as a share of import value would increase by 3.5 percentage points, up from its current level of 1.4% to almost 5% (see Chart 6). That would be well below the levels recorded in the early 1930s, when US duties surged to 20% as a share of the overall import value and 59% of dutiable imports, following the introduction of the Smoot-Hawley Act in 1930. However, US duties as a share of the import value would likely increase to levels last seen in the early 1970s. In addition, given retaliation would likely follow, the move would be largely mirrored at a global level.
Chart 6: US tariffs are currently at historically low levels but they could increase to a 40-year high under the proposed measures
Source: US International Trade Commission as at 2017 and Hermes’ estimates as at July 2018
Importantly, macroeconomic models probably underestimate the impact from higher tariffs and protectionist threats. In particular, they focus on direct effects from trade limitations on trade flows and import costs, while they underplay indirect effects from uncertainty and tighter financial conditions. Persistent trade threats point to protracted uncertainty on trade arrangements, which can weigh on business decisions about investment and hiring, via the confidence channel. It is possible that these effects have already played out to some extent, which would partially explain the divergence in growth between the US and the rest of the world in the first half of 2018. Indeed, manufacturing surveys – which are highly sensitive to developments in external demand and trade policies – have started to show some cracks in China and, to a lesser extent, Europe in recent months, while they have been largely unscathed in the US (see Chart 7).
Chart 7: Manufacturing surveys have declined in China and the Eurozone but they have been largely stable in the US
Source: Reuters Datastream (based on national sources) as at July 2018
Trade tensions have had no impact on the US economy so far, but the trade offensive could backfire. US growth is set to accelerate to about 3% in 2018, up from 2.2% in 2017, reflecting the boost from fiscal stimulus (adding around 0.5 percentage points to growth in both 2018 and 2019, according to our estimates). However, the outlook for 2019 is more uncertain: an escalation of trade measures – driven by the US administration – has the potential to backfire, more than offsetting the positive impact from fiscal stimulus in 2019.
Meanwhile, the implications of a trade war on monetary policy would be ambiguous. Central banks would need to set policies to balance the trade-off between reining in higher inflation and supporting faltering growth. In our view, central banks would most likely look through the temporary spike of cost-push inflation (driven by higher tariffs, weaker currencies and goods shortages) and focus on the likely longer-lasting negative impact on growth. Policy rates would likely stay close to the floor, implying that the ‘loose for longer’ policy has probably years left to run.
Finally, trade tensions have some broader long-term consequences that are hard to quantify. First, trade openness is typically associated with enhanced efficiency and, therefore, higher productivity. The increased integration of global supply chains in the last few decades has probably intensified that link. De-globalisation would put this process in reverse and the unwinding of efficiency-enhancing supply chains would likely have a negative impact on living standards by depressing productivity in the long term. As Bank of England Governor Mark Carney said in a recent speech, empirical estimates based on historical data suggests that a 20% reduction in trade tends to weigh on productivity by about 5% in the long run8.
In addition, trade tensions and wars might have wider geopolitical ramifications: they could result in a more fragmented global landscape in the long term, which would be more vulnerable to tensions and conflict.
The (bumpy) road ahead
Going forward, the situation might need to get worse before it can get better. Trade tensions are likely to persist in the coming months in the run-up to the November US mid-term elections. So far, the anti-trade rhetoric aired by the US administration has paid off in terms of consensus, but there are reasons to suggest that this strategy is nearing its boundaries. First, because the additional measures would increasingly impact the US consumer, there should be a limit to which these threatened targets are translated into actions. More importantly, the Trump administration may be pursuing a trade deal with China, which would be presented to the American public as a win just before the mid-term elections. However, the acrimonious exchanges between the US and China in recent weeks suggest that scope for further negotiations has become more constrained. In turn, this implies that the risk of a policy accident in the coming months remains high.