Tsunami: protectionism spreads
Protectionism has been one of the main factors weighing down global activity over the past 18 months. In our edition of Ahead of the Curve last August, we argued that trade tensions were the biggest risk for the world economy. We still believe this and see the tariff war as one of the greatest threats going forward. The US-China spat remains at the centre of this protectionist surge.
What is the confrontation about? America’s $419bn trade deficit with China – which has risen steadily since China’s accession to the World Trade Organisation in 2001 – is a sore point (see chart 1). But on a more fundamental level, the US increasingly views China as a strategic threat. Not only is China a rising technological powerhouse, it also operates according to a very different set of values to America.
Chart 1: Equal partners?
Source: Refinitiv, US Census Bureau, China Customs, as at August 2019.
The route to achieving a deal is no clearer than it was when the trade war erupted last year (see timeline). Treasury Secretary Steven Mnuchin said that 90% of issues were resolved before talks collapsed last spring, including the trade imbalance and intellectual property. But the remaining issues – notably the enforcement mechanism – have proved hard to crack.
The technology war has muddied the waters. In May, Washington cited national-security concerns and added Chinese firm Huawei to its Entity List, meaning US companies are unable to trade with the company without government approval. Read more about this in our latest issue of Gemologist.
But the US views Chinese technological ambitions as a much longer-term issue than the trade imbalance, and the conflation of the two will make it harder to reach an agreement. In our view, strained US-China relations are likely to persist in the years to come, involving periodic flare-ups over trade.
Meanwhile, protectionism has spread. The European Union (EU) has one of the largest current-account surpluses in the world, which has attracted Washington’s attention. Recently, the US threatened to impose higher tariffs on $4bn-worth of imports. While this move was largely symbolic, the US and the EU are set to resume negotiations on auto tariffs later this year and a more critical confrontation looms.
Higher tariffs on auto imports would be significant for both sides. The Organisation for Economic Development (OECD) has warned that the eurozone economy, already in poor health, would be ill-prepared to respond to such a shock. If the US applied a 25% tariff to all imports of autos and auto parts, American levies would be at the highest level in half a century (see chart 2).
Chart 2: Ghosts of trade wars past
Source: US International Trade Commission as at 2018, and Hermes’ estimates as at August 2019.
Brace for a bumpy landing
The first round of tariffs that were implemented last year have already affected the global economy. Global trade volumes fell by 0.2% year-on-year in the three months to January – the first contraction since the end of 2009. Trade growth has hovered around zero in recent months and surveys suggest this will continue in the immediate future (see chart 3).
Disruption to trade has broad ramifications, causing inefficiencies which result in so-called ‘dead-weight losses’. The reshuffling of global supply chains – which have become increasingly integrated over recent decades – is also costly. Moreover, reduced trade flows can have long-lasting effects by weighing on productivity growth.
Chart 3: Tailing off
Source: Refinitiv, CPB – Netherlands Bureau for Economic Policy Analysis, Markit/JP Morgan, as at August 2019.
Traditional models suggest that the tariffs imposed so far have had a relatively small impact on economic growth. Both the Bank of England (BoE) and the OECD estimate that the higher tariffs should reduce global GDP by 0.2%-0.3% over two-to-three years. But additional tariffs on the horizon – in particular, the extension of a 25% tariff to all US-China trade and a 25% levy by the US on all auto trade – could shave off an additional 0.6% (see table).
Trade tensions might also affect the economy via indirect channels like confidence shocks and tighter financial conditions. The BoE reckons that a severe shock to business confidence in the US and China – similar to that experienced by the UK since the Brexit referendum – could more than double the effect of tariffs on global GDP. Separately, the BoE has noted that confidence shocks can affect the economy for up to a decade.
The negative consequences of trade tensions could also easily – and quickly – spread to countries that are not directly involved in the spat. The potential for contagion through worsening financial conditions has been neutered so far by the dovish turn of central banks. But the threat of a global confidence shock still exists.
China will play a pivotal role in determining the overall economic impact of the trade war, given its size and the extent of its integration into the global economy. China accounts for more than 15% of world GDP and a quarter of global trade (see chart 4), meaning that a sharper slowdown could reverberate beyond its borders.
Chart 4: Ripple effects
Source: Refinitiv, World Bank, International Monetary Fund, as at August 2019.
Worryingly, the Chinese economy has already started to sputter. In the second quarter of this year, GDP expanded at its slowest pace in 30 years (see chart 5). Trade-related disruption is probably partly behind this, given that China has been the main target of higher tariffs.
Chart 5: Not what it was
Source: Refinitiv, China National Bureau of Statistics, People’s Bank of China, as at August 2019.
Beijing has deployed fiscal and monetary stimulus to counter the effects of tariffs. The authorities announced a tax-cut package worth 2% of GDP late last year and will probably continue to support the economy. But the government will struggle to balance its desire to stabilise growth with the need to deleverage. The result could be greater financial imbalances and an accumulation of debt.
Meanwhile, academic studies have found that the impact of tariffs on the US has been muted up until now. One concluded that US consumers have born the pain of higher tariffs, but that the net effect has been small – real incomes were reduced by only $1.4bn a month by the end of last year. Another analysis discovered that after accounting for tariff revenue and gains to domestic producers from higher prices, the net loss to producers and consumers was 0.04% of GDP in 2018.
But ultimately, the US economy could be even more affected than China’s (see table). American producers are already scrambling to rearrange supply chains and protect margins, while consumers will start to feel the pinch if Washington applies a 25% tariff to all remaining imports from China, the bulk of which are consumer goods.
Looking beyond the US and China, the eurozone looks particularly vulnerable. The bloc has a notably open economy – exports account for about half of GDP – and a prominent auto sector. Trade-related uncertainty is already weighing on growth. German manufacturing has been particularly affected and the sector slipped into recession in the second half of last year. The European economy will undoubtedly take a hit if auto-tariff negotiations turn sour.
There would probably be a worldwide recession if the trade war becomes a global standoff. Central banks, already operating in a low interest-rate environment, would struggle to offset the impact of a broad-based rise in tariffs.
Trump: aggressor or accelerator?
The economic fallout from a full-blown global tariff war would be severe. Yet there are also several longer-term trends that explain the ongoing reconfiguration of global trade patterns.
In a sense, the current protectionist wave is simply bolstering anti-trade sentiment that has been underway for decades. While the net effect of greater trade openness is positive, globalisation has created winners and losers. Since the mid-1980s, the gap between developed and emerging markets has shrunk significantly, but inequality within countries – particularly in advanced economies – has widened. The low-skilled workers that typically fall in the upper-middle section of the global income distribution have suffered from more exposure to international competition (see chart 6).
These trends were brought into sharp relief by the financial crisis. The crash disproportionately hit low-income households, exacerbating the perception that unfettered cross-border trade can aggravate income inequality. In turn, that fuelled support for populist and protectionist policies.
Chart 6: Dissent brewing
Source: Lakner and Milanovic, 'Global Income Distribution From the Fall of the Berlin Wall to the Great Recession', November 2013.
The retreat of cross-border trade predates the recent protectionist wave, suggesting that there are other factors at play. Growth in trade volumes has slowed sharply since 2012, relative both to historical performance and overall economic expansion (see chart 7). Weaker structural growth and the decline of trade-intensive components of economic growth (such as investment) help explain this.
Chart 7: No longer in the lead
Source: Refinitiv, International Monetary Fund, as at August 2019.
Technology has probably also played an important role. Automation has enabled the re-shoring of manufacturing activity and the contraction of global value chains. The availability of cheap, automated technology and rising foreign labour costs have encouraged firms in the US and other western countries to start to repatriate manufacturing activity. One study found that one extra robot for every 1,000 workers is associated with a 3.5% rise in re-shoring.
Because of this, the long-term prospects for global trade are not clear cut. Is the US-China spat a disruptive force for global trade, or is it simply a catalyst hastening the reversal of globalisation and bringing about the birth of a new and unavoidable equilibrium?
Brave new world
What is apparent is the sense that we are moving from an integrated, international model to one that is based around two or three regional trade blocs, each with its own regulatory system, shorter supply chains and limited cross-border activity.
The emergence of a bifurcated global economy looks increasingly likely, given that US-China tensions spread far beyond trade. Indeed, tariffs look secondary to technological tensions, security concerns and diverging cultural values.
It is unclear whether there will be room for a third player: Europe’s lack of cohesion means it risks being squeezed by the two behemoths surrounding it. The continent’s divided response to China’s ‘Belt and Road’ initiative is testament to its lack of direction at this stage.
There are many downsides to a more fragmented world. The re-shoring of manufacturing is unlikely to increase wages for lower-skilled workers. Instead, it will probably boost the incomes of professionals who are not affected by automation, leading to even greater income inequality.
Regions and countries will also be excluded or disrupted from a globe split in two. Africa and Latin America might fall between the trading blocs, while economies that export to both China and the US will have to make difficult choices.
Moreover, multilateral cooperation will probably become harder. A lack of international coordination could impair the effectiveness of efforts to tackle climate change and sustainability issues. In addition, the chance of a military conflict could increase.
The transition period will inevitably come with challenges. Yet we think it could also throw up opportunities. Should an alternative economic order emerge, investors will need to be savvy when navigating the new system and identifying emerging opportunities.
Re-shoring may predominantly benefit skilled workers, but it could also create an opportunity to address inequalities. If well managed, the repatriation of jobs should lead to more investment in R&D and education that is geared towards reskilling and the continuous training of the labour force.
And while we seem to be moving towards a more inward-looking system, some overarching issues will linger and intensify. As the consequences of climate change become increasingly obvious and widespread, more countries will need to implement containment and adaptation strategies. This could help foster coordination at a regional or even international level.
The new economic order will not be built overnight: it is a long-term story that is likely to develop over decades. But the trade war has exacerbated forces already in motion and change is certainly on the horizon.