A road map to trade wars

Chief Economist's View

The road to trade wars now stretches back almost two years to the election of Donald Trump to the Presidency of the United States in November 2016. At the time, a key plank in President Trump’s policies was tariffs on China and Mexican imports of 45% and 35%, respectively. It took some time before President Trump finally pulled the trigger on tariffs. The first forays were tentative, with the Administration imposing tariffs on imported solar panels and washing machines in January 2018. From March to June of this year, President Trump began to escalate tariffs, imposing a 25% tariff on steel imports and a 10% tariff on aluminium imports; although Australia, along with Korea, Argentina and Brazil, were exempt. The steel and aluminium tariffs drew a response from US trading partners, with Canada, Mexico, the EU and China retaliating with tariffs of their own on a range of US imports. In July, President Trump began targeting China, imposing 25% tariffs on US$34 billion of China imports with a further US$16 billion of China imports under review. Not surprisingly, China has retaliated with tariffs on an equivalent amount of US imports.

The situation now seems destined to further escalation, with the prospect of US and China descending into a full-blown trade war. President Trump has instructed US Trade Representative Lighthizer to investigate the imposition a 10% tariff on US$200 billion of China imports, with recent announcements that the tariff rate may be lifted to 25%. Predictably, the Chinese have indicated they will respond in kind to any escalation of tariffs by the Americans. So where does that leave us and what are the potential outcomes of further escalation? We have identified three phases that the US/China trade war can undergo. The first phase is currently playing out and sets the scene for the remaining two phases in that the escalation of the trade war, whereby the US initiates tariff hikes and China responds with a tit-for-tat strategy. We are now approaching the second phase of the trade war, where the US imposes a 10% tariff on US$200 billion of China imports. Due to China’s much lower value of US imports, compared to the value of US’ imports, a 10% tariff response by China would fall short of impacting the US by the same margin as the 10% US tariff impacts China. China would need to place a 25% tariff on the remaining US$80 billion of US imports to ensure a tit-for-tat response. In addition, as the trade war escalates, we would expect a deterioration in investor sentiment, leading to rising risk premia and higher credit spreads. As the tit-for-tat strategy requires China to raise tariffs on US imports by more than the increase in US tariffs on China imports, it is not difficult to see the trade war escalating further. Phase 3 of the trade war sees the US impose a 10% tariff on the remaining US$256 billion of China imports into the US, with China responding tit-for-tat.

We model the potential impact of tariff hikes using NIESR’s Global Econometric Model (NiGEM). Our modelling suggests that the currently announced $50b tariff hikes (phase 1) are manageable. A 25% tit-for-tat tariff hike on $50 billion of imports will lower the level of real GDP in both the US and China by just under 0.2 percentage points (ppts) after three years. However, should the trade tensions escalate, there is potential for much more significant macroeconomic impacts. Phase 2, where the US imposes a further 10% tariff on $200b of Chinese imports and China responds tit-for-tat, would see the level of GDP fall by a further 0.3 ppts in both the US and China. Heightened risk premiums would add to the growth downturn, reducing the level of real GDP by another 0.2ppts. Overall, the net effect of phases 1 and 2 lead to a GDP loss after 3 years of around 0.6ppts in both the US and China. Economic activity would also suffer globally and in Australia, but by less than the US and China. We find that the net impact of phase 2 would be to lower global GDP by 0.5ppts and Australian GDP by 0.3ppts, over a three-year horizon. In phase 3, where the US imposes a further 10% tariff on their remaining imports from China, the growth impact could be almost twice as large. In phase 3, including a further lift in risk premiums, the total hit to real GDP from the trade wars is around 1.2ppts in the US and almost 1ppt in China. The global economy would also suffer from the all-out trade war, with GDP down by almost 1ppt after 3 years. The Australian economy will be less impacted with growth around ½ ppt lower.

The US/China trade war is escalating. While the potential outcomes are many, we have defined three distinct phases that lead to an outright trade war between China and the US. Currently we have entered the first phase of 25% tariffs on US$50 billion of China imports. We find that the US, China and global economies can absorb the effects of phase 1 with minimal disruption. The next phase of the trade war will see tariffs introduced on US$200 billion of China imports. The impact of phase 2 becomes significant and would cause the robust momentum in the US, China and global economies to stall. The last phase, where the US imposes tariffs on all China imports, would significantly impact US, China and global growth. Phase 3 would see the US economy flirt with recession, and would condemn the Australian economy to three more years of sub-trend growth.

Table 1: Financial market movements, 26 July - 2 August 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,827.2

-0.4%

US

2.99%

1.0 bps

US Dollar Index (DXY)

95.17

0.4%

Nikkei 225

22,512.5

-0.3%

Japan

0.13%

3.2 bps

USD-JPY

111.66

0.4%

FTSE 100

7,575.9

-1.1%

UK

1.38%

9.9 bps

GBP-USD

1.302

-0.7%

DAX

12,546.3

-2.1%

Germany

0.46%

5.6 bps

EUR-USD

1.159

-0.5%

S&P/ASX 200

6,240.9

-0.1%

Australia

2.73%

4.5 bps

AUD-USD

0.736

-0.2%

Source: Bloomberg

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