US‐China Trade War: Back to the Future

Special
Hugo Erken, Michael Every and
Björn Giesbergen

The US had announced USD 50bn of tariffs on Chinese exports

China has already responded with a matching USD 50bn of tariffs on US exports
However, the US has now raised the ante with a further unspecified USD 200bn of tariffs on
Chinese goods ‐ and the threat of a further USD 200bn if China responds again in kind
China can no longer respond directly on trade: it instead needs to think in other dimensions if it
wants to pressure the US back ‐ yet all of these also carry significant risks
There is no economic logic in these trade actions: we calculate overall GDP growth can survive a
USD50bn bilateral trade hit, but the higher trade tensions rise, the worse the potential damage
becomes
However, there may be a strategic logic at play here in terms of both upping the ante and in what
the struggle is really about

Tariffs are back…

After months of negotiations the US finally introduced import tariffs of 25% on USD 50bn of Chinese exports
on June 15. The total range was smaller than the previously announced package of 1,300 products but still
involves 1,102. The tariffs will be implemented in two rounds, the first tranche of USD 34bn ﴾818 products﴿ on
6 July, and USD 16bn ﴾284 products﴿ after public consultation. Notably, the products US levies are on
specifically relate to the ‘Made in China 2025’ plan to develop high‐tech sectors such as aerospace, ICT,
robotics, industrial machines, and ﴾green﴿ cars. In short, unlike US tariffs threatened on European cars or
Mexican car parts, these stem from a genuine US perception of national security in terms of its relative
dominance of high technology.

Immediately after the announced protectionist measures by the US, China responded it would retaliate with
similar measures. The US therefore also faces two rounds of Chinese tariffs on their exports worth USD 50bn.
The first round of USD 34bn also takes effect on 6 July and consists of 25% tariffs on agricultural products such
as soybeans, corn, wheat, beef, pork, poultry and various types of vehicles. The second round of USD 16bn is
assumed to cover the import of chemicals, medical equipment and energy related products, such as coal and
crude oil.

…Bigly

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There had been worries that rather than the US buckling in the face of Chinese retaliation it would instead
increase tariffs further. Market whispers were of a repeat of the threatened USD 100bn increase mooted before
negotiations took place and trade tensions seemed to ease. However, the US has raised the ante in this poker
game even more 'bigly'. President Trump released a statement that:

"China has determined that it will raise tariffs on USD 50bn worth of US exports. China apparently has no
intention of changing its unfair practices related to the acquisition of American intellectual property and
technology. Rather than altering those practices, it is now threatening US companies, workers, and farmers
who have done nothing wrong... Therefore, today, I directed the United States Trade Representative to identify
USD 200bn worth of Chinese goods for additional tariffs at a rate of 10%. After the legal process is complete,
these tariffs will go into effect if China refuses to change its practices, and also if it insists on going forward
with the new tariffs that it has recently announced. If China increases its tariffs yet again, we will meet that
action by pursuing additional tariffs on another USD 200bn of goods. The trade relationship between the US
and China must be much more equitable."

Needle and the damage done

In short, another USD 200bn of 10% US tariffs Figure 1: US‐China export breakdown
loom, and if China responds again, that will
become USD 400bn. Together with the existing
USD 50bn in measures already being out in place,
and tariffs on steel and aluminium, we potentially
have in excess of USD 456bn of goods with tariffs
put in place against China ‐ against total exports to
the US of USD 505bn in 2017 according to US data.
That means around 90% of Chinese goods could
soon face a tariff ﴾Figure 1﴿. That surely moves this
from a trade spat to a full‐fledged bilateral trade
war.
Sources: OEC, Rabobank

One can take the view that for now this is still just a US threat ‐ an attempt to 'needle' China into opening up
its markets. However, what will be the damage done even from the existing USD 50bn of measures that we can
already analyse more concretely.

Calculating the macroeconomic impact

In terms of the direct economic impact of protectionist measures by both China and the US, ideally
one would like to use world trade models which have incorporated all tariffs and non‐tariff barriers
for different product groups, such as Global Trade Analysis Project ﴾GTAP﴿.

As these calculations tend to be very time‐consuming, alternatively we use export elasticities by

Imbs and Mejean ﴾2010﴿. Although there are some drawbacks from this approach, it is sufficient to
get at least a quick and dirty indication of the economic impact.

Our calculations show that the duties on USD 34bn worth of goods that will be imposed on 6 July on either

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side will shave off 0.15ppt and 0.1ppt of Chinese and US GDP, respectively. If we add the tariffs on the
additional USD 16bn worth of goods that are planned to be implemented after public and business
consultation, as well as the protectionist packages already in place on both sides, the total direct economic
damage would end up being ‐0.24ppts of GDP for China and ‐0.14ppts for the US. This relatively mild
impact is not actually surprising, as exports only constitute a small proportion of the total economy in both
countries ﴾19% in China and 12% in the US﴿. By contrast, smaller and more open economies are more likely to
bear the brunt of protectionism.

Nonetheless, there are possible second‐order Figure 2: So far markets have shrugged off trade
effects. It is hard to see how business confidence in war threats
both countries won't suffer an impact ‐ although it
will be interesting to note any dichotomy between
the reaction of small US firms, which are generally
not trading internationally and/or which face
increasing 'China price' competition in the domestic
market, and US multinationals, who are far more
exposed to global trade tensions. We will also have
to track how financial markets react ‐ though so far
in terms of both benchmark US equities and the VIX
volatility index, there has been no panic selling
similar to that seen in Europe during the recent
stand‐off over the formation of the Italian Source: Macrobond, Rabobank
government, for example ﴾Figure 2﴿. Yet that may
change rapidly now that we are looking at a potential US‐China trade war.

Calculating the agri market impact

Although the total hit to Chinese and US GDP under the existing USD 50bn bilateral tariffs that are
proposed is quite small as shown, the same cannot be said for the Chinese or US agri markets.
Indeed, the imposition of a 25% tariff on soybeans, as just one example, has enormous implications
for various industries. Raboresearch F&A team covering China has undertaken an extensive analysis
of the impact of the steps already announced to date, which will be published this week. It
underlines how much disruption can be hidden beneath a small change in aggregate national GDP.

Our Agri Commodities Market Research team will also be releasing their analysis of the outlook for
the US agri markets on Thursday 21 June.

How bigly in response?

The key issue now becomes what China will do in response. One thing is clear: it cannot act on tariffs alone
proportionate to the US because it does not import anywhere near as much from the States as the US buys
from it ‐ only around USD 105bn per year. Indeed, that is what the US is partly complaining about! As such,
what are China's non‐trade options? They have several ‐ and yet none of them are either painless or without
serious side‐effects.

China has an enormous stock of around USD 1trn US Treasury holdings and thus to some extent finances the
US current account deficit by buying US government debt with the USD it receives from trading with the US. If

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China were to decide to diversify into non‐US assets ﴾i.e., by selling these securities﴿ this could potentially
exacerbate a rise in US interest rates, which would hurt the US economy. There are suggestions that part of the
spike in 10‐year Treasury yields above 3% recently was helped by aggressive Russian diversification away from
US Treasury holdings in its FX reserves. Perhaps the threat of rising rates might force the US to change policy
position? However, there are several counterarguments to that view.

First, the value of China’s USD 3.1trn of FX reserves would naturally be hit should China sell off its Treasuries,
pushing yields higher and the Treasury price lower.

Second, what else could China buy instead of US Treasuries? As noted above, China buys these assets as the
counterpart of its trade surplus with the US. If the trade surplus is reduced ahead, so will Treasury buying in
lock‐step. But until that happens China needs a liquid, safe home for its vast FX earnings. European
government markets are suffering from a shortage of supply; Japanese government bonds are likewise being
rapidly bought‐up by the BOJ; and emerging‐market government bonds and developed‐market corporate
bonds, and equities, are all too volatile for Beijing to invest in. In short, China has no real viable options but the
US.

Third, a mass dump of US assets would result in further upward CNY/CNH pressure. This would lead to even
lower exports through higher export prices, and thus a deterioration of the competitiveness of Chinese
exporters on top of the hit from US tariffs.

Perhaps in biglier dimensions?

As such, if China needs to find another way to respond in this poker game it arguably needs to look elsewhere.
Not only will US agri exports now be hit, but likely a far broader range of US goods and services. One
can draw up a short‐list of the key US brand‐name products and firms that will suddenly see problems with
customs clearance, or with local bureaucracy or with "spontaneous" consumer boycotts. China is already
threatening "qualitative" assessments of US firms as a non‐tariff barrier. China is also likely to adopt a US
services boycott. Tourism inflows to the US, where there is a hefty US surplus of course, would rapidly dry up,
for just one example; furthermore, any time there would be a Chinese choice between a US and another
foreign service provider it would be clear who would win the battle.

Another potential option to offset the loss of competitiveness due to US tariffs would be to devalue
the CNY against the USD. Ironically, China could do that under the guise of allowing market mechanisms to
function freely. All that it would take for a serious market‐led CNY/CNH depreciation would be for the PBOC
to announce that from now on the currency is free‐floating and that it will let the market set its value and/or
perhaps to remove capital controls. We have already seen how the market has tried to test towards USD/CNH
7.0, and that would no doubt be achieved in short order. Indeed parity with USD/HKD at 7.75, and beyond,
would not be unrealistic. However, this is surely still a last resort. It would risk a collapse in FX reserves, a USD‐
crisis, and financial instability. The key Belt and Road Initiative would also be impacted, as its local‐currency
price tag would rise dramatically. Moreover, it might trigger an even more aggressive US trade response: even
though CNY/CNH would be trading freely, it seems unlikely that the US would refrain from accusations of
currency manipulation that harms US interests, and even higher tariffs in response.

So what other areas does China have to explore if it wants to raise the ante? Potentially, geopolitics.
There will be an attempt to build an anti‐Trump trade coalition with the EU: such overtures are already being
made. However, who in Europe trusts China on trade? And who in Europe is willing to risk the loss of the US
defence umbrella? More pertinently, the recent Trump‐Kim summit happened with Chinese help. Is detente
there, as Trump proclaims, or might China swing Kim back towards a more belligerent stance that would make
Trump lose face and be forced to contemplate the ruinous expense of military action? Kim is about to visit

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Beijing: one wonders why. Yet perhaps he successfully played China off against the US, and is no longer a
strategic tool for Beijing. In that case China might raise geopolitical tensions elsewhere to ask the question of
the US: "Are electronics goods worth that fight?"

Different logics
Traditional economic analysis sees all trade wars as harmful ‐ and this one is unlikely to be an exception. In
case this winds up into a global trade war, with a general 20% import tariff in the US vs. all other countries,
and a retaliatory tariff of 20% by all US trading partners, not just China, scenarios run with our macro
econometric model ﴾NiGEM﴿ show serious, negative outcomes.

In such a case, the global economy would lose out on 2.5ppt of economic growth over 5 years in total. The US
would end up in a recession in 2019 and the economic damage would be substantial in the first 5 years: ‐
6.3ppt of growth loss compared to a situation where trade tensions would be absent. We are talking about
massive amounts here, up to USD 1,000bn of lost economic growth, something which is ironically the same
amount Trump vowed to invest in infrastructure over the next ten years during his campaign. For China, the
negative impact of a global trade war would also be substantial ﴾‐1.6ppts over five years’ time﴿, but far lower
than in the US. This is due to the fact that China would have the opportunity to step up trade with the rest of
the world, as their relative competitiveness vis‐à‐vis the US increases.

Let's not forget though that there is always the possibility that the US cranks up political pressure to force its
trading partners and political allies, like the EU, to implement protectionist measures against China as well. If
other countries followed up on US demands to 'tackle China' with tariffs, the economic impact on Asia's giant
would be much more substantial. Could even expected Chinese domestic stimulus compensate? It's doubtful it
could for long. As such, this is a very high stakes game of poker.

So, Back to the Future, then

Against that backdrop one has to ask why we are still seeing escalation and not de‐escalation at this stage.
Perhaps because the underlying logic here is the peculiar strategic, not economic one. The US wants to
change China's economic model; China doesn't want to change it. If one sees this is as about trying to impose
a painful change of behaviour then the logic is hopefully clearer: only by imposing the threat of a crippling
cost can one hope to dissuade an opponent from fighting back. That's the same strategic logic for
having a nuclear defence option even when we all know that nuclear weapons are something nobody actually
wants to use. ﴾For doubters, consider if Trump would still have been meeting in Singapore with Kim if North
Korea didn't now possess nukes!﴿

As such, not only are US tariffs back, but: a strategic logic says the US threats of USD 450bn, not just USD
50bn, in tariffs on China may be real. For China, the same strategic, not economic, logic points to upping the
ante in any number of ways too, rather than backing down ‐ even if that creates other global risks/volatility;
and the same strategic logic says we are back to the issue of US vs. China trade wars as part of a larger fight
over whether it will be a US‐ or China‐led economic future. The economy itself appears to be just a bystander.

Author﴾s﴿
Hugo Erken Michael Every Björn Giesbergen
RaboResearch Global Economics & RaboResearch Global Economics & RaboResearch Global Economics &
Markets Markets Markets
+31 30 21 52308 +852 2103 2612 +31 ﴾0﴿30 21 62562
Hugo.Erken@rabobank.nl michael.every@rabobank.com Bjorn.Giesbergen@rabobank.nl

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