Will the U.S.-China Trade Tempest Make Landfall or Blow Out to Sea?

S&P Global Ratings
Written By: Beth Ann Bovino and Satyam Panday
S&P Global Ratings
Written By: Beth Ann Bovino and Satyam Panday

As the U.S.-China trade spat drags on--albeit without any significant tit-for-tat tariff threats in recent weeks--it's become clear that a prolonged period of iciness between the countries, or an escalation of the dispute, could have notable effects on the world's two biggest economies.

 
Key Takeaways

  • While we estimate that U.S. tariffs of 25% on $50 billion worth of Chinese goods would shave a modest 0.1 percentage point from GDP annually this year and next, the dispute has ramification for supply chains, employment, and inflation.
  • The proposed U.S. tariffs would likely translate to an overall increase in consumer price inflation of 0.1-0.2 points above our current forecast. While that level alone isn't enough to spur the Federal Reserve to raise rates any faster, it does add to inflationary pressures that have been building in the supply chain.
  • A number of industries could see their input prices rise. And states with the most significant exposure to trade are vulnerable to the U.S.-China tug-of-war.
  • Add to this the potential job losses in certain industries--with more than 2 million American workers exposed to Chinese retaliatory tariffs on the export side, according to one estimate--and it's clear that an escalation in tensions between the two countries would have noteworthy, real-world ramifications.
 

As the U.S.-China trade spat drags on--albeit without any significant tit-for-tat tariff threats in recent weeks--it's become clear that a prolonged period of iciness between the countries, or an escalation of the dispute, could have notable effects on the world's two biggest economies.

While the direct effects on the U.S. economy would likely be relatively small in GDP terms, the potential hit to business confidence, increased financial-market volatility, and collateral damage to global supply chains could prove more damaging--not just in the U.S., but around the world.

S&P Global economists estimate that U.S. tariffs of 25% on $50 billion worth of Chinese goods would shave a modest 0.1 percentage point from GDP annually in 2018-2019, with disruptions to suppliers that rely on imports--particularly for aircraft manufacturing, information and communications technology, and general machinery and equipment. The U.S. would likely lose an additional 0.1 point of growth because of China's reciprocal tariffs targeting $50 billion worth of American exports--with the agricultural, automobile and aircrafts, and chemicals industries more exposed than others. An escalation of U.S. tariffs--to $150 billion total--combined with an equal response from China would roughly triple the drag on growth to 0.6 percentage points.

More directly, the proposed U.S. tariffs on $50 billion of Chinese goods would, according to our estimates, boost import prices roughly 0.5 percentage points. That translates to an overall boost to consumer price inflation of 0.1-0.2 points above our current forecast--thus eroding, at least partially, the boost that tax cuts gave to households' spending power.

Implicit in our calculation is that American importers will bear the full costs of the tariffs, domestic producers have the capacity and willingness to step up supply, there will be a full pass-through of cost to consumers, and that the tariffs are viewed as permanent from the onset. In reality, these assumptions wouldn't necessarily hold true for all products in the same way, and price changes would vary by degree of reliance on Chinese imports. Moreover, tariffs on the usual U.S. exports to China would likely result in lost export business for American farmers--and, with more domestic supply without buyers, would drive down prices at home. The impact on final prices also depends on the so-called "elasticity" of demand for a product. The more elastic a product, the more easily shoppers can substitute one for another. Here, businesses may decide to "eat" the extra cost rather than risk losing market share, assuming that the tariffs are short-lived.

Add to this the potential job losses in certain industries--with more than 2 million American workers exposed to Chinese retaliatory tariffs on the export side, according to one estimate--and it's clear that an escalation in tensions between the two countries would have noteworthy, real-world ramifications.

There is also some concern about how the trade spat and its ramifications could affect the Federal Reserve's normalization of monetary policy. S&P Global economists now expect the U.S. central bank to raise the benchmark Federal funds rate four times this year, after March's quarter-percentage-point hike to 1.50%-1.75%--the first under new Fed Chairman Jerome Powell. Although a 0.2 percentage point increase to the price level above the current forecast in isolation is not sufficient to spur the monetary policy authorities to raise rates any faster, it does however add to inflationary pressure that has started to build in the supply chain of late. If a lack of clarity on the dispute suppresses long-term borrowing costs as investors seek the safety of U.S. Treasuries, could the Fed's lifting of short-term rates inadvertently cause an already fairly flat yield curve to invert? With the gap between short- and long-term rates already holding near its narrowest in more than a decade, market watchers may worry whether this augurs a recession in the near term, as has been the case in the past many times. This is certainly something the Fed would like to avoid.

The Worst-Case U.S.-China Scenario: How Bad is Bad?

How bad could a full-blown tariff war between the U.S. and China be? In a worst-case scenario, each country could levy tariffs on all of the goods that the other sends to its shores--a total of $130 billion of American exports to China and $506 billion of Chinese exports to the U.S. Tariff rates could also be hiked higher than 25%. It's important to note that China can only counter any U.S. tariffs by levying its own on $130 billion of American goods--the full value of what the U.S. sends to China. However, this doesn't account for any potential increases in exports to an economy that is growing at an annual pace exceeding 6%--more than twice the global rate. Moreover, China can weigh on U.S. business in other ways. Although the tariffs are not yet in place, soybean farmers may already be feeling the squeeze, with Chinese buyers reportedly having already halted purchases of this year's U.S. soybean crop.

Maybe the most important element of the ongoing trade dispute involves intellectual property (IP). While it has garnered fewer headlines that the promised tariffs on steel and aluminum--perhaps because of the political expediency around shoring up U.S. manufacturing--U.S. President Donald Trump's directive last August to launch an investigation into China's theft of U.S. IP could reverberate more widely. The move, under Section 301 of the Trade Act of 1974, allows the president to act without consulting the World Trade Organization (WTO). But Section 301 is rarely used and is viewed by many to be an act of aggression given the U.S.'s commitment to resolve disputes through the WTO. (It's worth noting that China became a member of the WTO in 2001; since that time, U.S. imports from that country have more than quadrupled, while American goods sold there have surged sixfold.)

In the end, S&P Global believes the U.S.'s proposed tariffs on up to $50 billion of Chinese imports will have a subdued impact on the global technology sector. The list of products subject to U.S. tariffs include more than 1,300 imported goods, such as aerospace technology, industrial machinery, medical equipment, medicine materials, and much more. Conspicuously absent from that list are products that would cause significant disruptions to the U.S. economy or consumers, such as personal computers, laptops, cell phones, servers, or telecom equipment--even though they represent a large proportion of U.S. imports (see "Global Trade At A Crossroads: How The U.S.-China Spat May Hurt The Tech Sector, And The Latest On Qualcomm And Broadcom," published April 25).

Collateral Damage: Which Sectors May Suffer

It is feasible that a larger country with substantial market power like the U.S. can improve welfare by imposing some amount of tariff relative to free trade. In essence, by imposing a tariff, it is able to obtain the goods it continues to purchase at a lower world price, in effect, shifting the burden of the tariff onto the exporting country. But this assumes that there is no retaliation and that tariffs are imposed on final goods. The current proposed tariffs by the U.S. are neither focused on final goods nor does it appear that China will simply turn the other cheek. In fact, intermediate inputs and capital equipment comprise almost 85% of the $50 billion of imports subject to most of the new proposed tariffs (see chart 1). (Note: Research has shown that for a large country like the U.S., a unilateral optimum tariff might be close to 30%.)

That said, there are a number of industries that could see their input prices rise due to potential import tariffs on Chinese products. Not only do the tariffs have the potential to directly raise the prices of Chinese products, they also give non-Chinese suppliers of those products the opportunity to raise their prices. For example, two-thirds of the inputs for aircraft manufacturing are at risk of higher prices, either directly or indirectly, from the announced list of tariffs. Other industries with high degrees of exposure to the price-raising effects of tariffs include electrical equipment, appliances and components, fabricated metal products, plastics and rubber products, machinery, computer and electronic products, chemicals, and primary metals.

On the exports side, from a macroeconomic perspective, the effects of China's tariff on American exports will likely be muted. While the targeted products account for 38% of American goods sent to China, they make up just 3.2% of overall U.S. goods exports--and a minuscule 0.25% of GDP. On a more micro level, the business environment could become more challenging for the agricultural, motor vehicles, aircraft, and chemicals industries--all of which have higher exposure to China in terms of the share of their exports. But when measured as a percent of total industry output, this exposure looks more manageable. For example, the gross output of the agricultural products industry totaled $375 billion in 2016, with exports representing less than 5%. Aircraft, motor vehicles, and chemicals had even lower ratios.

While pockets of the farming population are likely to feel the effects more than other industries, the farming sector in the U.S.--a net exporter with relatively high rates of productivity gains in the past 100 years, as machines substituted for labor--employs less than 2% of the population. So, tariffs on soybeans, sorghums, and other fruits and vegetables aren't going to move the macro needle on the employment front.

At the same time, roughly 2.1 million American jobs are exposed to Chinese retaliatory tariffs, according to study published April 9 by the Brookings Institution. Simple arithmetic shows that even a loss of 5% of those positions would displace 100,000 workers; a 10% cut would mean 200,000 jobs lost. Exports equal more than 10% of 2016 state GDP in 11 states. Among the states with the most significant exposure on this front are Louisiana (21%), Washington (17%), and South Carolina (15%) (see chart 2). Disruption from the other effect--higher cost steel and aluminum imports--would be relatively greater in the states where these imports represent a larger share of total imports (see "Global Trade At A Crossroads: U.S. States And Localities May Take Another Look At Budget Forecasts," published March 9, 2018). States with a large presence in aircraft manufacturing, such as Washington and South Carolina, may be exposed to a potential China retaliation, while farming states will likely be squeezed from actual and potential tariffs on agricultural products.

Notably, the study concluded that the "wide variation in the type and number of exposed jobs…suggests that Chinese trade bureaucrats have as good, or perhaps even better, of a feel for the diverse and culturally significant key elements that comprise the U.S. production base than their U.S. counterparts."

The Supply Chain is Only as Strong as its Weakest Link

Perhaps it's no surprise that the U.S. is taking protectionist steps, given the president's campaign rhetoric, but this particular vine wouldn't have been ready to bear fruit were it not for the still-modest economic recovery. Since the Great Recession--now nearly a decade behind the U.S.--the period of economic expansion has been the slowest since World War II and has only recently brought about stronger job gains and a pickup in wages. The belief (often accompanied by anger) that "free trade" has stolen American jobs has been festering for some time, with hordes of blue-collar workers unemployed or leaving the job market in the past 40 years.

This view, which has its merits, ignores the benefits that free trade confers on American consumers in the form of more product choices at lower prices. Naturally, these benefits accrue most to lower-income households--precisely those that have been hit hardest by the country's shifting manufacturing landscape and who suffered most during the recession (and, in fact, have yet to fully recover).

At any rate, we believe the tariffs announced so far by both countries will have minimal direct macroeconomic effects--boosting consumer-price inflation only marginally and weighing a bit on already sluggish productivity growth. We earlier found that the first-order effect of the steel and aluminum tariffs is likely to be very small, and exemptions for many other major trading partners, extended until June 1, removed the risk of more reprisals. And while China and the U.S. have lobbed for more protectionist actions toward each other since Section 301 was invoked, the direct ramifications have so far been rather small and at a level the world's two largest economies should be able to absorb.

However, a significant tariff on intermediate goods in the information and communication technologies (ICT) sector could disturb the distribution chain. For U.S. businesses that use ICT goods in their production process, the extra cost may cause them to curb investment in ICT-based capital goods, slowing their productivity and hurting their competitiveness. To the extent that U.S.-based businesses are ICT-goods producers that rely on components from China, tariffs increase their cost of making those products.

Chinese suppliers could "country hop" by moving production facilities to tariff-free countries, something seen with solar panels in the recent past, according to Panjiva Research. While that helps reduce midterm disruption, it ultimately leads to a downward spiral of "whack-a-mole" tariff cases from the U.S. In this light, U.S. businesses may seek out less-expensive sources--though this is complicated by the fact they may be in long-term contracts with Chinese suppliers or there may not be other suitable candidates. The remaining question is whether businesses can pass through higher costs to consumers. And even if they could, would they choose not to on worries they may lose customer loyalty in response to a tariff adjustment that may be short lived.

Severed or disrupted supply chains mean diminished production efficiency, higher costs, and lost competition--and, further, less need to hire workers. The North American Free Trade Agreement (NAFTA) and the auto industry often spring to mind when we think of supply chains, but the issue is a global one. While many of China's largest exports to the U.S., such as phones, clothes, and shoes, are not yet on the list for tariffs, the supply chain of Chinese components and equipment used by American businesses has been hit. When a country moves to repatriate the supply chain, it typically makes for higher costs and, ultimately, reduced profitability and job loss (see "De-Globalization Could Disrupt U.S. Supply Chains," published May 30, 2017).

New Best Friends--Or, Pick Your Battles

Either way, an escalation of this magnitude wouldn't necessarily bring the U.S. to its knees, given the relatively small amount that exports add to the American economy, which is largely domestically driven. But the cost wouldn't be trivial, either, especially for the most-exposed sectors. There would likely be large (though difficult to quantify) knock-on effects through supply chains and financial markets, and stranded assets would have major negative effects on companies' balance sheets and income prospects.

This may help explain why the Trump Administration gave key trading partners Canada, Mexico, and the EU another 30-day stay from punitive steel and aluminum tariffs. That the EU supported the U.S. in its confrontation with China over trade may have helped sway President Trump. Or maybe the White House realizes that it needs to pick its battles and that a confrontation with China may be all Uncle Sam can handle for now. While the reprieve gives the U.S.'s trade partners more time to make their case, the European Commission responded by warning on May 1 that the decision "prolongs market uncertainty, which is already affecting business decisions."

Interestingly, NAFTA negotiations are also improving with U.S. Vice President Mike Pence saying that it was a "real possibility" an agreement could be reached in the next several weeks. Although we are happy to hear that trade talks are less gloomy elsewhere, it may be that the White House doesn't want to fight a trade battle on multiple fronts at the same time. Whether the U.S. follows up the China dispute with others remains to be seen.

 

Writer: Joe Maguire