Speculation on what a Trump Presidency means for US/China trade relations is high. Recent rhetoric from both sides suggests that at least some trade friction is on its way. At this point, no one has solid indications of what kinds of tariffs or barriers the US might inflict on Chinese imported goods, nor do we know how Beijing might respond. However, almost any amount of trade friction will cause pain to some unlucky firms or consumers in both countries, and risks upending an economic relationship that has been stable for nearly forty years. This blog post will not focus on the effectiveness of imposing trade barriers and tariffs on China. Nor will it discuss the geopolitical gains set to be made by China as the US abandons the TPP, disengages from Asian economies, alienates longstanding trade partners and allies, and opens the door for China to become the architect of an Asian economic partnership. This analysis will focus on how US protectionist policies might affect China’s economic prospects going forward.
A quick note on the recent developments between the US and Taiwan:
In the analysis in this blog post, I am making an assumption that trade and economic disagreements between the US and China will not escalate into a wider conflict. However, it is important to note that President-elect Trump has made it clear he intends to use US recognition of the “One China” policy as leverage in economic bargaining. In his book, The Art of the Deal, Trump asserts that one of his key philosophies is leverage: “Leverage is having something the other guy wants. Or better yet, needs. Or best of all, simply can’t do without.” He seems to be trying to create the maximum amount of leverage possible in order to improve the US position in trade and economic negotiations.
There are a number of reasons why Beijing would consider the independence of Taiwan - especially if that independence is expedited by the US - as non-negotiable. Taiwan’s official independence could embolden separatists in Tibet and Xinjiang, for example. But, the primary reason for maintaining Taiwan’s effective, but not official, independence resides in China’s lessons from history. After the Opium Wars in the 19th century, colonial powers carved up parts of China in a period known in China as the “Century of Humiliations.” That period lingers in China’s collective memory, where a once proud and sophisticated civilization was broken, carved up, and humiliated by foreign powers. The later end of that century was particularly brutal under Japanese occupation. China took Taiwan back from the Japanese shortly after the end of World War II. That “Century of Humiliations” has shaped social and economic policies in China for the last 70 years. One of the mandates of the Communist Party was to make sure that China is never interfered with or humiliated ever again. Taiwan is neither independent nor dependent. That ambiguous state of independence limbo has allowed for Taiwan’s self-rule without violating mainland China’s historical sensitivities and provoking armed conflict.
The US “One China” policy stance on Taiwan is ambiguous on purpose. Chinese citizens view Taiwan’s status as an official province of China as extremely important. Ten years ago when I lived China, nearly everyone I knew viewed Taiwan’s status as important as any environmental or economic issue. The US population, on the other hand, has never had strong feelings on Taiwan’s status either way. And, in Taiwan, according to Forbes, over 65% of Taiwanese prefer the political status quo of effective, but not official, independence. There has been very limited motivation on the part of the Chinese, US, and Taiwan citizens to change the status quo of independence limbo for the last forty years. Accidentally or purposely breaking the strategic ambiguity could result in armed conflict with limited reason or gain. If the new administration sparks a major geopolitical conflict in the South China Sea - a region where over $5 trillion in global trade cargo passes each year - by making a political miscalculation in using Taiwan’s status as leverage in trade negotiations, then the analysis below will need to be adjusted significantly.
What is in store for the Chinese economy with a Trump Presidency?
There is no way of knowing what kind of trade tariffs and barriers Trump’s administration will seek. Trump’s recent escalation of China-bashing rhetoric, however, seems to imply that he will probably attempt to follow through on at least some of his trade protection threats from the campaign trail. It is unclear at this point where trade measures will fall on the spectrum of seriously punitive to a flash-in-the-pan. The range of possible effects on the Chinese economy is pretty wide. So, to understand the many possible outcomes of a US trade barriers and tariffs on China’s economic prospects, we need to ask the following questions: How serious could US trade protectionist policies get, how long might protectionist policies last, and what can China do to counter export losses?
Before we answer those questions, let’s take a look at the state of US/China trade. Here are some important number to note:
The US trade deficit with China dwarfs all other countries. In 2015, the US trade deficit with China totaled $366 billion. The next closest deficit country was Germany, with a relatively tame $74 billion. $366 billion amounts to roughly 2% of US GDP, and has been stable around that percent for the last five to six years. The US/China trade deficit was 0.5% of GDP in 1996, and accelerated dramatically over the early-to-mid 2000s. The state of US/China trade today is as much a result of US policies in the 2000s, which stoked high rates of consumption funded by unsustainably low savings rates, as it is a result of China’s own trade policies.
US trade is becoming less important to China’s economy. According to data from the US Census Bureau and World Bank, exports to the US have gone from as high as 10.7% of GDP a decade ago to 4.4% by the end of 2015. That has largely been driven by China’s transition to domestic consumption as the major driver of economic growth in the economy. China is less reliant on trade in general than in the past.
Exports to China are growing more important at the margin to the US economy. Exports to China as a percent of US GDP are roughly 0.65%. But, that comes from a base 20 years ago of 0.10%. US exports to China are 9.7 times higher than they were in 1996. As a comparison, China’s exports to the US are 9.4 times higher.
China’s main product categories in the US/China trade deficit have grown more complex and advanced over time.
China sends more advanced products to the US than the US send to China. According to the US Dept. of Commerce, the US shipped $34 billion worth of what is described as “Advanced Technology Products” (ATPs) to China. China shipped $155 billion of ATPs to the US. But, nearly all of the difference comes from a single category, information and communications. Of that category, most of the difference comes from mobile devices and cell phones.
A large portion of the US trade deficit with China comes from other economies. High-tech imports, defined by China’s Customs Administration, amount to 85% of China’s high-tech exports. Much of what is considered advanced product shipments coming out of China are advanced components manufactured in places like Japan, South Korea, and Germany that have been assembled in China. Just over 50% of China’s trade is categorized by the China Customs Administration as “General Trade” meant for or produced in the domestic market. The rest is processing, assembly for export, and other.
Mobile devices and phones make up China’s largest US destined export category. According to the US Census Bureau, mobile devices constitute 13.4% of all of China’s shipments to the US, and 17% of the trade deficit. 77% of all US cell phones come from China. The next largest supplier of mobile phones is South Korea, with 12% of the total.
The largest US export to China continues to be aircraft. Shipments in 2015 amounted to over $15 billion. China sales are roughly 13% of Boeing’s total revenues.
A favorite talking point during the election, steel imports from China, could likely become a prime target for trade barriers or tariffs. But, for all of the headline grabbing concerns over China steel shipments, iron and steel imports from China are only about 0.60% of US total imports from China. Steel exports to the US account for 0.02% of China’s economic output. The largest supplies of foreign steel are Canada, Brazil, and South Korea.
How serious could trade barriers and tariffs get?
- What can the US president actually do?
The Constitution gives Congress the sole authority to impose tariffs on foreign goods, with a few limited exceptions. There are options for the President to act unilaterally. Based on the US Trade Act of 1974, the President has the ability to impose blanket tariffs of up to 15% for no longer than 150 days. If a foreign country is found to have unjustifiable and damaging trade policies targeted at the US, targeted quotas and tariffs may be applied. The Trump administration would likely find targeted trade restrictions on Chinese products easier to implement. A large blanket tariff on all Chinese goods would require congress, and would be politically challenging.
The WTO would present an obstacle to US protectionist plans. Under WTO rules, any member must treat all imports from member countries equally. Additionally, a WTO member can’t impose tariffs beyond the bound rate in its tariff schedule. Hefty tariffs on Chinese goods would likely violate WTO rules. Unless the new administration decides to withdraw from the WTO, trade protection overreach could be limited.
Labeling China a currency manipulator as proof of unjustifiable and damaging trade policies in order to clear the way for targeted quotas and tariffs seems likely given the rhetoric on the campaign trail. But, that would require evidence that Chinese authorities are intervening to devalue the currency, when in fact China has spent $700 billion in foreign reserves in order to keep the yuan from a freefall in the face of capital outflows. Most market indicators, including long-term real effective exchange rates, reveal the Chinese yuan as one of the world’s most overvalued major currencies. But, proving the value of a currency is a murky exercise, and there is plenty of room for imaginative interpretation.
- How far is the US willing to take things?
This is probably the most important consideration in the calculus of trade import restrictions. Trade restrictions or taxes on Chinese imports, with or without Chinese retaliation, will cause at least some short-term pain in the US.
Pain felt by Trump’s core supporters could limit the willingness to take punitive trade measures too far. A blanket tariff on all China shipments will certainly be felt in the form of price increases for everyday products. According to the Economic Policy Institute, a liberal think-tank, 11% of Chinese imports are sold through Walmart. That would constitute nearly 40% of non-grocery US domestic sales at the retailer. Blanket tariffs and the inevitable decline in the Chinese yuan in the face of reduced China economic sentiment would be punitive for the Trump administration’s core supporters. Sizeable imported inflation numbers would also likely expedite Fed rate hikes, cooling the recent employment growth. The administration may not be willing to take things too far if his core supporters feel too much pain at the checkout line.
Without Chinese trade retaliation, tariffs and trade barriers on specific Chinese imports would concentrate the pain on specific sectors and firms. It would be difficult to make a sizeable dent in the China trade deficit without putting up barriers to tech products. The US trade deficit with China is dominated by tech. 44% of the trade deficit falls in the category of tech, telecom, tech components, or electrical machinery. Anyone looking to purchase a mobile device, computer, or nearly any product that has incorporated some tech components would see prices rise. Window dressing by raising tariffs and barriers on products that grab headlines but have limited effect on trade numbers, like Chinese steel, would be an option for an administration less willing to inflict economic pain on voters.
Chinese retaliation would increase the pain of a protectionist trade policy. China’s trade retaliation is expected to be levied against the major US export products, like soybeans and aircraft. According to the USDA, over two-thirds of US soybean exports go to China. But, soybeans are a globally traded commodity. China would need to get soybeans from other producers, like Brazil. US farmers would need to supply markets that once bought soybeans from Brazil. Agricultural product retaliation probably won’t be too painful. However, China accounts for 13% of Boeing’s sales, so the aircraft manufacturer has the most to lose from trade policy retaliation. Additionally, Beijing officials have a great deal of control over domestic markets, and can apply punitive policies to US firms operating in China. US carmakers are highly vulnerable to Chinese retaliation. GM revenues from China this year are higher than those generated in the US and represent 38% of the firm’s total sales. Tech firms have a particularly high level of interest in China. According to Bloomberg, 43% of Micron Tech sales, 23% of Apple sales, and 57% of Qualcomm sales come from China. Over 30% of Texas Instruments sales come from China. China can make things very difficult for firms operating on the mainland, and many of those firms have deep pockets for lobbying the US congress to stop the pain.
Pain felt by US allies could limit the willingness to take punitive trade measures too far. China is not only a manufacturer of export products, but the world’s largest assembler of component parts manufactured elsewhere. Just over 50% of China trade is categorized by the China Customs Administration as “General Trade” meant for or produced in the domestic market. The rest is processing, assembly, and the like. Nowhere is that fact more evident than in China’s $65 billion mobile phone and device shipments sent to the US market in 2015. The iPhone is a good example of the extent to which China is simply the last stop for many goods on an extensive global supply chain. Apple has component suppliers in 31 countries. Big-ticket components, like displays and processors are made in Japan, South Korea, and Taiwan. The cameras are made in Japan and the US. The gyroscopes are made in Europe. According to Credit Suisse, Taiwan suppliers are projected to earn up to $26.9 billion from the iPhone 6 alone. A trade war with China would effectively be a trade war with staunch US allies, namely Japan, Germany, South Korea, and Taiwan. An escalating trade war would also be felt globally by friend and foe alike. In October, the IMF warned that a rise in global protectionism could shave 1.5% off of global growth for the next several years.
How long could trade tariffs and barriers last?
How new tariffs and import barriers impact China’s economy not only depends on the severity of those measures, but the length of time they are in place. Chinese leaders can patch the hole from short-lived tariffs by extending cheap financing to exporters in order to help bridge the production gap, and running some short-term stimulus. A one-time devaluation of the yuan would help, as well. However, a long, protracted trade war would require more intensive actions to fill the hole in China’s economy, and result in stoking inflation, delaying economic rebalancing, and increasing China’s large debt burden.
Unfortunately, examples of historic trade measures have varied significantly. In 2009, the Obama administration set punitive import taxes of 25 – 35% on Chinese tires for three years. In 1964, President Johnson put a 25% import tax on potato starch, dextrin, brandy, and light trucks entering the US. That import tax still exists today, 53 years later. So, based on historical presidential action, punitive tariffs might last three years, or they might linger for over 50 years.
Two factors probably point to import penalties landing on the short end of the time spectrum. First, Chinese retaliation against deep-pocketed US firms like GM, Apple, and Boeing will probably result in increased lobbying efforts for a speedy end. Congress is ultimately responsible for imposing tariffs, and Congress is also susceptible to lobbying. The second factor comes from Trump himself. What we know about the President-elect more than anything else is that he considers himself a master dealmaker and negotiator. It stands to reason that the administration will be looking to use trade protection measures to produce a deal that, at least in appearance, can be held up as an example of stellar negotiating and successful policymaking. While the timing of US trade protectionist measures against China is an unknown, it is likely that such measures will be short-term.
What does it all mean?
So, what does all of this mean for China’s economic prospects? The outcome for China lies somewhere between the unlikely worst case and the best case scenario.
The worst case scenario for China economic prospects – assuming no major geopolitical escalations beyond trade policies – would be a blanket tariff on all Chinese goods of 45%, a number Trump frequently cited in campaign speeches. If we make a very simple assumption that a 45% tax on all China imports results in a 45% drop in US imported goods from China, and China’s domestic production falls by the same amount, then the economic output shortfall will amount to roughly $216 billion. But, since half of China's trade is assembly and processing of components manufactured elsewhere, not all of China’s export revenues are captured by domestic producers. So, if we conservatively assume that domestic producers only feel 60% of the production drop, the production shortfall would be $130 billion, or 1.20% of GDP. Using simple math and not accounting for multiplier effects or tariff evasion and other secondary effects, GDP growth could drop from 6.7% to around 5.5%. Production declines would primarily be focused on light manufacturing and tech assembly, industries concentrated in the wealthy southern coastal provinces. It will be difficult for the government to use fiscal stimulus to help those industries without buying excess products and dumping them on another country. Unless Beijing can somehow extend support to export firms directly affected by the tariffs, the result could be tens of millions of job losses, and that would be a serious problem for China’s leaders.
The best case scenario would be "window dressing" policies that both Presidents can point to in order to prove their nationalist bonafides. The Trump administration could apply more trade barriers to Chinese steel imports with close to zero economic implications for China. China could respond in kind with some headline grabbing, but fairly benign trade restrictions of its own. That would limit the economic impact on China to virtually zero.
But, the likely scenario will be somewhere in the middle. Specific Chinese products will probably be targeted by US tariffs rather than a blanket tariff on all goods. A realistic assumption is that some of the largest product categories face 25% to 35% import tariffs for a limited number of years. In that scenario, China could see 0.30% to 0.50% shaved off of annual growth, and 3 to 4 million jobs at risk, concentrated in the wealthy coastal regions. That outcome would be painful, but manageable.
What can China do to limit the impacts of trade friction?
China has tools to dampen the impact of increased US trade protectionism. But, plugging holes in economic output and escalating retaliation to force an end to trade barriers would risk stoking inflation, damaging China’s restructuring efforts, and boosting the debt burden. Here are some measures China can take in the face of increased US trade protectionism.
- Evading trade tariffs and barriers.
Chinese firms will likely try to evade trade restrictions. Tariff evasion has been used for years by clever importers. Ford Motor came up with a clever method to skirt the steep 25% tax on its foreign-manufactured imported light trucks. The firm simply adds windows and seats, imports the light trucks in disguise for the much lower 2.5% passenger car import tax, and then removes the windows and seats back in the US. In the 1980s, in order to give extend a lifeline to Harley-Davidson Motorcycles, the US put in place 45% import taxes on 700 cc Japanese motorcycles. Yamaha and Suzuki evaded the tax by producing a 699 cc engine for export to the US. Evasion can relieve some of the pain of protectionism, but will not work on all tariffs and barriers.
- Retaliation or threaten to retaliate.
It would be hard to imagine that Beijing would not respond to import taxes or quotas with retaliatory trade protectionist measures of its own. If we use the same worst-case scenario from a previous example and assume China responds by stopping 45% of all imports from the US, US GDP growth could potentially be impacted to the tune of 0.30%. But, almost a third of all US shipments to China are commodities and agricultural products traded in global markets. So, the full impact of a 45% drop in US exports to China would be less than 0.20%, without adjusting for secondary effects.
If China wants to expedite the end of US protectionist policies, the most likely retaliation target will be US firms with deep enough pockets to hire armies of lobbyists. Large US firms with a significant presence in China, like GM and Ford, could start to be subject to sizeable punitive retaliation. Apple and other tech firms might also be subject to Beijing interference in their Chinese operations. Pain from China’s trade retaliation will be concentrated more in specific firms than in overall US economic growth prospects. US firms facing potential losses in the tens of billions have great motivation to step up lobbying efforts.
China’s retaliation would not come without costs to its own economic health. Restricting agricultural imports or US aircraft purchases, for example, would drive up both food inflation and service sector inflation. Chinese citizens are particularly sensitive to food inflation. Food constitutes over a quarter of household expenses for the average Chinese family. Retaliation by China may also run afoul of WTO rules.
- Domestic stimulus to counter the impact of export losses.
The most likely measure to counter an export driven slowdown will be fiscal and monetary stimulus. Traditionally, officials have countered unexpectedly slow growth and economic shocks with infrastructure spending and rapid credit expansion. Beijing deployed $157 billion of infrastructure spending in 2012 to counter a couple of years of pretty steep economic deceleration. That stimulus stabilized growth for some time. To counter the global financial crisis in 2008, the central government massively boosted credit expansion to reflate growth. Outstanding annual credit growth peaked in November 2009 at 40%. In absolute terms, outstanding debt increased by an eye-popping $2 trillion in 2009. Countering the worst-case scenario $130 billion drop in exports and production discussed earlier with massive stimulus measures is well within the realm of extraordinary actions taken in the past to stabilize growth. But, domestic stimulus has its own downsides. Monetary easing to boost credit growth and fiscal stimulus are both inflationary. More credit will exacerbate China’s already risky debt burden. Stoking inflation at the expense of consumers and spending massively on infrastructure would go against China’s urgent efforts to rebalance the economy.
- Devalue the currency.
Once the US labels China a currency manipulator, the threat of using that label as a negotiating tool will disappear. China could let the yuan go into a freefall without worrying about a US retaliatory policy response because that policy response will have already been used. Given the long-term valuations of the yuan and the capital outflow pressures faced by the central bank, it would not be outside the realm of possibility for the yuan to drop over 20% in response to harsh US blanket tariffs. The cheaper yuan would provide a sizeable lifeline to exporters in the face of rising US tariffs. But, a yuan devaluation would not be without costs. Inflation, already accelerating, would certainly rise, and complicate the job of the central bank. A falling yuan would effectively be a tax on consumers in order to support exporters. Such a tax would be in direct conflict with economic restructuring towards a consumer and service based economy, a transition seen pivotal to China’s long-term economic sustainability.
All in all, there is a great deal of uncertainty about China’s growth prospects as the Trump administration prepares to take the reins of government. At this point, there are some likely events and outcomes. US import taxes and barriers on Chinese goods will probably be targeted and short-term. China’s retaliation will probably hurt influential US corporations with large stakes in China’s markets. Beijing’s measures to counterbalance export declines will exacerbate inflation and the country's debt burden. And, the risk of political miscalculation rapidly escalating into major conflict is rising. Listening to the rhetoric in the lead up to January 20th, I can’t help but imagine that China’s leadership is in for a bumpy ride for the next four years as it copes with an administration unlike any it has contended with in the last forty years.