This article was originally published in March 2018, and has been updated to reflect recent events.
The U.S. and China are raising the stakes in their tariff fight. After several months of threats, the U.S. last week imposed 25% tariffs on $34 billion of Chinese exports. As expected, China retaliated with tariffs on a similar amount of U.S. exports. The U.S. has threatened to go further, with tariffs on as much as an additional $400 billion of Chinese exports — a figure that far exceeds China‘s imports from the U.S. This raises the risk that Beijing will retaliate with nontariff measures, such as consumer boycotts or heightened enforcement of regulations on American businesses operating in China. With the trade conflict intensifying, a key question is whether the U.S. administration will follow through on its additional threats or cut a deal with China before the November midterm elections.
All-out trade war not a foregone conclusion
Even as the battle heats up, one shouldn‘t assume that President Trump‘s unusual and aggressive negotiating style is a prelude to an all-out trade war, which would hurt both sides. Indeed, when it comes to the U.S.-China relationship, the events unfolding are not inconsistent with the likelihood of a new equilibrium being reached on trade over the next few years. However, as each side feels the other out and tests the other‘s mettle and ultimate goals, it seems likely that we‘re in for an unsettling period of tit for tat that may rattle markets and companies caught in the crossfire. China will be seeking to offer the fewest concessions it can to accommodate the president, while Trump‘s bottom lines seem (by design) unclear at this point.
The political calculus leading into the November midterms will bear watching. To the extent that Trump believes tough talk with China is a political winner that will benefit Republican congressional candidates in November, he will have less incentive to strike a grand bargain with China before then. He will continue to take a hard line so long as he believes his voters will stick with him, even if key constituencies such as farmers face near-term pain — a situation the administration has indicated it expects. Indeed, China has designed retaliatory tariffs to inflict pain on influential lawmakers and constituencies the administration cares about. Another consideration is the trajectory of talks with North Korea and the extent to which China might intervene in ways that would alter the administration‘s trade calculations.
Looked at more broadly, the U.S. is on the verge of a fundamentally new moment on trade with China. As the Middle Kingdom‘s economic power grows and its global ambitions become clearer, a new consensus has emerged in Washington that a more hardheaded approach to both trade and geopolitics is merited. Trump‘s challenge to current trade arrangements, building on arguments he made during his campaign, should be viewed within this broader framework.
What comes next?
Beyond additional tariffs, other actions the U.S. could take include filing new cases with the World Trade Organization, instituting new requirements on reciprocity on investments and/or enacting new visa restrictions. China, in turn, is likely to continue to match U.S. actions and pursue nontariff measures to make life more difficult for U.S.-based firms operating in China.
For China, the longer-term strategy is to create a more balanced and self-sufficient economy that is less dependent on foreign firms in key industries. It also wants to compete head-on in a number of key industries of the future; these ambitions contribute to Washington‘s fresh perception of the Chinese challenge. For example, China is investing massively in the development of its own semiconductor industry and in artificial intelligence. While this will take time, American policymakers and business leaders are growing more anxious about the perceived threat. This has led the U.S. to thwart proposed deals by Chinese companies.
The burgeoning trade war comes as China‘s economy is slowing following a massive stimulus program that helped support growth over the past two years. The government continues to pursue a transition from an export-oriented to a consumption-led economy, and aims to maintain growth while curbing excess debt in the financial system. But as the U.S. has taken the offensive on trade, Chinese stocks have begun to feel the pain, with a sharp selloff in recent weeks. China‘s currency has weakened as well. In response, China‘s central bank has lowered the reserve ratio to make more cash available for banks to lend.
Potential investment implications
This new moment means some of the synergies from years of economic integration and trade deals are likely to come under pressure. We could see some weakening of linkages in both trade and investment, with some established supply chains perhaps disappearing, although this could take years.
So what are some investment implications? Sectors across the U.S. economy may find themselves in the crosshairs if the trade dispute intensifies. Already, Beijing has hit agricultural products, tobacco, whiskey and other products with tariffs, and it is likely to enlarge the list of targeted sectors the longer the dispute lasts. It is no surprise that U.S. industrial and transportation company stocks have weakened of late.
To understand where the trade dispute goes next, it‘s worth keeping an eye on the growing school of thought in Washington that argues today‘s economic integration with China harms long-term U.S. economic and security interests. Even short of any full “decoupling”of the two economies, a broad consensus is emerging that China‘s mercantilist policies are ripe for challenge. That view, and China‘s desire for greater clout in the global economy, could make for contentious negotiations ahead.
About Matt Miller
Matt Miller is a political economist and corporate affairs advisor at Capital Group. Matt has been a senior advisor at McKinsey, a Washington Post columnist and author, host of public radio‘s “Left, Right & Center”program and a White House aide for the Clinton administration. Matt joined Capital in 2014.