Escalating trade tensions – China strikes back


Just a few weeks ago, the outlook for the world’s largest economies, US and China, appeared to be promisingly upbeat- China’s Q1 GDP came in at 6.4% and the US reported growth of 3.2%, both exceeding analysts’ expectation. This resulted in tentative optimism that both countries’ growth was stabilising. Contributing to the positive data releases was an expected imminent resolution to the US- China trade war with reports of an “epic” trade deal about to be reached.

 

However, in a sudden change in course, President Trump gave warning that the tariffs were to be re-imposed, claiming that China had reneged on its promises, particularly in relation to intellectual property theft. Last Friday, the White House carried through on this threat increasing tariffs on $200 Bn of Chinese imports, from 10% to 25%. 

 

  

 Source: Peterson Institute for International Economics

 

 

China retaliates

 

On Monday morning, China responded with a tit-for-tat imposition of tariffs on some $60 Bn of US goods, starting on June 1 (see timeline of trade war escalation below).

 

The Dow Jones fell by 580 points on the news and the NASDAQ dropped by 3%, heightening the volatility experienced by the global markets over the past couple weeks. However, due to the lopsided trade balance- China imports only $130 Bn of US goods compared to exporting approximately $500 Bn to the US- the tariffs may likely still weigh more heavily on the Chinese economy. Therefore, in addition to the tariffs, other policy moves available to China include:

 

Currency depreciation: While the yuan has fallen to it’s lowest level since December in response to the trade hostilities, it seems unlikely that the government would resort to currency manipulation, given their stated commitment to the “basic stability of the yuan” and their desire to avoid massive capital flight.

 

Off- loading US Treasuries– with $1 trillion worth of US debt, a decision to sell off these bonds would be chaotic for markets, depressing treasury prices and raising yields. This in turn could increase the cost of borrowing in the US, adversely affecting growth prospects. However, again, this reaction would likely be even more harmful to China, the largest holder of US debt, since they would be forced to recognise losses on their own balance sheet.

 

 

Further stimulus from China and the US?

 

China’s Q1 rebound was largely attributed to the government’s stimulus measures- accessible credit, increased government spending and tax cuts. With the escalation in trade tensions, the country has again announced cuts to its reserve ratio to encourage lending to SMEs.

 

However, the economic cost of these efforts to prop up its economy is high for China which already has an estimated debt to GDP ratio of approximately 300% and as such, continued stimulus may become unsustainable. Furthermore, the country’s ability to service its US debt and fund its foreign investments for its Belt and Road initiative has come under pressure which all points to the economy having less room to maneuver in the midst of these escalating hostilities.

 

Meanwhile in the US, a rise in tension could also put the country’s rebound at risk with the increasing cost of imports likely to hurt corporate profits or be passed on to the consumer. Thus, on the news of the raised tariffs, market’s expectation of a rate cut has been renewed. According to the Atlanta Fed President, the tariffs could trigger a rate cut, with the decision hinging on how long the tensions continue without resolution and how businesses react.

 

 

What are the implications on global markets?

 

With the outcome of trade talks increasingly uncertain, prolonged tensions or a complete breakdown in negotiations may drag on global growth and lead to increased volatility in the markets, with the heightened uncertainty curtailing corporate investments.

 

For the currency markets, the traditional safe haven currencies, may experience upward movements and in fact the yen and US treasuries advanced on the immediate news of the rising tariffs. However, any derailment to the US growth based and potential rate cuts may offset this upward pressure. Meanwhile, the grimmer outlook for China will likely weigh on commodity-based currencies (AUD, CAD and other EM currencies).

 

The path ahead remains undefined and as investors navigate this uncertainty, protection against near-term risks will remain critical.

 

 

 

Author: Nirvani Sookdeo

 



 

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