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China has more to lose from a trade war than US

China has more to lose from a trade war than US

09-07-2018 | Monthly outlook

Tariffs will hurt China more than the US as a trade war begins in earnest, Robeco Chief Economist Léon Cornelissen warns.

  • Léon  Cornelissen
    Léon
    Cornelissen
    Chief Economist

Speed read

  • Trade war escalates as Trump slaps tariffs on Chinese goods
  • China’s ability to respond with same effect is more limited
  • Fears over lower yuan, capital outflows and bear market

On 6 July, US President Donald Trump slapped a 25% tariff on USD 34 billion of Chinese imports ranging from machinery to electronic parts. China responded with similar amounts, targeting US farm goods such as soya beans in order to hit states that support Trump, with an eye on influencing the mid-term Congressional elections due in November.

“In macroeconomic terms, these tariffs are still insignificant, amounting to 0.1% of GDP for both countries,” says Cornelissen, introducing this month’s outlook from Robeco Investment Solutions. “However, the US has already indicated that if China retaliates, it will in turn retaliate to this, so this risks sparking a global trade war. Trump has threatened to extend tariffs to almost all Chinese trade to the US, currently worth around USD 500 billion.”

“And China cannot retaliate to the same extent, as imports from the US are much lower in absolute terms. Instead, it will probably escalate tensions by making life difficult for US companies in China. In anticipation of this step-up in the trade war, China has allowed the yuan to depreciate by more than 3%.”

Capital outflows concern

“In our opinion, we think it’s a warning sign that the Chinese authorities believe they can easily compensate for the 25% tariffs using the depreciation of the yuan, and we do not expect further depreciation because that would not be in the economic interests of China.”

“Capital outflows could easily increase if nervousness about the future exchange rate rises, and this could force monetary tightening (i.e. higher interest rates) and stricter capital controls. This is counter to the wishes of the Chinese authorities to free up their capital account and internationalize the yuan, so further pressure here would be a step backwards.”

“Further, the Chinese economy is being weakened due to tightening measures in the credit markets, so any increase in interest rates to effect tightening would be counter-productive. The Chinese economy has more need for monetary loosening. And the market thinks that Chinese equities have already entered a bear market amid worries that growth is declining.”

“So it seems for now that China will be the prime loser of this conflict, while the July figures showed that the US economy has strengthened, as both the ISM manufacturing and non-manufacturing readings rose. Meanwhile, the US stock market has barely reacted to the trade war rhetoric because it has such a limited effect on the US.”

Grander plan

A trade war could also form part of a grander plan to curtail increasing Chinese power on the global stage, Cornelissen says. “There are people in the US administration who fear the rising technological dominance of China, and they want to counteract the ‘Made in China 2025’ ambition, in which China is striving for world dominance in key technological sectors by that date.”

“So, they want to slow down the rise of China by any means. And there are ways of doing this outside of tariffs, such as ruling out Chinese investments in US sectors which are considered to be of strategic importance, restricting visas for Chinese students, and so on.”

However, there is still a downside for the US. “While the direct effects of China imposing tariffs on US goods are limited, there could be a lot of indirect effects which are more difficult to measure, including somewhat higher inflation, lower growth, and the risk of damaging producer confidence,” Cornelissen says.

“Some companies have already signaled to the Fed that they are putting investment decisions on hold. And of course, these tariffs can damage global supply chains in a way that is not easy to predict, which could reverberate against the US.”

Second front with EU

Meanwhile, a second front is opening up against the European Union. After Trump tariffs were announced on steel and aluminum produced by the EU, China and Canada, all three retaliated with tariffs on US products. In return, the US has now threatened to slap a 20% tariff on European cars, after Trump complained that too many BMWs and Mercedes were cruising along Manhattan. This also isn’t a one-way street: iconic US motorcycle maker Harley-Davidson responded by saying it would increase production in Europe to escape the higher costs.

Given all the uncertainty, Robeco Investment Solutions has moved from overweight to neutral on equities in its multi-asset funds, and is underweight on emerging markets versus developed markets equities. But there may be a silver lining.

“A dampening of investor optimism from a trade war would ironically benefit US Treasuries and the dollar, as these are traditionally safe havens,” Cornelissen says. “It could even benefit the US stock market, which is also a kind of safe(r) haven for equities. So there is a perverse kind of incentive here for the US.”

“Trump has at least shown to be susceptible to pressure from the stock market, which for investors at least is a comforting thought if it does go down.”

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