The Im­pact of A US - China Trade Fric­tion

China's Foreign Trade (English) - - Economy - By Wei Li , Shuang Ding

• US tar­iffs on USD 60bn of Chi­nese im­ports could cause 5% fall in China’s ex­ports to US, 0.15% drop in GDP • We main­tain our China GDP growth fore­cast of 6.5% given strong Q1 growth, un­cer­tainty on US reme­dies • China’s eco­nomic de­pen­dency on the US fell from 6.3% of GDP in 2006 to about 3.0% in 2017 • US eco­nomic de­pen­dency on China rose steadily from 0.1% of GDP to 0.7% dur­ing 2000-2014 • US GDP could fall 0.2% if China re­tal­i­ates, ban­ning US food, trans­port im­ports; 0.9% if all im­ports banned

An­nounce­ments from both the US and China have trig­gered fresh con­cerns about a po­ten­tial trade war. On 22 March, US Pres­i­dent Trump signed a memo that could im­pose a 25% tar­iff on up to USD 60bn of im­ports from China (but only af­ter a 60-day con­sul­ta­tion pe­riod). In re­sponse, China’s Com­merce Min­istry said “China will take all nec­es­sary mea­sures to de­fend its le­git­i­mate rights and in­ter­ests”. The de­vel­op­ment is in line with our long-held ar­gu­ment that Us-china trade fric­tions will in­ten­sify this year, though a full-blown trade war re­mains a tail risk.

In this re­port, we an­swer the five most fre­quently asked ques­tions.

(1) How de­pen­dent are the US and China economies on each other?

(2) How much will China’s ex­ports fall as a re­sult of the higher US du­ties?

(3) How big will the im­pact on China’s econ­omy be if the US bans (a) only im­ports of hi-tech goods from China; (b) all di­rect im­ports from China; (c) all di­rect and in­di­rect im­ports from China?

(4) How will the US econ­omy be af­fected if China re­tal­i­ates?

(5) Which in­dus­tries/coun­tries will be af­fected most by a Us-china trade war?

In short, we es­ti­mate that the 25% tar­iffs on USD 60bn of Chi­nese im­ports could re­sult in a 5% fall in China’s to­tal ex­ports to the US. Given that US de­mand ac­counts for about 3.0% of China’s GDP, higher US tar­iffs, if im­ple­mented, could lead to a 0.15% drop in China’s GDP. We main­tain our 2018 China GDP growth fore­cast of 6.5% in light of the econ­omy’s strong Q1 per­for­mance and given un­cer­tainty about the even­tual trade reme­dies by the US.

We have an­a­lysed all anti-dump­ing ( AD) and coun­ter­vail­ing duty ( CVD) or­ders that the US is­sued against im­ports from China from 201016. The find­ings sug­gest that ev­ery 1ppt in­crease in US du­ties will likely re­sult in a 1.6ppt de­cline in China’s ex­ports to the US in the next 12 months. It also raises ques­tions about the ef­fec­tive­ness of tar­geted im­port du­ties against China

in pro­tect­ing US in­dus­tries from im­port com­pe­ti­tion and nar­row­ing the US trade deficit.

Our study, based on the Leon­tief model and the lat­est World In­put-out­put Data­base ( WIOD), also sug­gests that China’s eco­nomic de­pen­dency on US and for­eign de­mand has been fall­ing (Fig­ure 1). Al­most 6.3% of China’s econ­omy was driven by US de­mand in 2006. The ra­tio fell to 3.1% in 2014 (lat­est WIOD data). We es­ti­mate that China’s de­pen­dency on the US fell fur­ther to c.3.0% in 2017.

US eco­nomic de­pen­dency on China, how­ever, rose from 0.17% of US GDP in 2000 to 0.7% in 2014 (Fig­ure 1). US eco­nomic de­pen­dency on all for­eign de­mand also in­creased from 6.2% in 2002 to 9.0% in 2014.

A trade war would be in no one’s in­ter­est. Our World Eco­nomic De­pen­dency Ta­ble sug­gests that c.20% of the world econ­omy is cre­ated by for­eign de­mand via global trade. Fig­ure 2 shows how much key economies un­der our cov­er­age are driven by for­eign de­mand.

How­ever, if a broader trade war be­tween the US and China did hap­pen, the es­ti­mated de­cline for China’s econ­omy is about 1.3% of GDP if the US banned all hitech man­u­fac­tured prod­uct im­ports from China. The pro­jected eco­nomic losses for the two more se­vere sce­nar­ios out­lined in Ques­tion 3 on page 1 are 2.6% and 3.2%, re­spec­tively.

If China re­tal­i­ated, the ex­pected de­cline for the US econ­omy would be 0.2% of GDP if China banned all agri­cul­tural and trans­port equip­ment im­ports from the US. The losses would rise to 0.9% if China banned all di­rect and in­di­rect im­ports from the US.

We dis­cuss each of the above-men­tioned five ques­tions in more de­tail be­low.

How much do US and China economies rely on each other?

One can­not ac­cu­rately gauge two coun­tries’ eco­nomic in­ter-de­pen­dency or trade re­la­tion­ship by only look­ing at their di­rect trade. This is be­cause goods and ser­vices are of­ten ex­ported and im­ported sev­eral times be­fore they reach end-con­sumers. Re­gard­ing US ex­ports to China, for ex­am­ple, of to­tal goods and ser­vices the US ex­ported to ful­fil China’s fi­nal de­mand in 2014, our model sug­gests that only 68% was shipped di­rectly to China; the other 32% was ex­ported to other coun­tries first, and then re- ex­ported to China. In this case, di­rect ex­ports un­der­state the true scale of US ex­ports to China (the true US- China trade im­bal­ance could be much smaller). There is an­other prob­lem with di­rect trade. Of to­tal US di­rect ex­ports to China in 2014, 14% was not for China’s fi­nal de­mand, and there­fore was re-ex­ported by China (af­ter pro­cess­ing) to other coun­tries. From this per­spec­tive, di­rect ex­ports could also over­state true US ex­ports to China.

To over­come the prob­lems as­so­ci­ated with look­ing at only di­rect trade, we have tapped into the WIOD, a project of the Eu­ro­pean Com­mis­sion, led by the Uni­ver­sity of Gronin­gen. The WIOD presents global trade among 44 economies and 2,464 in­dus­tries, which can be re­grouped ac­cord­ing to their fi­nal de­mand us­ing the Leon­tief model. This way, we are able to cal­cu­late an econ­omy’s true de­pen­dency on do­mes­tic and for­eign de­mand.

Our study shows that China’s eco­nomic de­pen­dency on US and for­eign de­mand has been fall­ing steadily since 2007, while China’s con­tri­bu­tion to the world econ­omy has been ris­ing over the same pe­riod (Fig­ure 1). The story was dif­fer­ent be­tween 2001 and 2006, though. Dur­ing this pe­riod, ac­cess to the WTO and a boom­ing US econ­omy saw China’s de­pen­dency on US de­mand rise from 3.9% of GDP to 6.3%, while China’s de­pen­dency on to­tal for­eign de­mand rose from 17.4% to 27.8%. Only 72.2% of China’s econ­omy was gen­er­ated by its do­mes­tic de­mand in 2006, down from 82.6% in 2001.

The on­set of the 2008-2009 global fi­nan­cial cri­sis (GFC) forced China to change its growth model. China has been pri­ori­tis­ing do­mes­tic con­sump­tion over ex­ports since then. Con­sump­tion now con­trib­utes about 65% of China’s to­tal eco­nomic growth, up from un­der 40% pre- GFC. As a re­sult, China’s re­liance on US and for­eign de­mand fell from 6.3% and 27.8% in 2006, re­spec­tively, to 3.1% and 18.8% in 2014. The share of China’s econ­omy driven by do­mes­tic de­mand was up from 72.2% to 81.2% over the same pe­riod. We es­ti­mate that China’s de­pen­dency on US de­mand fur­ther de­clined to 3.0% at the end of 2017, as the share of do­mes­tic de­mand in­creased from 81.2% of GDP in 2014 to 81.6% in 2017.

US eco­nomic de­pen­dency on China de­mand rose steadily, from 0.17% of its GDP in 2000, to 0.7% in 2014 (Fig­ure 1). By the type of China de­mand, about 0.32% of the US econ­omy was driven by con­sump­tion, ver­sus 0.38% by in­vest­ment. US eco­nomic de­pen­dency on China should have in­creased fur­ther from 2015-2017, as a re­sult of China’s steady, do­mes­ti­cally-ori­en­tated growth

over this pe­riod. The rise of China’s mid­dle-class means that the US, as well as the world econ­omy, should con­tinue to see an in­creas­ing por­tion of their economies driven by China de­mand in the com­ing years (Fig­ure 2).

A trade war is in no one’s in­ter­est. Ac­cord­ing to the lat­est WIOD, a se­ri­ous dis­rup­tion to global trade could see up to 20% de­clines in the world econ­omy. US de­pen­dency on to­tal for­eign de­mand has been ris­ing since 2004, from 6.2% of its GDP to 8.9% in 2014. While China’s econ­omy is in­creas­ingly de­pen­dent on its do­mes­tic de­mand, ex­ter­nal de­mand still drives some 18% of its to­tal GDP. Our World Eco­nomic De­pen­dency Ta­ble shows each econ­omy’s re­liance on for­eign de­mand.

How big an im­pact will higher US tar­iffs have?

As the odds of the US in­creas­ing im­port du­ties on se­lect goods from China are ris­ing, a bet­ter un­der­stand­ing of the im­pact of higher US du­ties on China’s ex­ports to the US is re­quired.

We list our key ob­ser­va­tions from the case stud­ies.

1. In 19 of the 22 cases, China’s ex­ports to the US (in vol­ume terms) fell af­ter AD/CVD or­ders were is­sued. On av­er­age, ev­ery 1ppt in­crease in US AD/ CVD tar­iffs on im­ports from China re­sulted in a 0.8ppt drop in China’s ex­ports to the US in the first year fol­low­ing the AD/CVD or­ders.

2. In 15 cases, US im­ports from non- China economies in­creased fol­low­ing the or­ders to levy higher du­ties on Chi­nese im­ports. On av­er­age, ev­ery 1ppt in­crease in US AD/CVD tar­iffs on im­ports from China re­sulted in a 0.5ppt in­crease in US im­ports from non-china economies in the first year fol­low­ing the AD/CVD or­ders.

3. There is no clear re­la­tion­ship be­tween China’s mar­ket share (the share of to­tal US im­ports from China for that par­tic­u­lar prod­uct) and the ex­tent of fall in China’s ex­ports af­ter the AD/CVD or­ders are is­sued. For ex­am­ple, al­though China ac­counted for 88% of US im­ports of high-pres­sure steel cylin­ders and 49% of util­ity scale wind tow­ers, the drop in China’s ex­ports of these prod­ucts to the US as a re­sult of a 1ppt in­crease in AD/ CVD du­ties was much big­ger than for some other prod­ucts, where China had a lower mar­ket share.

4. In 10 of the 22 cases (or 45%), US im­ports from non-china economies in­creased by more than the fall in China’s ex­ports to the US af­ter AD/CVD or­ders were is­sued against China im­ports. This raises ques­tions about the ef­fec­tive­ness of tar­geted im­port du­ties in pro­tect­ing US in­dus­tries from im­port com­pe­ti­tion (and in nar­row­ing the US trade deficit).

We think the im­pact of higher puni­tive tar­iffs that the US is cur­rently con­sid­er­ing will be twice as large as sug­gested by his­tor­i­cal AD/CVD cases. This is be­cause AD/CVD or­ders are de­signed only to bring prices to fair mar­ket lev­els, and not to make them more ex­pen­sive like a puni­tive tar­iff does. As a re­sult, we es­ti­mate ev­ery 1ppt in­crease in US tar­iffs on im­ports from China to re­sult in a 1.6ppt fall in China’s ex­ports to the US in the next 12 months.

In such set­tings, a 25ppt in­crease in US tar­iffs on USD 60bn of Chi­nese goods (about 12% of China’s to­tal ex­ports to the US) could see China’s to­tal ex­ports to the US fall by 5% in the next 12 months. Given that China’s eco­nomic de­pen­dency on the US is about 3.0% of GDP, a 5% de­cline in China’s ex­ports to the US would re­sult in a c.0.15% de­cline in China’s GDP. How­ever, in light of China’s bet­ter-than ex­pected growth in Q1, and un­cer­tainty re­gard­ing the fi­nal trade reme­dies the US may take against China, we main­tain our 2018 China GDP growth fore­cast at 6.5%.

How much would a trade war hurt China’s econ­omy?

While we think a full-blown trade war is still un­likely, we pro­pose three in­creas­ingly se­vere sce­nar­ios to es­ti­mate the po­ten­tial eco­nomic losses for China if a trade war be­tween the US and China did hap­pen:

1. In the least se­vere, but most likely sce­nario, we as­sume that the US only bans, as a re­sult of its Sec­tion 301 in­ves­ti­ga­tion, im­ports of hi-tech man­u­fac­tured prod­ucts from China. In this case, China’s ex­ports of com­puter, elec­tronic and op­ti­cal prod­ucts, elec­tri­cal equip­ment, ma­chin­ery, ve­hi­cles and other trans­port equip­ment to the US would most likely be af­fected. Such hitech prod­ucts ac­count for about 50% of to­tal China’s to­tal di­rect ex­ports to the US, with a weighted av­er­age value-added ra­tio of 76% ac­cord­ing to our model. In the worst case un­der this sce­nario, as­sum­ing the US stopped im­ports of hitech prod­ucts from China com­pletely, the to­tal eco­nomic losses for China, from all eco­nomic ac­tiv­ity as­so­ci­ated with the pro­duc­tion and ex­ports of hitech prod­ucts to the US, should be about 1.3% of China GDP.

2. In the se­cond sce­nario, we as­sume that US- China trade fric­tions es­ca­late, with the US lim­it­ing all di­rect im­ports from China (note that 20% of China ex­ports for US con­sumers ar­rive in the US in­di­rectly through our other coun­tries). In this case, our model sug­gests the to­tal eco­nomic losses for China could rise up to 2.6% of China’s GDP, from 1.3% in Sce­nario 1.

3. In the worst case, we as­sume that the US is ca­pa­ble of ban­ning all im­ports from China for its own con­sump­tion, in­clud­ing those be­ing im­ported in­di­rectly from other coun­tries with China com­po­nents. Our model sug­gests the to­tal eco­nomic losses for China could rise fur­ther to 3.2% of China’s GDP, up from 2.6% in Sce­nario 2.

How hard would China’s re­tal­i­a­tion hit the US econ­omy?

If China re­acted to US trade sanc­tions by lim­it­ing im­ports from the US, how much would such mea­sures hurt the US econ­omy? Again, we have pro­posed three sce­nar­ios based on their sever­ity and like­li­hood:

1. In the first sce­nario, we as­sume that China re­acts to US sanc­tions on im­ports of China hi-tech prod­ucts by ban­ning im­ports of US agri­cul­tural prod­ucts and trans­port equip­ment. Such prod­ucts ac­count for about 30% of US to­tal di­rect ex­ports to China. Ear­lier this year, China’s Min­istry of Com­merce said it launched an AD/CVD in­ves­ti­ga­tion into im­ports of sorghum grown in the US. In this sce­nario, we es­ti­mate that to­tal eco­nomic losses for the US could be c.0.2% of US GDP.

2. In the se­cond sce­nario, we as­sume that China bans all di­rect im­ports from the US (note that around 32% of US ex­ports due to China de­mand ar­rive in China in­di­rectly via other coun­tries). In this case, our model sug­gests an eco-

nomic loss for the US equiv­a­lent to 0.6% of its GDP.

3. In the worst sce­nario, as­sum­ing China bans all di­rect and in­di­rect im­ports from the US, eco­nomic losses for the US could amount to 0.9% of its GDP, ac­cord­ing to our model.

Which in­dus­tries are likely to suf­fer most in a trade fric­tion?

Our anal­y­sis sug­gests no real win­ner in a trade war. But we at­tempt to iden­tify the in­dus­tries and coun­tries (other than the US and China) that are likely to be worst af­fected, as­sum­ing a com­plete ces­sa­tion of trade be­tween the US and China.

If the US bans all im­ports from China

Our model sug­gests that the loss of the US mar­ket could de­press China’s man­u­fac­ture of fur­ni­ture (FU) by c.16% and pro­duc­tion of com­puter, elec­tronic and op­ti­cal prod­ucts (CEOP) by 14%. The pro­jected de­cline in China’s air trans­port (AT), tex­tiles (TX), rub­ber and plas­tic prod­ucts ( RP), elec­tri­cal equip­ment (EE) and chem­i­cal in­dus­tries (CI) ranges from 6% to 10%. The de­cline in pro­duc­tion of pa­per prod­ucts (PP), fab­ri­cated metal prod­ucts (FM) and cer­tain ma­chin­ery equip­ment (CME) could be around 5%.

From a broad GDP per­spec­tive, the slow­down in China’s com­puter, elec­tronic and op­ti­cal in­dus­try as a re­sult of a Us-china trade war is likely to have the largest im­pact on China’s econ­omy, sub­tract­ing c.0.4% of GDP. The im­pact of a slow­down in whole­sale trade, tex­tiles and min­ing in­dus­tries is next, at c.0.24% of GDP.

A ban of China im­ports by the US would not only neg­a­tively af­fect China, but there would likely also be col­lat­eral dam­age. In Fig­ure 5, we list the top 10 economies that could see the high­est im­pact from a slow­down in China’s ex­ports to the US. In par­tic­u­lar, eco­nomic losses for Tai­wan, Ko­rea, Aus­tralia and Ja­pan would likely amount to 0.8%, 0.4%, 0.2% and 0.1% of their re­spec­tive GDP.

If China bans all im­ports from the US

Fig­ure 4 shows the top five US in­dus­tries that are likely to suf­fer the most from China’s ban of im­ports from the US. For the air trans­port (AT), non-ve­hi­cle trans­port equip­ment ( NVTE), com­puter, elec­tronic and op­ti­cal prod­ucts (CEOP), agri­cul­tural prod­ucts (AP) and ma­chin­ery equip­ment (ME) in­dus­tries, pro­duc­tion could slow be­tween 3% and 6% ac­cord­ing to our model. From a value-added per­spec­tive, the slow­down in the ac­count­ing and man­age­ment con­sul­tancy, com­puter, elec­tronic and op­ti­cal, whole­sales, chem­i­cal and non-ve­hi­cle in­dus­tries would have the high­est im­pact on US GDP.

Fig­ure 5 shows the economies that are likely to be af­fected most by a slow­down in US ex­ports to China. The top five economies worst af­fected are Canada, Mex­ico, Ire­land, Tai­wan and Ko­rea (note that Tai­wan and Ko­rea ap­pear to be most vul­ner­a­ble to col­lat­eral dam­age as they are closely linked to both China and US ex­ports).

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