US/China Trade War: Truth & Consequences

trade with china

Every man lives by exchanging”—Adam Smith

For as long as there has been commerce, there has been trade between nations. 

However, in recent years, debate over US trade policies had taken a back seat to other, more ‘hot button’ economic and social issues. 

That is, until the 2016 presidential election.

In one of the few areas of bipartisanship, there have always been those in both major political parties advocating on behalf of both freer trade, and conversely, more protectionist policies. However, in the last election, the generally accepted view of the benefits of US participation in international trade agreements—and, especially the nation’s trading relationship with China—came under severe criticism by then-candidate Donald Trump.

The president, in defiance of many within his own party, advocated the view that for the last several decades China had “taken advantage” of US trade policy, exporting massive amounts of goods while allowing only a fraction of that amount to be imported from the US. 

As empirical proof of this view, the president pointed to the fact that the US trade deficit with China climbed to its highest level on record last year, hitting an all-time high of $375.2 billion, an increase of just under $30 billion from the previous year. While some economists said the increase in the trade deficit was in large part a result of the strong US economy—and therefore increased consumer demand for imported products such as clothes, electronics and appliances, many made in China—the Administration saw the deficit as proof of the need to take action against Chinese exports in order to “level the playing field” of US/China trade.

So it came as no surprise to many when President Trump announced he would be imposing tariffs on Chinese imports; earlier this year, the president announced that $200 billion of Chinese goods would be subject to 10 percent tariffs—and they will automatically increase to 25 percent by year-end.  In addition, the president has warned that if China retaliates with its own tariffs, he will ultimately end up with slapping tariffs on an additional $267 billion of Chinese exports to the US, effectively placing tariffs on all Chinese exports to the US.

The Cause: How Did US/China Trade Relations Come To This?

For at least the last three decades, the US and China have had a ‘unique’ trading relationship. Unlike the US trading relationship with other large trading partners such as Canada (with whom the US has had a fairly balanced trade level), China has historically benefited from the ‘normalization’ of US/China relations that commenced in the 1970s following President Nixon’s visit to China due to its very low labor/manufacturing costs and (until recently) lax environmental rules.

In the 1980s, China became an active participant in international trade; while building “economic zones” within its own borders, China began developing the requisite infrastructure (roads, bridges, ports) that would be required if the nation was to become a major player in international trade. Importantly for the Chinese economy, these economic development measures allowed the country to grow its economy by expanding its export markets and thereby earning foreign currency—which, in turn, was used to further develop the nation’s infrastructure. 

Since China is ruled by a one-party system, the Chinese government was able to put into place any laws it deemed necessary to protect its own interests with minimal opposition; this resulted in devaluation of the Chinese Yuan and strict controls over the imports of foreign goods, including those made in the US. 

As globalization grew during the course of the last quarter century, China formed its own ‘Ministry of Foreign Economic Relations and Trade’, with a mandate to oversee the nation’s trade policies, and strictly control its imports and exports; this was accomplished by establishing strict licensing and quotas. Critics of US/China trade policy—including the president—have long pointed to these restrictions as evidence of how ‘unfair’ US/China trade has been to Chinese trading partners, particularly the US.

Throughout the 1990s and into the new millennium, many US companies established manufacturing facilities in China, taking advantage of exceptionally lower labor costs and favorable business environment.

Predictably, as demand for cheaper Chinese goods, especially apparel and appliances, grew over the years, so too did the US trade deficit with China. Although the European Union remains China’s largest export market, the US is their second largest, with just under 18 percent of Chinese exports arriving on US shores.

Keeping His Campaign Promise: Trump Imposes Tariffs On Chinese Exports

Whatever one’s views are on the value—or potential damage—of US tariffs on Chinese imports, there’s no longer any doubt that the president’s pledge to impose the tariffs was more than an idle campaign threat.

While proponents of the tariffs believe they will have multiple benefits, especially as a means to incentivize China to negotiate ‘better, fairer’ trade with the US, others warn the resulting trade war could do real economic damage—in the near future.

A recent analysis conducted by Axios found that the escalation of the China/US trade battle could affect as many as 11 million American jobs, with rural and low-population counties being the hardest hit. 

And perhaps no businesses are more worried about the effects of a China/US trade battle than those involved in the nation’s supply chains; Forbes magazine points out that of the initial $34billion of US tariffs, 60 percent will fall on foreign companies operating in China—some of which are, in fact, American. 

An example of the unintended consequences of the new tariffs: Volvo Cars, a Chinese owned company based in Sweden, had previously committed to build autos in South Carolina to serve the US, as well as for export to both Europe and China. 

However, in the wake of the new tariffs, the company has said it is putting its US hiring on hold.

Additionally, some financial industry voices warn that tariffs could severely affect investor confidence; JPMorgan CEO Jamie Dimon is among those warning that as investor confidence is shaken by the US/China trade battle, supply chains may begin to shift, and industry leaders may begin to pull back on investments until the proverbial dust settles. 

Dimon may be right: a recent survey of US CEOs by the Business Roundtable found that roughly two-thirds of the executives believe the tariffs will be a ‘moderate or significant’ drag on their companies’ capital spending plans.

The same survey found a decrease in confidence and increased executive uncertainty surrounding trade policy could prompt firms to move to regions that are less affected by these new tariffs. Perhaps the highest profile of these types of moves, according to the survey, was the supply chain shift announced by Harley-Davidson (who announced earlier this year they’d be moving some production overseas to avoid European retaliatory tariffs.)

In addition, it’s a well-known business adage that ‘the market hates uncertainty’—and prior to the arrival of tariffs, the certainty of this Administration’s commitment to deregulation, combined with last year’s major tax cuts, helped boost the Dow Jones to heretofore unparalleled heights. 

However, in recent weeks, the stock market has experienced some wild swings, losing over 1,300 point is just two days in early October. Now, market swings are not that uncommon, but when swings of those magnitudes occur there is usually something specific ‘spooking’ investors—in recent weeks, the rapidly expanding trade battle between the world’s two largest economies has been seen as the most likely cause.

Perhaps most disconcerting is the fact that we have yet to see anything beyond the tip of the proverbial iceberg, as far as the impact of these new tariffs. US/China relations are in a very bad place right now, and there is little reason to believe that this confrontation will be ending anytime soon. 

As a result, there is a genuine possibility that—in the absence of any new trade deal with China before 2019—the president will increase the initial tariffs on Chinese exports to the US to 25 percent on January 1, 2019, further damaging supply chains and raising the price of goods in the US. 

The Road Ahead: A More Even Playing Field vs An Expanding Global Trade War

There has been a great deal of rhetoric about the short and longer term economic implications of the imposition of US tariffs on Chinese imports, and the reciprocal tariffs by China on US exports. 

However, beyond the noise and rhetoric, at the end of the day there are really only two likely outcomes of the strategy of using tariffs to attempt to ‘level’ the trading playing field between the worlds two largest economies.

It’s important to understand the size of the economic titans in this battle and their impact on the global economy: the US economy generates about $19.4 trillion and 25 percent of the gross world product, while China’s GDP is estimated to be in excess of $23 trillion (although US per capita GDP is still much larger than China’s—as of 2017, the US per capita GDP led at $59,609 vs China’s $16,676).

So there is no doubt that the stakes at play in this trade battle couldn’t be higher.

Proponents of the tariffs argue that, if the president has made the correct choice with the imposition of tariffs, then China will, eventually, be willing to loosen many of the very tight restrictions it currently has in place limiting international—and specifically, American—imports to their country. Were that to occur, the economic results have the potential to jettison US economic growth, and create tens of thousands of manufacturing jobs as American businesses clamor to get a share of the newly opened Chinese market.

However, the risk in this policy is just as high as the potential ‘reward’.

In a worst case scenario, especially in the age of globalization, many companies contributing to the global supply chain may have little choice but to relocate factories and/or distribution centers in an effort to avoid the new tariffs. This, in turn, could dramatically effect investment decisions and lead to an exit of investment capital in both the industries—and regions—hardest hit by the tariffs. 

The result of all these disruptions and changes could well result in shock waves to global trade and cross-border commerce. In fact, the collateral damage of the tariffs is already starting to be felt by many small and midsize US businesses.

Take the case of Kent International Inc., a bicycle company that recently opened a factory in South Carolina to start assembling some of the bicycles it sells to retail giant Walmart Inc. As recently reported by the Wall Street Journal, Kent currently employs about 167 people but planned to expand the facility next year by importing steel tubes cut in China—plans were in place for 2019 to hire about 40 more workers for the plant (which assembles about 300,000 of the 3 million bicycles the company sells internationally each year.)

When the president imposed tariffs on the Chinese steel Kent planned to use for their bicycles, the company’s executives traveled to Thailand, Cambodia and other nations to find new suppliers for Chinese products hit by the tariffs. Kent’s plans to hire more US workers are now on hold as it examines the option of opening facilities in those countries instead of expanding at home.

In essence, Kent is a prime example of how globalization and the free-flow of capital may make it difficult if not impossible to successfully utilize tariffs as a ‘negotiating tool’; many companies, such as Kent, will simply seek out ‘safer ground’ that is tariff-free, and the end result may be a loss, rather than gain, of US manufacturing jobs.

While some companies hit by tariffs will simply raise their prices to offset the added costs, others may delay or cancel plans to expand their US footprint or shift production offshore. 

If this was 1970, or even 1980—a world in which American manufacturing dominance was unquestionable and China remained a ‘closed economy’—the notion of tariffs might have greater likelihood of success; however, the opening of China, along with modern technology combined with globalization of commerce over the last 3 decades means that companies have options, and will likely seek out places and means to avoid tariffs that would raise their costs, and cut severely into their bottom line profits.

To be clear: tariffs are really just another word for ‘taxes’. And in the short term, if this trade battle with China continues unabated, the results will most likely include:

  • Increased constraint on imported goods, as well as higher cost of those goods
  • Strained relationships with America’s trading partners, that may spill over into unintended consequences benefiting America’s geopolitical opponents (particularly China)
  • Disruption in the global supply chain for American manufacturing and technology companies; if these tariffs result in a full-blown trade war with China, companies that feel the full impact of the US tariffs may look to relocate operations and the employment/financial results could be severe

In the short term, we may also see tighter margins as businesses scramble to prepare for the imposition of additional tariffs and their effects on the cost of goods.

Over the longer haul, on the positive side, these changes could help delineate the weaker businesses from those that are well capitalized; in addition, we may also see a diversification of books of business through short-term opportunities not previously available.

The Final Chapter Has Yet To Be Written In This Trade Battle Of The Titans

As of now (fall, 2018) it is—literally—impossible for even the most perspicacious businessperson to predict the outcome of this trade battle 

There are many reasons for this fact, not the least of which is the president himself; the president has gone on record as saying he doesn’t like to ‘telegraph’ his future moves, and he sees politics from a ‘transactional’ viewpoint. To date, he has shown a willingness to roll the proverbial dice in a way that few—if any—politicians have ever done.

As previously noted, the real world results of the tariffs on Chinese goods—and reciprocal Chinese tariffs on US exports–are already being felt by many businesses in both the manufacturing and agricultural sectors. As of now, it remains uncertain if the president will move forward with expanded tariffs, and if the Chinese will respond in kind. 

At a minimum, we are already seeing the collateral effects of higher prices due to the tariffs, including inflationary pressures that are beginning to be felt. That has the potential to push the Federal Reserve to further raise interest rates in an effort to curb inflation. 

In a best-case scenario, cooler heads (on both sides) will prevail, and the US and Chinese trade negotiators will be able to reach a mutually beneficial trade agreement, not unlike the recently agreed to ‘USMCA’ (essentially the revised version of the North American Free Trade Agreement, or Nafta).

One thing is certain about the current trade battle between the world’s two largest economies: the economic stakes could not be higher, and virtually all US businesses will be closely watching to see the outcome of what may well end up being the signature issue of the Trump Administration.