Is a US trade war imminent?
- Trump signed his plan to impose 25% tariffs on steel and 10% on aluminum imports. The tariffs will take effect in 15 days from now
- Despite high productivity levels, the US steel sector has witnessed a productivity growth slowdown, which might be a good motive for Trump to introduce tariffs. However, a large part of the slowdown has been caused by lower domestic investment
- Europe, by contrast, has stepped up its innovative capacity in response to Chinese dominance in the production of bulk steel
- China’s response so far has been muted, which can partly be explained by both economic as well as strategically political reasons
- The economic impact of a full-blown trade war would be large and hurt the US economy far more than China and the EU. Both China and the EU would have the opportunity to step up trade with each other, as their relative competitiveness vis-à-vis the US increases
- Risks of escalation in US trade tensions have increased with this latest action and could do so even more with domestic political dynamics towards the mid-term elections. However, given the expected severe effect of a full-blown trade war, incentives are in place for Trump to refrain from triggering such escalation.
Donald Trump has crossed the Rubicon. Surrounded by workers in the steel sector, on Thursday he signed a plan to impose 25% tariffs on steel and 10% on aluminum imports. After economic advisor Gary Cohn, the countervailing power to protectionism in the White House, stepped down earlier this week, it was clear that Trump was going to push ahead with his plan. Admittedly, last year we still were convinced that Trump would not follow up on his protectionist campaign rhetoric. However, these plans show that curbing the US trade deficit is the next goal in the crosshairs of the Trump team, after Congress managed to deliver Trump’s first major victory on the domestic front last year with the adoption of the Tax Cuts and Job Act. In this report we ask ourselves the question whether Trump’s steel plans are the opening shots fired in an imminent trade war. And if so, what would be the consequences?
The US steel sector: what are we talking about?
The US steel sector generates more than USD 200bn of value added each year and generates jobs for 1.7 million people. In relative terms, however, the sector only constitutes 1.2% of total US value added and 1.1% of all US jobs. The US steel sector is highly productive: in 2015 the productivity level per hour was USD 51, by which it outperformed the EU28 (USD 41) and the UK (USD 28) by an arm’s length (figure 1). However, productivity growth has been stagnant in the US steel sector, which could be one of the reasons why the Dutch steel sector has managed to become more productive than its American counterpart. Stagnant productivity might be one of the underlying motives of President Trump to lift tariffs and to prop up growth perspectives of the US steel sector.
Strikingly, US productivity growth has especially been lagging behind in the US (and the UK) due to declining investment. The contribution of non-ICT capital to total annual productivity growth between 2011 and 2015 was -0.7ppts (figure 2), which means that a large part of the innovative, efficiency and schooling efforts were counterbalanced by lower capital intensity. In Europe, the steel sector has not experienced capital destruction on such a large scale. Moreover, Europe has stepped up its innovative capacity in response to Chinese dominance in the production of bulk steel, by focusing on highly specialist niches (see FT, 2016). By raising tariffs and sheltering the US steel sector from competition, Trump runs the risk that X-inefficiencies will be piling up and US steel companies feel an urge to invest even less in R&D and innovation. That would mean even more bad news for US productivity growth and US steel competitiveness.
Retaliation by trading partners
The European Union has already stated that it is working on import tariffs of 25% on iconic US trade such as motorcycles, bourbon and jeans, which are chosen to hurt economies of key Republican US states, such as Kentucky and Wisconsin. Trump’s plans, however, does contain various escape routes: Canada and Mexico are exempted for now, as Trump can use the plan as a bargaining chip in the ongoing renegotiations of the North American Free Trade Agreement (NAFTA). Furthermore, Trump has also indicated that he might lift the tariffs on allies if they do something in return on “national security”.
This means that one important US trading partner that is not able to dodge Trumps tariff bullet is China. And with the US article 301 investigation on infringement by China of US intellectual property rights (IPR) coming up next months, trade tensions between the US and China could easily escalate. There are a number of explanations for the modest response from China so far. One clear reason is that although Trump wants to make tariff exemptions for US allies (which may not include China), China is a relatively small exporter of steel and aluminum to the US. Last year China was not even in the top-10 list US of steel imports ranked by country. China exported 0.74 million tonnes of steel, slightly higher than the Netherlands (0.64 million tonnes) and far less than other East Asian counties such as Korea and Taiwan. Given this, any (fierce) retaliation measure from China would overestimate the importance of these type of exports. Next to this, there are various investigations into China's trade and investment practices. In addition to this specific article 232 investigation into steel and aluminium practices, there also is a so-called article 301 investigation into the violation of intellectual property rights. The potential impact in terms of actions towards China is expected to be much greater from this latter investigation, therefore partly leading to a wait-and-see approach after the steel- and aluminium tariffs.
Another economic logic for China’s muted reaction can be related to China’s dependence on specific imports from the US (figure 3). China mostly depends heavily on imported soybeans, which supply 90% of the country’s annual consumption. Rabobank’s Food & Agri Research analysis showed earlier that the US is the second largest supplier of soybeans to China, accounting for 40% of China’s import needs. Brazil and Argentine roughly count for the other 50% and 10%. Given this, South America is unable to fully meet China’s import appetite, at least in the short run. Therefore we believe that it is highly unlikely that the Chinese government would retaliate with high tariffs on US soybeans, given its high import dependence. Other imports from the US are mostly intermediate products and parts, making these imports alternatively a necessity for China’s domestic production as well.
Furthermore, in the background there are also a number of subjects that are more political in nature, but could partly explain China’s moderate response. First of all, the yearly National People's Congress started on March 5. Stability around and during these kinds of important communistic party events is considered as very important. In addition, China plays an important role in the conflict around North Korea, although the most recent news seems to reduce this direct role as North Korea seems to look for more direct consultation with the US. One thing that is certain is that China wants to prevent any form of escalation on the Korean peninsula. Finally, the situation around Taiwan also lurks in the background. China has recently threatened war with Taiwan if the United States would approve a law that provides for more contact with the ‘apostate island’ that China considers its own territory. All in all, China will therefore operate strategically and weigh its actions carefully to minimize the overall risks of further escalation.
Impact of full fletched trade war
A trade war is easily triggered, especially as Trump has resorted to the argument that steel imports pose a threat to national security, an exceptional approach. In response to the current steel levies, trading partners such as the EU, Japan and China might retaliate by increasing duties on US imports. Consequently, US could start to target the imports of cars and partners retaliate once again. Ultimately, the situation could spiral out of control.
The economic impact of a trade war can substantial. First, higher tariffs lead to higher import prices and will add to inflation. This will consequently result in higher export prices, especially if the targeted goods are important intermediates for US producers of final products (table 1). Higher export prices will deteriorate of US competitiveness.
Moreover, US consumers are confronted with higher domestic prices as well, which will weigh on domestic consumption. On top of that, higher inflation feeds into higher interest rates. Higher inflation will force the Fed to hike its rates. Higher interest rates will further discourage private consumption borrowings and investment. In our scenario, we show that higher interest rates increase demand for dollar assets. Consequently, the US dollar appreciates, slightly lowering the negative impact of the import tariffs, but further lowering global demand for US products.
In the rest of the world we also see negative effects of US protectionist trade measures. First, export growth in other countries slows, which also feeds into lower investment, employment and consumption growth. As lower growth in the rest of the world also lowers import demand in the rest of the world, the US economy takes another hit in the second round. Of course, small open economies like the Netherlands and countries that have the strongest trade ties with the US, like Canada and Mexico, are hit relatively hard in a trade war. In response to US tariffs, trading partners retaliate. This would make US export even more expensive and lower the US export market size. Of course, inflation in the retaliating countries weighs on private consumption, investment, export and import in the same fashion as it initially affected the US, lowering economic growth.
Quantifying the impact
To simulate the economic impact of a full-fletched trade war between the US and its trading partners, we have used the macro-econometric trade model NiGEM. To simplify matters, we assume that the trade war will result in an additional import tariff of 20 percent on all US imports and assume that foreign countries will install an additional tariff 20% on all imports from the US. This is, of course, a firm assumption, and should be regarded as a thought experiment in case of a full-fletched trade war.
Our calculations show that such a scenario would have a large negative impact on the US economy of -6% GDP up to 2023 (figure 4), which is far more substantial than, for instance, a hard NAFTA breakdown. This comes down to USD 1000bn, which is ironically equal to the amount Trump has vowed to invest in US infrastructure over the next ten years.
For China (-1.6% total GDP losses up to 2023) and the EU (-1.7% GDP losses), the negative impact of a trade war would be substantial, but far lower than in the US (figures 5 and 6). Both China and the EU would have the opportunity to step up trade with each other and the rest of the world, as their relative competitiveness vis-à-vis the US increases. This assumes, however, that both countries continue their trade ties on the same footing, whereas tensions between Europe and China have been rising. Of course, the US would not have that luxury and in our stylized scenario would face tariffs by all its trading partners.
US President Trump has crossed the Rubicon with his plan to lift duties on steel import of 25% and aluminum of 10%. Analyses of the US steel sector performance, however, shows that declining productivity growth is due to declining domestic investment in the US, whereas Europe chose to increase competitiveness of the steel sector by stepping up innovation. From an economic standpoint, it would be more sensible for the US to invest in the strength of its steel industry rather than to limit foreign competition.
Meanwhile, the EU has asked for exemptions, but has also suggested that it could retaliate the steel plan of Trump by imposing duties on typical American imports, such as jeans and bourbon. China’s response is muted for both economic and political motivations. Nevertheless, with Trump’s decision, the risk of trade tensions escalating into a trade war have increased. Rough calculations show that an outright trade war with across the board 20% additional import levies between the US and all its trade partners would especially hurt the US, which could face GDP losses of -6% up to 2023. This comes down to about USD 1,000bn and ironically equals the amount Trump has vowed to invest in US infrastructure.
For China and the EU the impact would be far lower than in the US. Both China and the EU would have the opportunity to step up trade with each other and the rest of the world, as their relative competitiveness vis-à-vis the US increases. Given the expected severe impact of a full-blown trade war, our expectation remains that the US will want to avoid it and in the end will show constraint in its trade policy, although admittedly the risk of escalation has increased.
 The term X-inefficiencies refers to slack in the production process and higher production costs than necessary, which are the result of a lack of competitiveness pressure in the market.
 Of course, the Fed would take into account the fact that it is dealing with cost-push inflation and not demand-pull inflation. As such, in order to prevent significant damage to the economy, the Fed will calibrate its policy rate on nominal GDP developments (nominal GDP targeting) instead of the usual mix of nominal GDP and inflation (Taylor rule).