The Trump trade war intensifies: which segments are most vulnerable?
- On Thursday 22 March, President Trump signed a plan to impose 25% tariffs on USD 60bn worth of Chinese products. Details on which products are targeted not be revealed for another 15 days.
- Chinese export volumes could take a hit of USD 35bn due to the plans. The tariffs are expected to hurt the US as well, since US high-tech corporates and retailers have their products assembled in China to benefit from cheap Chinese labour.
- China has little options to retaliate with tariffs without shooting itself in the foot. A large share of US goods shipped to Mainland China consists of necessity imports, such as medicine, (medical) instruments and soybeans.
- Ironically, the trade ties between the US and the EU are much more susceptible to protectionist measures, with cars, electronic equipment and aircrafts (equipment) being the most vulnerable sectors. While Trump’s aim is not to provoke a trade war with Europe, things could spiral out of control. Integration of supply chains is limited, while there are alternatives for a substantial share of current imports
- While seeking exemptions from US steel and aluminium tariffs, it will be difficult for the EU to fully comply with the US demands to step up defence spending due to the massive costs involved
- At the current juncture, it is very difficult to predict how things will develop over the next weeks. However, in broad terms the recent string of events indicates that further escalation of trade hampering actions is more likely than we anticipated before
- If trade tensions escalate, we currently foresee two outcomes: one where Europe cooperates with the US and one where Europe alienates from the US. These two scenarios could have significant negative implications for world trade and the global economy. We deem cooperation between US-EU towards China currently as more realistic than the other way around
Lifting the veil
Trade Representative Robert Lighthizer has been leading negotiations with different trading partners and firms on the terms and conditions to be exempt from the steel (25%) and aluminium (10%) levies that will take effect this Friday. Apparently, the US has put five demands on the table that trading partners must abide to in order to get excluded from the tariffs (see Bloomberg):
- Limit steel and aluminium exports to levels of 2017;
- Actively address China’s trade-distorting policies;
- Being assertive and cooperative with the US at the G20 Global Steel Forum;
- Cooperate with the US in launching cases against Chinese practices at the WTO;
- Enhance security cooperation with the US.
These five conditions shed more light on the motivations of the Trump team to actually press ahead with imposing current and new protectionist measures. Although some of these demands are rather opaque, two main messages clearly stand out. First, the US wants other countries to team up with the US against Chinese trade practices. Second, Trump clearly wants the EU to step up its efforts on defence spending, and consequently, lean less heavily on US support. In anticipation of the new tensions in the trade war saga, in this Special we assess which economic segments are most vulnerable in China, Europe and the US. We subsequently look at bilateral trade ties and product groups, assets, food & agri flows and fiscal deficits related to higher defence spending.
Vulnerabilities in US – Chinese trade
On Thursday 22 March, the Trump administration announced a new package of 25% annual tariffs on USD60bn of Chinese exports and restrictions on Chinese investment into the US. Details on which products are targeted are not detailed for 15 days, with another 30 days scheduled as a consultation period with US industry. The tariff revenues are regarded as compensation for infringement of US intellectual property rights (IPR) by China, as Chinese policies prescribe that a company must hand over its technologies if it wants to do business on their markets.
Although many US companies agree with Trump’s message to stop US IPR violation, many disagree with a package of sanctions. Obviously, Trump is aiming for another goal here, which is to rein in the massive trade deficit that the US runs with China (figure 1). On an annual basis, US exports to China add up to USD 160bn, but at the same time USD 490bn worth of goods are shipped from China to the US. In Trump’s opinion, the 330bn trade deficit demonstrates China’s dishonest trade practices and going forward we can certainly expect more trade measures. And the thinking of the Trump team is that it is able to “win a trade war” because tariffs are more painful for the economies having a large trade surplus with the US, as they stand to lose more.
The next question is which segments of the Chinese economy are most susceptible to trade barriers. Figure 2 shows a breakdown of US imports from China. Roughly half of all US imports from China consists of electronic machines, ranging from computer parts, telephones, broadcasting equipment and video displays. Other important imports are textiles and shoes. The US government allegedly is considering a wide range of tariffs, targeting exactly all these segments (Bloomberg). However, gross trade flows do not illustrate the importance of internationally sliced-up value chains. It is well-known that large US high-tech corporates and retailers use relatively cheap Chinese labour to assemble their products. Therefore, gross trade flows do not reflect revenue flows. To give an example, iPhones are made largely by Foxconn in China and each phones shipment from China to the US adds to the 330bn trade deficit. At the same time, research into revenue flows show that for each and every sold iPhone, 58% of total revenues ends up being profit for Apple, whereas Chinese labour only receives a marginal 1.8%.
Raising tariffs on final and intermediate products shipped to the US will crank up domestic prices for US consumers and producers. In case of US firms assembling their products overseas, higher costs can only partially be passed onto consumers and so this will eat into their profit margins; as such these tariffs could shock the US stock market as well.
The US government claim to impose 25% tariffs on USD 60bn worth of Chinese imports has negative consequences for the Chinese export market size. Our calculations show an impact of USD 35bn, which is limited given the total export volume of 490bn of Chinese goods shipped to the US each year. Earlier, Chinese premier Li Keqiang already responded at the annual National People’s Congress that hewants to avoid a trade war and that the government plans to further open up its manufacturing sector. However, Trump has stated that this package is “the first of many”. This adds to the threat of a lingering trade war. In fact, the first retaliation measures in response to steel and aluminium tariffs, which became effective on Friday 23 March, have been announced by China already. On Friday, the Chinese Ministry of Commerce said that it plans to target 3bn of American imports, covering 128 US import products, ranging from US steel pipes, fresh fruit and wine against a 15% tariff, and pork and recycled aluminium against a 25% duty.
Limited options for China to retaliate
Moreover, we believe that China has little leverage to retaliate against any tariffs imposed by the US. Figure 3 shows a breakdown of Chinese imports from the US. Machines (i.e. telephones, gas turbines, integrated circuits, computers) take the lion’s share (24%) in total Chinese imports of American goods. As the US can be regarded the technological leader in many high-tech segments, it won’t be easy to find suitable substitutes for these specific American high-tech products, at least not at current volumes of USD 39bn and against existing quality and price standards. The next two import categories are chemicals/medicines, (medical) instruments and soybeans, all of which can be regarded as necessity rather than luxury imports. The first two US imports products which are prone to possible tariff retaliation measures by China are airplanes/helicopters and cars, which (to a certain extent) could be substituted by products from Europe or Asia. Apparently, China is planning to target soybeans, sorghum and live hogs (WSJ) and companies are lining up alternative sources. However, based on research by our Food & Agri team, we have stated before that South America is probably unable to fully meet China’s import appetite, at least in the short run. Bottom-line: China appears to have limited retaliation options as far as trade ties are concerned. Of course, China could impose non-tariff barriers, by pressuring US firms operating in China to comply to, for instance, stricter regulatory and security checks. Or just instruct Chinese (state-owned) companies to lower business-to-business deals with US partners operating in mainland China. Another probable lever for China which is often mentioned is the large stock of US assets in the hands of the Chinese, which is used to plug the US’s huge trade deficit.
But what about China’s US treasury holdings?
Next to any possible Chinese retaliation in terms of trade barriers, there has been a lot of speculation in what way China could hurt the US if one takes into account their level of US treasury security holdings. China is the biggest holder of these securities (figure 4), holding on average 18.4% of total outstanding securities between January 2017 and January 2018, compared to Japan’s 17.8%. China finances a large part of the US current account deficit by buying US government securities from the excess of US dollars it receives in trading with the US. China buys these securities because if they would put all the received trade dollars back into circulation on the foreign exchange market, this would result in a strong appreciation of China’s currency, the yuan (CNY). Furthermore, US securities offer a relatively high return in comparison to European high-grade sovereign paper.
If China decides to diversify more into non-US assets (i.e. by reducing or selling these securities) for its foreign currency reserves, this could potentially exacerbate the rise in US interest rates and result in weakness of the US dollar. As we already highlighted in an analysis on the potential impact of rising protectionism on the US economy that higher interest rates will further discourage private consumption borrowings and investment. Such a move would, however, not only harm US interests, but the Chinese ones as well. China’s FX reserve portfolio – currently consisting of approximately 3.1 trillion USD – would potentially lose considerable value. These reserves are used to intervene in FX markets in order to control CNY movements within a trading range set on a daily basis. Aside from this, it would be hard for China to sell these assets and to switch to other currencies like the euro or yen. More importantly, a mass dump of US assets would result in further upward CNY pressure. This would additionally lead to lower exports through higher export prices, and thus a deterioration of the competitiveness of Chinese exporters. On balance, net trade would contribute less to economic growth, while the contribution of net exports to economic growth is still important given the expected cooling of China’s domestic demand. Therefore it would be hard for domestic demand to replace the shortfall in net exports’ contribution, not in the last place because of the recent decrease of China’s fiscal deficit target from 3% to 2.6% at its most recent National People’s Congress.
Any stimulus from the government should therefore be subdued, at least for now. Aside from the proposed lack of any higher fiscal stimulus, domestic demand is also expected to decrease on the back of a cooling housing market and the aim to deleverage the economy. Both have been important drivers of growth in recent years. Of course China’s monetary authorities could decide to offset the currency strength by printing more money, but in the light of its aim to reduce systemic risk in the financial system and the possibility of the Fed retaliating in the form of halting its rate hike path, this may face some hurdles.
All in all, given the limited retaliation possibilities from a trade and US securities point of view, at least from a rational economic perspective, we foresee a moderate response from Beijing.
Vulnerabilities in US – European trade
On 22 March, the Trump team also announced that the EU (among others) are temporarily exempted from the steel and aluminium tariffs, just hours before they would become effective. That does not mean that the EU is completely off the hook, and more trade measures could be expected by the US government in order to raise the pressure on the EU to side along the US against China.
In that case, the EU has to choose between accepting the new trade barriers, adhering to US demands, or to retaliate. Simply accepting the tariffs seems to be no option at this point. With respect to US demands, the EU might be open to team up against China as it too regularly accuses China of unfair trade policies. In fact, in May last year the EU announced 20 new anti-dumping measures on steel and iron exports from China. But the demand to "enhance security cooperation with the US" might face more resistance, because it could imply major costs for several Member States (see the paragraph "Defence spending gap and fiscal deficits" below). Moreover, caving in to US demands could make the block look weak.
A few weeks ago, in response to the US plan to raise steel and aluminium tariffs, the EU stated that it was working on import tariffs of 25% on iconic US trade such as motorcycles, bourbon and jeans. Such tariffs are unlikely to have a significant impact on the US economy, but could hurt economies of key Republican US states. As a response, the US has threatened to impose levies on European car imports should Europe decide to retaliate. Trump’s threat to target European cars make sense if we look at the most important products traded between both sides of the Atlantic. The automotive sector has the highest share (USD 70bn) within total US import of European goods (figure 5). In fact, as far as cars trade is concerned, the US runs a large trade deficit with the EU of more than USD 30bn. With car exports of USD 22bn, Germany is sending most European cars to US shores.
Besides cars, other product groups which are vulnerable to protectionist measures by the US are European exports of electronic equipment and aircrafts (& components) and even art and antiques (figure 6). Taken together, the import value would amount to USD 110bn, which almost equals the US-EU trade deficit of USD 120bn. It is less likely that Trump would target sectors such as medicines, specific chemicals and the F&A sector, as it is more difficult to switch to alternatives, at least on the short term.
In case of EU retaliation, there are numerous options as well (figure 6), for instance by targeting American motor vehicles, aircraft and electronic equipment. The upshot is that while especially the EU would try to prevent a trade war with the US, things can easily spiral out of control as the trade structure between both regions is fragile in terms of protectionism. Integration of supply chains is limited, while there are alternatives for a substantial share of current imports. Both the US and the EU would likely be confronted with higher costs on cars, electronic equipment and aircrafts (equipment).
Zooming in on the car sector
As highlighted above, Trump could choose to target the European car sector to make up for US losses in competitiveness over the last couple of years. Indeed, in the recovery phase from the global economic meltdown in 2008, the US car sector has been losing ground at a fast pace (figure 7). Before the global economic meltdown, both the German and US car sector moved on par in terms of productivity per hour and also took an equally large hit during the crisis. However, in the aftermath of the crisis, US productivity levels have been stagnant, whereas Germany and the EU at large were able to increase their competitiveness. Noticeably, stagnant US productivity was especially caused by destruction of human capital, which probably finds its roots in a quality compositional shift of the workforce active in the automotive sector. In other words: highly-skilled and highly-educated baby boomers have been retiring from the sector at an increasing pace, and have been replaced by less skilled and lower educated young(er) people. Moreover, as we saw with the US steel and aluminium sector, there has been major disinvestment in capital per hour as well, which has dampened productivity performance (figure 8). In Europe and Germany, we have not witnessed these negative developments, which explains why annual productivity growth in Germany (2.6%) between 2010-2015 outpaced that of the US by a factor ten (0.26%).
Vulnerabilities in global Food & Agri flows
Moving away from cars, a strategic part of trade flows between US and its trading partners EU and China is the Food and Agri component (figure 9). In 2016, US agricultural trade with the EU accounted for USD 12.4bn, whilst the reverse trade flow accounted for a whopping USD 22.9bn. Key factors that determine vulnerability may lie in volume or value on the one side, versus import or export dependency on the other side. Hereafter we will shed light on a number of trade flows that stand out for one or more of the aforementioned reasons. This will be of relevance in the discussions regarding feasibility of tariffs or other import barriers between the different trading partners.
US-EU F&A trade
When we assess EU-US F&A trade flows, wine, spirits, beers and cheese stand out (figure 10), whilst in the other direction, tropical fruit, nuts and spices, soybeans and spirits and liqueurs are the most important. Wine and spirits exports to the US are fairly concentrated, with Italy and France responsible for more than two-thirds and the UK and France accounting for the lion’s share in the case of spirits. The Benelux is responsible for 22% of the EU volume that is shipped to the US. Another interesting case concerns EU cheese exports. Although in value terms cheese exports are just below USD 1bn, these exported goods are strongly skewed towards Italy, accounting for a quarter of the total. This type of concentrations in origin may lead to vulnerability for specific trading partners. Reversely, the aforementioned US F&A export to the EU are also concentrated to specific states in the US. For instance, corn and soybeans originate for a large part from the Mid-West states (Illinois, Iowa and Minnesota), bourbon is mainly produced in Kentucky and walnuts and pistachios are chiefly grown in California.
US-Chinese F&A trade
In the F&A trade relationship between the US and China, a significant imbalance exists. US exports to China are almost US 20bn, whereas only USD 4.3bn of goods are shipped from China to the US (figure 9). US exports to China are especially vulnerable when we look at soybeans, feed grains and pork exports. Vice versa, the US could target seafood import from China (USD 3bn). This trade flow consists of a variety of seafood products, ranging from whitefish to shrimps and prawns.
One important aspect besides magnitude of the trade flows is origin dependency. 40% of China’s soybean imports originates from the US. As said, replacing US soybeans for Brazilian or other South American soybeans will not be feasible in the short run due to insufficient supply. The same holds for feed grains (albeit at a much lower trade volumes): sorghum imports from US accounts for 93% of total sorghum imports. However, this trade was already brought to a halt by China’s recent introduction of anti-dumping duties on US sorghum. Finally, China is the world’s biggest pork importer, with the EU and US as main suppliers. In 2017, China imported approximately 2,452 thousand metric tonnes of pork, with the US as second supplier (figure 11).
All in all, the story of F&A trade flows between US – China and US – EU is not just about value and volume, but in certain cases also about import and export dependency, therewith adding to the complexity of the matter.
The defence spending gap and fiscal deficits
One of the things the Trump administration demands in exchange for an exemption on steel and aluminium tariffs is enhanced security cooperation with the US. Trump has claimed before that the EU needs to pay its fair share on defence if it wants to count on US support when necessary. While the US spends about 3.3 percent of GDP on defence, the EU only spends 1.3 percent of GDP (figure 12), i.e. much less than the agreed amount in NATO of 2 percent of GDP. Trump’s stance on this had already provoked some awareness of the issue around the block. But that does not mean that it will be as easy to accept the demand to increase defence spending in exchange for tariff exemptions.
Already two weeks ago, the EU made clear that trade and defence policy are separated. While the EU has a common trade policy, defence spending is regarded as a national matter. As such, the EU trade commissioner cannot make any commitments to the US on military spending, as it would require consensus among 28 EU Member States to individually increase their defence budget.
Increased defence spending would have major fiscal implications for European countries, which will probably determine whether Member States are receptive to US demands to step up their efforts. Currently, only Estonia, Greece and the United Kingdom spend 2 percent or more of their GDP on defence, where Ireland and Luxembourg spend the least on defence as a percentage of their GDP. In total, the EU would need to shore up defence spending by around EUR 100 bn a year, if they want to meet the 2 percent target. Moreover, any future US tariffs on EU goods would not affect every country to the same extent, and the substantial differences in defence spending between the Member States implies that the ‘trade-off’ between the impact of possible future tariffs against having to raise defence spending is not the same for each country.
Moreover, several Member States would violate European budget rules if they were to close the defence spending gap. While most would not breach the general budget balance maximum of 3 percent of GDP, there would be negative implications for the structural balance, something many Member States are already struggling to comply with under the current circumstances. Additional defence spending would need to be compensated in full by other spending cuts or higher revenues to meet the structural budget targets, which would certainly face much political and societal resistance.
In short, on the one hand, EU Member States seem to be aware that they should increase defence spending to comply with NATO commitments and safeguard US support if necessary. Yet on the other hand, fiscal constraints appear to curb additional defence spending.
 This is a revised figure of the EUR195 bn originally published.
Several scenarios that could shape up
At the current juncture, the situation surrounding global trade remains in a huge state of flux, making it very difficult to predict how things will develop over the next weeks. However, in broad terms we could see a number of scenarios shape up, all with very different consequences for the global economy and (political) relations between countries.
A. Status quo: it stays with pin-pricks
The US sticks with specific trade actions aimed at specific counterparts (notably China) and specific sectors, with retaliation limited, or perhaps very targeted as well. Many trade partners receive exemptions from the US tariffs on steel and aluminium. The mere threat of a significant rise in overall tariffs leads to a dialogue between countries (US, EU, China, Japan) and specific actions to address the global imbalances in the long-run with structural solutions (such as structural reforms, attacking overcapacity in global steel, etc.). This scenario would seem insufficient to derail global growth, but it would still be a factor holding back a more vigorous expansion of global trade, in part because of uncertainties that hamper the business sector.
B. A further escalation of tensions
However, the recent string of events indicates that holding the ‘status quo’ is looking increasingly unlikely and thus the risk now is that tensions escalate further. There are many ways in which tensions could escalate, with entirely different consequences. One decisive factor here, we believe, is the stance of the EU and some of its key member states, notably Germany. If Europe caves in to US demands and choses its side, we can see tensions rising between the ‘old’ Western world and China. If Europe acts on its intuition – driven by a general aversion of the Trump administration – and decides to show its teeth in the form of announcing countermeasures to the US tariffs, there is an increasing risk that this will lead to an all-out trade war, with China being a laughing third.
Europe caves in to the US
In this branch of scenario B, the EU ultimately decides to side with the US (under pressure by the US). In return for receiving an exemption from the steel tariffs, it agrees to a number of the demands set by the US, giving assurances that it wants to seek more equitable global trade rather than free global trade at any cost. The EU acknowledges that China has not been running a real “free trade agenda” and that it is willing to pay a price in the form of foregoing growth in order to maintain the current geopolitical and economic balance of power in favour of the West. In Germany and several other countries we already see a backlash, with German business and policy makers becoming increasingly worried about strategic takeovers of German companies by Chinese counterparties. The thinking here is by foregoing growth in the US (say 1% a year), China will be hit even harder (say 3% annually), so that China will not be able to become bigger than the US for a long time to come. This scenario could fold into “the world against China”, with huge implications for China. But it would also have significant consequences for global trade and global growth.
Europe becomes increasingly assertive vis-à-vis the US
But we could also envisage another branch of scenario B, albeit being less likely. The ‘hard line’ followed by Washington is becoming increasingly clear with the resignation of Gary Cohn and the ousting of Rex Tillerson. This further alienates Europe from its former ally. The EU wants to remain a staunch defender of ‘free trade’ and, acting partly out of resentment against the Trump administration, it announces retaliation measures, which themselves lead to new tariffs by the Trump administration, such as those aimed at the European car industry.
This tit-for-tat strategy could ultimately turn into a very complex situation where the geopolitical world order gets turned upside down as the EU turns its back against the US and even choses the side of China in some cases. This scenario may have the gravest consequences for the global economy. In a forthcoming piece we explore the ramifications of these extreme scenarios, both (geo) politically as well as economically.
In anticipation of the new tensions in the trade war saga, in this Special we’ve assessed the economic segments that are most vulnerable in China, Europe and the US. Especially China and the US are entangled in a catch-22 situation, as both countries have relatively few options to hurt one another with trade measures without taking a hit as well. US tariffs on Chinese import would disrupt globally sliced-up value chains and hurt US high-tech corporates and retailers who have their product assembled in China to benefit from cheap Chinese labour. Higher costs due to import tariffs can be only partially offloaded to consumers, which will eat into their profit margins; as such these tariffs could shock the US stock market as well.
Reversely, China has little options to retaliate, as a large share of US goods shipped to Mainland China consists of necessity imports, such as medicine, (medical) instruments and soybeans. For example, 40% of China’s soybean imports originate from the US, and replacing these imports for Brazilian or other South American soybeans will not be possible in the short run due to insufficient supply. Moreover, retaliation of China by a mass dump of US securities would harm Chinese interests, because it would lead to upward pressure on the yuan. A more expensive yuan would deteriorate international competitiveness of Chinese exporters and a faster than expected slowdown of Chinese economic growth, also given the expected slowdown of domestic demand.
Ironically, the trade ties between both sides of the Atlantic is much more susceptible to protectionist measures, although Trump’s aim is not to provoke a trade war with Europe. The vulnerabilities are clear. Trump could launch a package of tariffs on European cars, electronic equipment, aircraft (equipment) and art worth as much as USD 110bn. This would not only help to bring down the US-EU trade deficit (of USD 120bn), but could also aid the US automotive industry, which has been losing competitive ground vis-à-vis its European peer. Unfortunately for Trump, the EU has many options to retaliate as well, with American cars and aircraft (components) being two usual suspects.
Like Trump, the EU is not interested in a trade war between both sides. However, it is not likely that Europe is going to comply with the US demands to step up defence spending in exchange for an exempt on future trade barriers. In total, the EU would need to shore up defence spending by almost EUR 195bn a year, if they want to meet the 2 percent NATO target.
At the current juncture, the situation surrounding global trade remains in a huge state of flux, making it very difficult to predict how things will develop over the next weeks. However, in broad terms we could see a number of scenarios shape up, all with very different consequences for the global economy and (political) relations between countries. We distinguish three different scenarios. One is referred to as the ‘status quo’ and characterized by the US sticking to specific trade actions and possible retaliation by others. This scenario would seem insufficient to derail global growth, but it would still be a factor holding back a more vigorous expansion of global trade, in part because of uncertainties that hamper the business sector. However, the recent string of events indicates that holding the ‘status quo’ is looking increasingly unlikely and thus the risk now is that tensions escalate further.
If trade tensions do escalate, we currently foresee two outcomes: one where Europe cooperates with the US and one where Europe alienates from the US. These latter two scenario’s would have far more negative implications for world trade and the global economy, although we deem cooperation between US-EU towards China currently as more realistic than the other way around. In a forthcoming piece we explore the ramifications of these extreme scenarios, both (geo) politically as well as economically.