On October 11 the US Senate passed a bill intended to punish countries (read China) for maintaining “undervalued” domestic currencies. Beijing responded immediately, warning that the bill could spark a trade war. With the US in election season, the prospect of the currency bill becoming a law, and the ensuing threat of a Sino-US trade has raised concerns across world financial markets as a trade war could be seriously detrimental to the global economy.
While discounting the possibility a large-scale breakout of trade hostilities, we investigate the consequences of such a scenario should it materialise. We find that a US punitive 25% tariff on Chinese imports would reduce Chinese exports by an average of 13% and hit at least 670,000 US jobs. A trade war will not only hurt the world’s two largest economies, but also threaten the global economy’s fragile recovery.
On October 11, the US Senate passed a controversial bill titled “Currency Exchange Rate Oversight Reform Act of 2011”, aimed at forcing countries such as China to accelerate appreciation of their domestic currencies. The proposed Act
“instructs the Secretary [of the Treasury] to: (1) analyze semi-annually the prevailing real effective exchange rates of foreign currencies; (2) determine whether any such currency is in fundamental misalignment; and (3) designate it for priority action if the issuing country engages in specified behaviour, including excessive and prolonged official or quasi-official accumulation of foreign assets for balance of payments purposes.”
“requires the administering authority, upon the filing of a petition by an interested party, to initiate a countervailing duty investigation or review to determine whether currency undervaluation by the government of, or any public entity within, a foreign country is providing, directly or indirectly, a countervailable subsidy to its exporters or products.”
“requires the same kind of countervailing duty investigation upon the designation of a foreign currency as a fundamentally misaligned currency for priority action.”
In short, the proposed bill enables the US government to impose tariffs against a “currency manipulator”. The bill still needs to be passed by the House of Representatives and signed by the US President into law.
The Chinese government opposed the bill during its passage through the Senate, stating that it may seriously affect China’s currency reform process, and, if passed into law, could result in a trade war between the two economies, and on October 12, following the Senate vote, the Chinese Ministry of Commerce expressed its adamant opposition. China has labelled the bill “protectionist” and “violating World Trade Organisation (WTO) rules”, and warned that it could disrupt Sino-US joint efforts to restore global economic growth and urged the US government to “resolutely oppose” using legislation to pressure China on currency issues.
|China – Exports to the US
|| China – Exports vs US PMI
Implications for Intra-Asia Trade and China’s Trade with Australia
A Sino-US trade war has the potential to spill over into the rest of the global economy, further straining its already fragile recovery.
Economic interdependence between China and the US is high. From the Chinese end, 18% of its exports landed in the US in 2010 (after adjusting for Hong Kong’s re-exports of Chinese goods). Our estimates suggest that around 53 million Chinese jobs are directly involved in Sino-US trade. As shown below, China’s exports are closely correlated with the US PMI, which leads Chinese export growth by one quarter. US trade sanctions are likely to result in a sizable shock to China’s exports.
While China runs a trade surplus with the US and the EU, it also runs substantial trade deficits with Japan and the NIEs (Korea, Taiwan, and Singapore), and, to some extent, the major ASEAN economies. In regard to the latter, the trade deficit is largely due a unique feature of intra-Asia regional trade: China imports intermediate products, which are assembled using the country’s relatively inexpensive and abundant manpower and are then exported as final goods to the US and elsewhere. A trade-war related shock to China’s exports would affect China’s imports of raw materials from Australia and the resource-rich countries of Latin America.
|Jobs Supported by US-China
China – Trade Balance with Various Economies and Regions (USD, bn)
China’s Economic Growth Less Reliant on Exports
Since the global financial crisis (GFC), China has progressed significantly towards being a genuine continental economy depending more on internal demand and less on exports. Net exports’ contribution to growth has turned from being significantly positive before the GFC in 2008 to being negative in 2009. China’s growth over the last two and a half years (2009, 2010, and first half of 2011) has been driven by domestic demand, led by investment and consumption. The share of net exports to GDP fell from a peak value of almost 8% to 3% in 2010.
The importance of gross exports, measured as a ratio to GDP, has also fallen significantly from close to 35% before the GFC to around 25%, on average, over the last two years. Meanwhile, the ratio of gross imports to GDP has risen steadily from 20% in 2009 to around 24% in 2010. This suggests that China’s influence on the global economy is rising. Indeed, our calculation shows that since the GFC China’s growth alone makes up close to one-third of global growth, and, with the recent sharp downward revision of the G3 growth, is likely to exceed that benchmark this year.
|China – Contribution to GDP Growth Trade
China – Trade Balance with Various Economies and Regions (USD, bn)
China is a Major Market for the G3
There is no doubt that China’s export reliance on the G3 markets, as a whole, has intensified, with the G3 economies all ranking China their largest importing economy and one of their largest trading partners. China is now the number one export market for Japan, the second largest for the EU, and the fourth largest for the US after Canada and Mexico, the two US free-trade partners. Financially, China is also the largest foreign holder of US treasury bonds.
A key change in the economic relationship between China and the G3 is that China’s growth is no longer overly reliant on the G3 as an export market. The relationship has moved to one of interdependence with the G3 relying increasingly on China as an important consumer market and key investor.
Figure 1: China’s Shifting Weight of Reliance to the G3 as an Export Market
Implications of a Trade War for the US
For the US, a trade war with China would be damaging for its already stuttering economic recovery. With an unemployment rate at above 9%, the number of US manufacturing jobs affected due to a US-Sino trade war is estimated to be in the order of 670,000. Moreover, as China invests a majority of its foreign exchange reserves in US assets, the US is dependent on China for the low-cost financing of its current account deficits. According to US Treasury International Capital Flows data, China held $1.6trn of US financial assets at the end of June 2010, which represents around 15% of total foreign portfolio holdings, second only to European countries. If China were to sell US assets, the US capital market would likely see substantial volatility. Because of the US’ need for large external financing, any moves that might lead to a significant Chinese move out of US dollar based assets would send shock waves through the US Treasury and related markets.
Which Sectors Would be Most Affected?
Figures 1 and 2 list the top ten export goods between China and the US. Machinery and electrical equipment, which top both lists, would be affected the most. On the Chinese side, textile, footwear and plastic products, which are highly dependent on the US market, would likely be affected substantially as well. For the US, its victim list would also include agricultural and chemical goods, which are very competitive in international markets.
How Damaging would a 25% Tariff on Chinese Exports Be?
If the US were to impose a 25% punitive tariff on Chinese exports, as suggested by some observers, what would the damage be? We use an empirical model to evaluate the impact of a 25% tariff on Chinese exports, with the real effective exchange rate (REER) and G3 GDP growth as explanatory variables. A dummy variable is added for the crisis downturn in 2008. As China’s exports to the G3 economies are closely related to the processing trade, we have separated China’s processing exports and ordinary exports for this analysis. The model shows that processing exports are relatively more affected by G3 GDP growth but less by the REER effect, in line with our expectations. Meanwhile, China’s ordinary exports are strongly impacted by the exchange rate effect while impact of growth is relatively weak.
|Figure 2: Top Ten Chinese Exports to the US
Figure 3: Top Ten US Exports to China
We find that a 25% punitive tariff will bring about a double-digit decline in China’s overall exports. Assuming a GDP growth rate of 2.5% and pass-through effects are partial (60% in Scenario 1, and 50% in Scenario 2), a 25% import tariff would likely reduce China’s total exports by 11% to 14%, with an average value reduction of 13%. The impact on China’s ordinary exports will be highest, falling by 15% on average.
In contrast, the impact on China’s processing exports is relatively smaller, but still sizeable, at 10%.
Our empirical findings suggest that the fall-out from a Sino-US trade war would be large as it would not only affect economic growth and job creation in the two countries, but could have a negative impact on Australia and other resource-rich (exporting) economies. More critically, a Sino-US trade war would also create great uncertainty and increased volatility in international capital markets and almost certainly disrupt the very fragile global recovery.
While many market participants discount the possibility of an eventual breakout of a large-scale trade war between China and the US, concrete and constructive actions from both governments are required to stabilise volatile markets and their second-guessing of policy deliberations. The US will need to exercise discretion and diplomatic sensitivity in creating an environment for China to move progressively on the road to RMB exchange rate liberalisation. China, meanwhile, will also need to engage the world community in addressing the global imbalances of savings and investment, including a more flexible exchange rate system.
|Total Foreign Holdings of US Securities (as of June 2010)
Figure 4: Impact of a 25% Import Tariff on China’s Exports