Major escalation of US-China trade war by both sides

Trade correspondent L.C. writes:

President Trump’s threatened tariff escalation against China – announced a week ago – has now come to pass. The Section 301 tariff rate of 10% on $200 billion of US imports from China has been increased to 25%. The tariff increase went into effect for goods leaving China after 12:01 a.m. on May 10^th.

Beijing retaliated by announcing higher tariffs Monday on $60 billion worth of American goods. On June 1^st, tariffs of 5% to 25% will take effect on about 5,200 American products, including batteries, spinach and coffee. The negative trade news triggered a 617-point drop in the Dow-Jones Industrial Average today.

President Trump also ordered the US to prepare for the possibility of raising tariffs on the $300 bn. of remaining imports from China (“List 4”). These goods were left off the first three tariff hit-lists because they comprise many consumer goods rather than intermediate goods or equipment. A price hike on these goods will be felt directly and quickly by consumers, potentially sparking a political backlash. Additionally, they comprise many goods for which there are no available substitutes or alternate suppliers, meaning they have to be bought from China.

The two sides will continue talking – Vice Premier Liú Hè came to Washington for meetings on May 9-10 as planned. But the talks with Liú didn’t make progress. He didn’t come with new concessions to offer and was told by US officials that if a deal isn’t made within three to four weeks, the 25% tariffs will be extended to the remaining more than $300 bn. of Chinese exports not yet affected.

Liú, speaking with Chinese reporters after his Washington meetings, revealed the demands China is now laying on the table. Washington must end all its extra tariffs, set levels for Chinese purchases of US goods that reflect real demand, and accept a text that is “balanced” to assure the “dignity” of both parties.

Chinese backsliding

The White House found that after last week’s talks in Beijing, the Chinese reneged on commitments they had made to codify their promised changes by changing the relevant laws. Reportedly, a May 5th diplomatic cable sent by China to the US deleted key commitments made in all seven chapters of the previously negotiated 150-page draft deal. These were reversals that, Reuters reported, “undermined core US demands,” in particular by revealing unwillingness to change Chinese laws despite what negotiators had previously offered. Backsliding also occurred on intellectual property (IP) and trade secrets, forced technology transfer, competition policy, financial services access, and currency manipulation.

Now the Chinese say that they will only implement the changes through administrative or regulatory actions. Liú said this would be done through State Council directives. This would make it easier for the Chinese government to backtrack and harder for the US to demand enforcement than if laws were changed, as the Chinese had originally agreed to do.

“Over the course of last week we have seen an erosion of commitments by China,” Lighthizer said on May 6th.

There was much pundit speculation that both President Trump and
Premier Xí Jìnpíng might be overestimating the ability of their respective economies to withstand the escalating trade war. One report claimed that Xí decided he could push the President harder because he saw Trump’s demand that the Fed lower interest rates to be a sign that the US economy is weaker than has been claimed. Other reports say that the Chinese negotiators had been pushing the leadership to make more concessions to close the deal, but Xi stepped in at that point and said too many concessions had already been offered.

Hard-liners also are ascendant in the US, not just within the Administration but also on Capitol Hill. Key members of both parties are encouraging the President to hang tough with China and are making it clear that he will be attacked for being soft on China should the US be the one to back down in the current confrontation.

But while most US politicians are calling for a tough stand against China, there are some in each party who say that tariffs are the wrong weapon, instead calling for joint action with allies to push against China’s abuses at the WTO and on other fronts besides trade, e.g., the South China Sea, the Belt & Road Initiative abuses, and human rights. These voices, which include the New Democrat Coalition, note that maintaining the Section 232 metals tariffs on allies makes such cooperation more difficult and therefore should be rescinded.

The President is promising billions in financial aid to US farmers to compensate them for the damage his trade war with China is causing to US agricultural exports. He claims that the aid will be paid for by the tariffs that, he still claims, China pays, and that part of the money will be used by the government to buy US commodities and ship them as foreign aid to poor countries.

There are many things wrong with this proposal. Dumping US farm commodities in poor foreign countries would hurt those countries’ farmers and distort international agricultural trade. It would also be WTO-illegal because revenue from duties are supposed to go into general government coffers, not to pay for specific programs benefiting a special interest.

But the proposal is an admission that at least one part of the US economy will suffer further as tariffs – and China’s counter-tariffs – mount. This came as reports surfaced that economists at the Agriculture Department have been quitting after the department punished them for publishing reports showing how farmers have suffered from the Administration’s tariff and tax policy.

Apart from tariffs, China could wield its rising nationalism and encourage its citizens to boycott US products and services (e.g., Starbuck, Cadillac, Nike); this might happen spontaneously anyway. Beijing could also cause delays at the border by subjecting imports to increased inspections, hit US companies with tax audits or anti-monopoly investigations or intensified regulatory scrutiny, delay or deny licenses to US companies, and engage in other activities to make life even harder for US companies operating in and exporting to China without making any official changes. (This is apart from allowing the yuan to depreciate – something the government may not be able to prevent anyway – which would partially counter the impact of the US tariffs here and hinder US exports to China.) It is the potential for actions like these that has prompted US companies to tell the US government that while they are frustrated with China’s abuses, they don’t want to be connected in any way to complaints about them for fear of retaliation.

A bit of history

The idea that China’s rise was a negative outcome of allowing it into the WTO is an often repeated but not really accurate reading of the country’s economic history. Here’s a recap.

The first China economic spurt came after Deng Xiaoping consolidated power in ’79. Then starting in 1980 the US Congress every year granted China annual normal trade relations status – that is, temporary Most Favored Nation (MFN) status. This was achieved through waivers of the Jackson-Vanik amendment. So when Congress gave China Permanent Normal Trade Relations status after joining the WTO, the tariffs on its exports to the US didn’t change. What changed was that having permanent MFN gave investors confidence, so it did help attract foreign investment, much of which was aimed at selling to the US market. Crucially, though, the most important change after China joined the WTO is that it liberalized its internal economic policies, as required to meet its WTO accession commitments and in any case favored by the leadership. This set off another growth spurt that wasn’t from the cutting of US tariffs but from domestic changes. It was an auspicious time anyway as China was recovering fully from the ’97 Asian financial crisis that had slowed Asian economies and China’s post-Mao economic rise.

Trying to halt China’s development by keeping it out of the WTO would have been harmful for the US and world economies and likely have driven Beijing in a hard nationalist/statist direction that didn’t materialize until more recently. And that, by some accounts, was prompted, even before the ascension of Xi Jinping, by the 2008 US-sparked global financial crisis. The crisis caused Chinese leaders to question their prior respect for and acquiescence to the US economic system and the idea that it should be a model for other countries. It strengthened more nationalist Chinese voices who wanted to keep government control over the economy.

The US business community operating in China made sure that the Obama Administration was aware of the economic backsliding that intensified under Xi, provoking Obama to harden the US line on China trade and use the Trans-Pacific Partnership (TPP) — from which China would be excluded — and the WTO to try to curb its abuses.

Thus far, the most success the US has seen in forcing change in China has been through the WTO. But the WTO is criticized for taking too long and not being able to compel countries to follow its rules. Critics of the TPP negotiated by the Obama administration also charged that the TPP would have made it too easy for China to transship its products to the US.

Yet despite disagreements on strategy, all important political forces in the US agree that China is a noxious influence in the world and that the struggle against it is worth some sacrifice. That reality will make it politically difficult for the White House to resolve the current confrontation through US concessions.

WTO victories and monetary risks

Somewhat lost amid the tariff war news are several significant recent US trade victories over China. They took place at the WTO and had strong support from the EU and Japan, which have also been prodding Washington to work jointly on reform of the WTO and to strengthen it against Chinese abuses starting with its industrial subsidies. Japanese Prime Minister Shinzo Abe is also putting WTO reform on the agenda of the late-June G20 Summit he will host.

In the foreign exchange market this week, the dollar sank vs. the yen and euro. While equity prices around the world have been responding to every positive and negative signal from the US-China trade negotiations, currencies have been sensitive to the drama as well. The yen was generally supported by the new tariff turmoil as it continues to benefit from risk aversion and flight-to-safety strategies.

If there is no resolution to the US-China trade crisis soon, it could have implications for the Fed, in two directions. The Fed could come under mounting pressure for a rate cut to counter the economic headwinds unleashed by the tariffs – especially as inflation, as was shown by data again this week, remains below target. But it is also possible that if the full array of threatened tariffs hits, this could spark inflation and put pressure on the Fed for a rate hike. So markets are now facing financial as well as trade uncertainty.