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An uneasy equilibrium: the emerging U.S./China trade playbook

Escalating trade war. Rattled markets. Delayed tariffs. What’s next? Likely: a prolonged stalemate


Neither economic game theory nor informed political analysis could have predicted the twists and turns we’re seeing in the U.S.–China trade war. This unpredictability is generating uncertainty about the economic future, causing markets to overreact to every piece of news.

The recent escalation in trade tensions is a worrisome change in the countries’ negotiating stances. Increasingly, it seems they may not be able to reach a deal until the end of 2020–after the next U.S. presidential election.

Recent events have damaged trust. Right after the two countries wrapped up supposedly constructive trade talks in Shanghai, President Trump surprised with an announcement August 1 that the U.S. would start on September 1 imposing a tariff on the remaining US$300 billion of goods and products imported into the United States. China immediately allowed its currency to weaken. The U.S. Treasury responded by naming China a currency manipulator.

One positive: the U.S. subsequently backed down, somewhat. President Trump announced that he would delay some of tariffs until after Christmas. This is the first time his administration did not follow through on planned tariffs since the trade war started in early 2018.

The takeaway from these chain reactions is clear: Market volatility and increased talk of rising recession risks clearly helped drive the U.S. decision to delay tariffs. The U.S. administration apparently does not want to risk tipping the economy into recession or sparking a market sell-off in the lead up to an election year. Nor does it want to depress consumer spending—one of the U.S. economy’s lone bright spots. While long assumed, this is the clearest sign yet that the market is an important factor influencing the U.S. negotiating stance.

Uneasy equilibrium

This leads to an uneasy equilibrium.

There is a ceiling on U.S. tariff escalation, as further tariffs would have to be on consumer goods, upsetting voters and adding further uncertainty around the economic outlook. But, bottom line, there is only so much China is willing to offer following both the loss of face and the possibility that they could have a different negotiating counterparty following the election.

The U.S. continues to insist on large Chinese purchases of U.S. goods, sweeping structural reforms, and robust deal enforcement mechanisms. But China pushes back against these demands, focusing instead on a deal that is more equal and includes a more reasonable increase in imports from the U.S.. 

Beijing is signaling a reluctance to negotiate and appears prepared to wait until after the 2020 election. That means a deal may happen only if the U.S. backs down and accepts a weaker, transactional agreement. But how likely is that?

A great debate

In the U.S., a debate is raging between dealmakers and hardliners over which is best for American interests: deepening or reducing economic integration with China?

  • Dealmakers see China as a source of business opportunity and generally want to challenge China for greater reciprocity, but not to the extent that it risks recession.
  • Hardliners see China as an adversary and potential threat, and believe the U.S. should reduce its economic integration with China, also known as “decoupling”.

Trump himself appears to be a dealmaker with no ideological views on China. But hardliners in his administration seem keen to keep pushing potential sanctions, export restrictions and broad efforts to decouple the U.S. and Chinese economies. This has allowed escalation from the U.S. to take on a life of its own, where competing agendas have pursued hard line policies across a range of issues, making a deal harder to achieve.

It’s unclear which camp will win—creating a confusing environment for negotiators and analysts alike.

Stalemate

The most likely scenario leading up to U.S. election is:  no deal—but no substantial escalation. 

Existing tariffs are likely to remain, causing continued stress on certain sectors and supply chains. But, as producers, procurers and consumers adjust, the negative impacts will eventually wane.

This wouldn’t be the first time a trade war ended in a stalemate. In fact, the majority of past trade wars remain as “frozen conflicts” or last for many years, creating a new normal of higher tariffs and permanently restricted markets.

In this current trade between the China vs. the U.S., we now see a protracted stalemate as a base case.

As we’ve discussed previously, the economic and market implications of a stalemate are straightforward, but hard to estimate. Tariffs alter supply chains, weaken sentiment and reduce trade. The global manufacturing sector will continue to be under pressure, global trade growth will remain weak, uncertainty will continue to weigh on business investment and volatility will reign.

However, it is impossible to rule out surprises given how unpredictable U.S.–China relations have become. Both sides think they have the upper hand. Washington thinks it can inflict more economic pain on China. Beijing thinks it has the political upper hand as it doesn’t have an election cycle to think about. So, despite the odds, escalation remains a real risk.

 

 

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