Where Are We In The Trade Wars: A Q&A With Goldman Sachs

Trade tensions between the US and China have increased further over the last several days, with additional tariff measures announced by both sides over the past 24 hours, including China’s latest retaliation just this morning. At the same time, other areas of trade policy have taken a more constructive turn, including NAFTA, where negotiations appear to be making some progress.

Looking ahead, Goldman writes that while the outlook is uncertain, it now gives a 70% chance (up from 60% previously) that the White House will move forward with tariffs on the majority of the next round of $200bn in imports proposed in July. The bank also expects that the recently proposed 25% tariff rate (up from the earlier proposed 10% rate) will be applied to a subset of the $200bn of targeted imports.

The good news is that even as trade war with China has escalated, at the same time other areas of trade policy have taken a more constructive turn according to Goldman economists, including NAFTA, where negotiations appear to be making some progress.

Below we present the latest Q&A on the current state of global trade wars, from Goldman economist Alec Phillips.

Q: What were the US tariffs just announced?

A: Yesterday’s announcement finalizes the second installment of the tariffs on the original $50bn in imports. The US Trade Representative announced yesterday (August 7) that 25% tariffs on $16bn of imports from China would take effect August 23. This list of goods was the second installment of the original $50 billion in goods announced on June 15; the other $34bn of goods has already been subject to tariffs since July 6. The list is made up primarily of plastics, machinery, electrical equipment, and semiconductors (labeled US List 2 in Exhibit 1).

Q: How will China respond?

A: Retaliatory tariffs are likely. [ZH: China indeed announced it would retaliate in kind earlier today]

The Chinese Ministry of Commerce previously released a list of proposed retaliatory tariffs that would be implemented if the US followed through with these tariffs, and we expect that these will be imposed around August 23, when the US list is set to take effect. That list is composed mainly of chemicals, plastics, fuel, and precision equipment (labeled China List 2 in Exhibit 1).

Exhibit 1: Remaining Imports Not Subject to Tariff Diminish as Tensions Continue

Where Are We In The Trade Wars: A Q&A With Goldman Sachs

Q: What will happen with the proposed US tariffs on $200bn of imports from China?

A: We expect the majority of those tariffs to take effect. While the outlook is uncertain, at this point we expect the White House to implement tariffs on the majority of the next round of $200bn in imports proposed in July (70% chance). A 10% tariff was initially proposed on those imports, but the USTR announced last week that a 25% rate is being considered. At this point we believe the most likely outcome is that the White House will follow through with the 25% rate on a subset of the $200bn of targeted imports—non-consumer categories would be more likely to face a higher rate, in our view—but this will depend in part on whether the CNY remains around its current level. If it does, we believe it is more likely than not that the White House will impose the higher 25% rate on at least some of those imports, rather than the originally proposed 10% rate.

Regardless of the specific rate, we expect the escalation to continue for two reasons. First, while a slim majority of US voters appear skeptical of increasing tariffs, political support for the Trump Administration’s stance on China appears solid among the President’s base. For example, 73% of Republican voters and Republican-leaning independents believe increased tariffs will be good for the US (Pew, July 2018). Most Democrats disagree, and the partisan divide has widened over the last several months.

Second, there are no planned negotiations between high-ranking Chinese officials and US counterparts on trade issues. At some point this might occur—President Trump and President Xi are both likely to attend the UN General Assembly in late September—but there does not appear to be substantial common ground for an agreement, which is likely why no formal meetings have been scheduled. While we believe that US and Chinese officials will eventually reach a deal, this seems unlikely to occur within the next couple of months.

Third, the apparent progress made on other issues seems likely to provide the White House additional political flexibility to pursue an aggressive trade strategy on US-China trade issues. As we recently noted, we believe the tentative agreement between the US and EU to negotiate tariff reductions and other concessions increases the probability that President Trump will impose additional tariffs on China, as it allows the White House to argue that imposing tariffs on trading partners ultimately leads to improved trade policies. A successful NAFTA renegotiation or, more likely, an announcement of an agreement on auto sector rules, could add to that argument.

Q: Don’t the midterm elections pose an obstacle to additional tariffs?

A: This is one of the strongest arguments against additional tariffs, but in our view not sufficient to prevent further tariffs from being imposed. Increasing the price of consumer goods shortly before the midterm election poses clear political risks. However, the tariffs the White House has proposed so far generally avoid consumer products and aim at intermediate inputs and capital goods instead. While tariffs on these goods have the political advantage of being less visible in consumer prices, they are more likely to be economically damaging because they increase costs for domestic producers.

Retaliatory tariffs on US exports could also pose political risks ahead of the midterms. The US agricultural sector, for example, has already been negatively impacted by Chinese tariffs on US exports like soybeans, where China makes up the majority of export demand. However, this is an outlier and most remaining US exports not yet subject to retaliatory tariffs do not have as concentrated exposure to China. In addition, the supplemental agricultural subsidies the Trump Administration recently announced should offset some of these effects.

Q: If the US moves forward with tariffs on some of the next $200bn, how will China respond?

A: Further retaliatory tariffs are likely. The Chinese Ministry of Commerce released a list of $60bn of imports from the US that would be subject to retaliatory tariffs of 5%-25%, with the timing of implementation dependent on “actions by the US administration.” While the announcement appears to be in response to the recent announcement that the USTR is considering a 25% tariff on the next $200bn of imports, rather than a 10% tariff, these retaliatory tariffs do not appear proportional, as the weighted average tariff rate works out to only around 13%, which would generate less than $8bn in tariff revenue, compared to the US proposal to apply a 10%-25% tariff on $200bn, which would generate $20bn to $50bn in revenue.

As our colleagues in Asia point out, the Ministry of Commerce appears to have proposed lower tariffs on US imports with a high share in China and higher tariffs on US imports that make up a low share of total imports in a given category. The same general strategy has been used by the USTR to compile US tariff lists, which have generally omitted import categories in which Chinese companies are the dominant suppliers. While we would expect that the primary motivation for this strategy is to minimize the effects on Chinese consumers, it also suggests that China’s capacity to respond to additional US trade measures through retaliatory tariffs is nearly exhausted, as most of the remaining import categories not yet proposed for additional tariffs are in sectors where tariffs might have little effect on trade volumes, like aircraft, where orders are placed years in advance, or pharmaceuticals.

Q: What about the auto tariffs?

A: We expect the process to continue but believe the risk that tariffs will be imposed this year has diminished. Our expectation at this point is that the Commerce Department will release a report on the issue by September, but that the President will stop short of imposing auto tariffs in response to the report (15% chance). The recent US-EU agreement to negotiate tariff reductions lacked specifics, but appears to have set the relationship on a slightly better footing. In our view, this takes some of the momentum out of the Administration’s push for auto tariffs, as President Trump had often focused on EU auto exports in public remarks even though the tariffs under consideration would have applied to all imports.

The case for moving forward with auto tariffs would weaken further if an agreement on NAFTA auto sector rules is reached (see below). If the EU, Canada, and Mexico were exempt from auto tariffs, this would leave only Japan and Korea among the major sources of auto imports that would be subject to US tariffs, which seems an unlikely outcome in our view as neither has been a primary focus for the Administration’s trade policy. US Trade Representative Lighthizer meets with Japanese Economic Minister Motegi August 9-10 and we expect this to be a central topic of discussion, though we are skeptical that an agreement could be brokered similar to the recent US-EU announcement.

Q: Where does this leave NAFTA?

A: We think a deal on the auto sector is fairly likely, but we believe it will be difficult to reach a finalized agreement covering all aspects of NAFTA renegotiation. NAFTA negotiations appear to be headed in a positive direction, and we believe it is fairly likely (60% chance) that an agreement on auto-sector rules of origin will be reached in the near-term. The US and Mexico appear to be closing in on a potential agreement that would raise the regional content requirement to around 70-75% with lower requirements on high-wage content and use of North American steel and aluminum.

However, we are somewhat more skeptical that a full renegotiation will be completed by the late August deadline negotiators have laid out (35% chance), in light of uncertain progress to date on issues like the proposed 5-year sunset and changes to the dispute resolution system. While an agreement appears to be fairly close, we note that it appeared similarly close a few months ago, but was ultimately sidelined at least in part due to issues that remain unresolved, like the 5-year sunset. Since the US has made most of the demands in these negotiations, we believe it will be up to the US to soften its position in order to reach a deal. While this appears to have happened regarding the auto sector, it is unclear how much the US position on some of the other key issues has changed.
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