Heightened U.S.-China trade tensions, but no new trade war

As global economies begin their struggle to recover from the deep contraction imposed by COVID-19 and related government shutdowns, international trade will be both a source and a symptom of recovery.  Reignited by the pandemic, heightened tensions between the U.S. and China—the world’s two biggest economies and largest traders—pose a potential constraint. 

China’s well documented cover-up of the COVID-19 outbreak and its failure to alert global leaders of its serious nature combined with U.S. President Trump’s combative and vengeful nature and his dislike and distrust of China is a potentially potent mix.  Could heightened tensions boil over and result in new higher tariffs or other initiatives that would undercut trade at exactly the wrong time?  Possibly, but a far higher probability is that, amid the barbed threats, both China Premier Xi and U.S. President Trump understand the economic and personal risks of a renewed trade war and will back off.  Yet heated diplomatic rhetoric is likely to stir uncertainties. 

The bottom line is that both China and the U.S. face serious economic contractions that are affecting their society’s fabric and threatening the domestic political and international standing of their leaders, and they have to rely on each other by necessity.

The Chinese Communist Party leadership has lost credibility among its citizens who have been jarred by the COVID-19 experience and are weary of its oppressive actions (Hong Kong, treatment of China’s Muslim minorities) and other missteps.  The global perception of China as a reliable global leader has diminished greatly and distrust is high, according to surveys, and some emerging market economies are reeling from debt burdens imposed by China’s Belt and Road lending programs. 

President Trump’s erratic and poor guidance dealing with COVID-19 has added to the U.S. public’s questioning of his leadership and further raised international questions about the reliability of the U.S. as a global leader.  Skyrocketing U.S. unemployment unfolds as President Trump faces re-election in November.  Presidential incumbent party candidates’ election prospects tend to be closely correlated with changes in the unemployment rate and real disposable income, and both are now hugely negative. 

Both Chinese Premier Xi and U.S. President Trump will try to exploit their stances versus each other, but under current conditions neither can afford to initiate anything that would harm their economies or political standing.  

China and U.S. policy leaders face deep economic contraction.  The pandemic has imposed a serious blow to China’s economy.  It is incurring the sharpest contraction in the modern era.  Unemployment has increased dramatically more than suggested by official data, which do not count people in informal jobs, including many service sector and casual workers, nor do they include temporarily furloughed workers.  Most likely, the official data also very likely undercount the millions of migrant workers that have lost jobs in manufacturing and moved back to their permanent residences.  These job losses have significantly reduced disposable incomes.  Chinese leaders now acknowledge that a V-shaped rebound is very unlikely and their plans for the future are challenged.

The skyrocketing unemployment in the U.S. to the highest rates since the Great Depression is devastating.  While most of the initial layoffs in response to COVID-19 related shutdowns were in the leisure & hospitality and retail trades, the job losses have spread to every industry.  Normal economic activity has ground to a halt.  Even with the generous income support provided by the government, the lives of many millions of people have been upended, and for many, the prospects of getting rehired are largely uncertain.  Many businesses face a similar plight:  even with government loans and grants, many firms face bankruptcy, which will mean more layoffs even as other workers are rehired.  As state governments gear up for their step-by-step reopening, absent a miracle vaccine, a V-shaped recovery is out of the question, in our view.

Trade issues.  China remains the world’s largest trader and the center of global manufacturing.  Of its $2.5tn in exports, $418bn goes to the U.S., including a wide array of consumer goods and capital goods important to the supply chains of U.S. manufacturers.  It is noteworthy that China produces and supplies a majority of the pharmaceuticals consumed in the U.S. and critical medical supplies.  The U.S. exports much less to China ($107 billion), but a hefty 19% is agricultural goods and machinery.  Moreover, beyond the U.S.-China bilateral trade, they depend heavily on trade, content, and supply chains of other nations, particularly those in Asia.  

Following a rancorous 18 months of escalating tariffs and trade war rhetoric that elevated uncertainties and dampened global trade volumes, the U.S. and China reached a Trade Agreement in January 2020 that rolled back some tariffs and set out an explicit roadmap for coordinating on improving trade and addressed critical issues of intellectual property (The US-China Agreement: detailed and significant, January 15, 2020). But even with that positive Agreement, U.S. tariffs of up to 25% remain on $370bn in goods imported from China.  The spread of the COVID-19 pandemic postponed implementation of the Agreement and has initiated a dramatic escalation of tensions that call into question the future implementation of the Agreement and may lead to a reversal of key components.  

Both sides have stepped up diplomatic attacks on each other. The rancor has a lot of the flavor of the ideological confrontations of the U.S.-USSR Cold War, but the big difference is that China is an economic powerhouse with sights on expanding its global economic power, and the U.S. buys a lot of what China produces and also relies on it as a market for its goods.  

President Trump has blamed China for the spread of COVID-19 and makes off-handed remarks aimed at retaliation.  China has responded with a campaign of placing the blame on the U.S. and making personal attacks on Secretary of State Pompeo in response to statements he made about China.  We believe and hope these are non-actionable attention-getting barbs.  Beyond its statements, China has stepped up its delivery of medical supplies to the U.S. and other advanced and emerging market nations.  It is making efforts to maintain working relations with Russia, in part to ensure its smooth supply of natural gas, and with its Middle East alliance nations.  Yet these nations are suffering economically.  Its relations with India are extremely frayed.

The U.S. is working with “trusted partners” (Japan, Australia, India, New Zealand, South Korea, and Vietnam) to coordinate on common economic issues.   (Of note, Japan’s massive fiscal stimulus package equal to 20% of GDP includes an initiative that pays two-thirds of the expenses incurred by Japanese companies to move home companies and workers from China.) 

Amid the U.S.-China tensions, Europe is in a pickle, hoping for a global recovery without unnecessary tensions, increasingly weary of China on many dimensions, but perhaps more so frustrated by the unreliability of the U.S. under Trump. 

The Trump Administration has spearheaded an initiative to reduce the reliance on China in the supply chains of U.S. companies, and is said to be considering tax incentives and reshoring incentives for companies to facilitate the process.  China understands that for some products, like pharmaceuticals and critical medical supplies, the U.S. will reduce its reliance on China’s production overtime, despite the fact that Chinese medical scientists have been working closely with U.S. and global counterparts to develop a cure for COVID-19. 

But China knows that its companies remain the world’s most efficient and low cost producers of many products, including smart phones and other critical electronics, and it would take many years and expense to move production elsewhere. 

Trump will lash out at China to consolidate support among his political base, but his actual actions will be severely constrained by politics leading up to the November elections.  He cannot sacrifice the agricultural industry with any initiatives that would elicit Chinese boycotts on purchases of U.S. goods.  Such actions that were tolerated in 2018-2019 would not be tolerated now.  The same is true for basic U.S. manufacturing.  Nor can he risk harming U.S. consumer retailers that rely on Chinese goods as they struggle to recover from shutdown.  He must do everything possible to enable job creation, and this means facilitating, not erecting, barriers to trade, even if some companies move toward making changes to their global supply chains. 

Chinese leaders are equally constrained and must heed the warning signals that suggest cracks in its domestic and international support.  Premier Xi understands China’s fragile economy and will focus on stimulating its recovery and trying to mend global diplomatic fences. 

For these reasons, we expect diplomatic tensions to remain high but believe a renewed trade war will be avoided.

Mickey Levy, mickey.levy@berenberg-us.com