US China trade war and Europe: ‘If two quarrel, the third rejoices’

The contours of Trump’s trade policies are now becoming apparent.  China is the enemy number one, thus requiring full attention. Other trading partners are, especially smaller ones, threatened with great fanfare until they agree to some minor concessions which confirm existing trade relationships with some new marginal advantages for the US.  The revamp of the US-Korea free trade agreement; and the recently agreed ‘reform’ and renaming of NAFTA provide example of this.  The scene is thus set up for a bilateral Sino-US confrontation, which unfortunately has also a geo-strategic aspect which makes the trade issues more virulent.

But a key question for the rest of the world is what economic fallout to expect from a Sino-US trade war.  The short answer seems to be: “When two quarrel, the third rejoices”.

This is the conclusion suggested by economic theory.

Over the last decades the trend in trade policy had been towards trade liberalization. Generalised rounds of tariff cutting agreed among all WTO members were a key driving force from the 1960s to the 1990s.  The latest attempt to continue this movement, called the ‘Doha round’, never came to fruition, mainly because of the opposition of India (not China) to open some of its key markets.  Parallel to this global liberalization a number of regional agreements also sought to lower trade barriers, which was often easier among like-minded and deeply integrated economies.

Economists have always been skeptical about these regional free trade agreements because they are by nature ‘preferential’ in the sense that trade barriers are lowered selectively for some trading partners, but not others.   The imports of the participants in the regional agreements from the rest of the world tend to diminish because producers within the preferential trade agreement do not have to pay the tariff.  A priori there was thus always some doubt that preferential trade agreements might merely lead to more intra-area trade at the expense of trade with the rest of the world.  This phenomenon is called ‘trade diversion’ and it created the presumption that that third parties would lose from the formation of a preferential trade agreement.

This presumption has been generally validated by a huge empirical literature on the costs and benefits of preferential trade agreements.  The general conclusion from this literature is that existing preferential trade agreements tended to be beneficial to the participants, but also to impose small costs to third parties because of this ‘trade diversion’.

A (bilateral) ‘trade war’ between the US and China could simply be regarded a trade agreement in which tariffs are not reduced, but increased.  This implies that third countries should benefit from such a ‘negative preferential trade agreement’.  In practice, this means that European producers will enjoy a competitive advantage over Chinese producers in the US market, because they would not be affected by US tariffs on Chinese goods.  Moreover, European and other Asian producers will have also a competitive advantage over US producers in the Chinese market since European supplies would not be affected by Chinese counter-measures.  A substantial part of today’s trade between the US and China is thus likely to be ‘diverted’ to Europe, Japan and other Asian economies close to the Chinese market.  The benefit for the EU is likely to be substantial because it remains one of the largest trading partner of both, US and China, and because European producers are often the closest competitors for the US.

Moreover, in the US-China case, the costs are likely to be higher than one would expect if one were just to look at the experience with past preferential trade agreements. Trade diversion has often been regarded as a theoretical construct, which of little empirical importance because most of the economies which did engaged in preferential trade agreements had already rather low tariffs to start with.  Eliminating low tariffs on a preferential basis should not have a big impact on the rest of the world.  But the Sino-US trade war is different: both economies are rather open, but are now imposing substantial trade barriers on each other. The US is already imposing tariffs of 10 % on over 200 billion of Chinese goods, which is four times the existing average US tariff. Moreover, these tariffs could be extended and increased to 25 % next year. 

The US imports about 400 billion USD worth of manufacturing goods from China every year and a bit more (450 billion US) from the EU. This makes the EU and China the key suppliers on the North American market, providing about one half of all US imports from outside North America.

This implies that trade diversion could be rather substantial.  One mitigating factor should be the high degree of integration of the transatlantic economy. For example, Airbus might displace Boeing in the vast fast growing Chinese aviation market.  But more than a third of the value added of an Airbus comes from the US.  This is one the reasons why Trump might chose to prolong the truce with the EU agreed earlier in July.

Chines producers which are priced out of the US market will of course be tempted to sell more in the EU. From a mercantilist perspective this is bad for Europe, but from an economic logic is constitutes another advantage because Chinese suppliers will have to lower their prices to sell more in Europe, while European producers will be able to increase their prices, at least somewhat, given that Chinese competition will less strong in the US.  The net impact for the EU (and other industrial countries) should thus be an improvement in what is technically called the ‘terms of trade’: import prices go down while export prices can go up.

The rest of the world might thus benefit substantially from a tariff war between the US and China.  But these benefits come at the expense of the two economies engaged in this trade war where consumers and enterprises relying on imported machinery will have to pay a higher price.  The losses are likely to be higher for the US than for China because Chinese imports from the US consist to a larger extent of agricultural commodities for which it is relatively easy to substitute US suppliers.  China can import soy beans from Brazil instead of the US, with little additional cost.  Moreover, Chinese counter-vailing measures have been more moderate, there is little prospect of a blanket 25 % tariff on US imports.  At any rate, China imports only about 70 billion USD worth of manufacturing goods every year, a small fraction of overall imports.  In the ‘Trumpian’ logic this means that China is weak because the scope of its counter-vailing measures must be limited. But in the economic logic this means that making US imports artificially more expensive should have only a very limited impact on the Chinese economy.

 All in all, the economic costs of a Sino-US trade war are likely to be heaviest for the US, while China might lose a bit and the rest of the world should benefit. These are of course only static considerations.

If the Sino-US trade war persists, other countries to further improve their preferential access to the Chinese market, which could lead to a de facto isolation of the US.  Trump seems to be aware of this danger.  This is why the revamped NAFTA contains an unprecedented clause, which effectively states that the US can abandon the new agreement at very short notice if Canada (or Mexico) were to conclude a free trade agreement with a ‘non-market’ economy.  There is absolutely no economic logic to such a clause:  If Canada were to open its market to China there is no possibility for Chinese producers to somehow gain better access to the US market since the new NAFTA has very high local content requirements (now raised to 75 %).

This is a clear attempt to dominate the trade policy of a smaller neighbor.  It is likely that the US will attempt to put similar pressure on the EU, but it is unlikely that this pressure will succeed.  But the US is likely to pursue this policy of trying to isolate China with other smaller trading partners (e.g. post Brexit UK?).  The political and systemic costs of the Sino-US trade war could thus be considerable in the long run.