06.04.2018 (Capital Economics) –

• If the USTR follows through on Trump’s request to add an additional $100bn worth of Chinese imports to the proposed US tariff list, the Chinese will be reluctant to capitulate and seem likely to respond by expanding their own tariff list. In this case, our estimate for the potential damage to China’s economy would rise from 0.1% of GDP to closer to 0.5%. These higher stakes increase the urgency of reaching an agreement with the US but also risk a more damaging outcome if talks break down.

• On Tuesday, the US Trade Representative (USTR) published a list of proposed tariffs on $50bn worth of imports from China. The following day, China responded with its own list covering $50bn in imports from the US. (See our China Update, “China raises the stakes of US trade action”, 4th April.) Trump has now raised the stakes further by requesting that the USTR add another $100bn of imports to the US tariff list.

• How will the Chinese respond? We suspect that they will first wait to see what comes of Trump’s request. This would mirror their response to Trump’s earlier $50bn tariff threat, where they waited for specific measures to be announced before retaliating. Refraining from a pre-emptive strike helps to support the narrative that China is the victim. It will probably take at least a couple of weeks for the USTR to publish an expanded tariff list. Chart 1 shows the top ten largest imports from China that were not part of the initial tariff list. Of these, ICT products seem most likely to be included in any expanded list, though USTR may continue to omit the two largest product categories – phones and laptops – as tariffs on these products would hurt US consumers.

• Assuming the USTR does eventually publish an expanded tariff list, it’s not clear what course of action China would take. There is a case for a more muted response this time in order to avoid further escalating tensions. But doing so without reaching some kind of deal with the US would be seen as a capitulation by China. Xi may therefore feel he has no choice but to once again respond in kind.

• This would mean expanding the proposed Chinese tariff list to cover nearly all imports from the US, which Chinese data put at $155bn last year. Chart 2 highlights the key imports that didn’t make it into the initial tariff list. China could also curtail its services exports to the US ($54bn in 2016) or increase the regulatory burden for US firms operating in China, both tools it used to punish South Korea for deploying THAAD.

• We estimated that the initial US tariff proposal would have a negligible impact on China’s broader economy. (See our China Update, “Likely damage to China from tariffs only 0.1% of GDP”, 22nd March.) But assuming that the final US tariff list is expanded to cover $150bn in imports and that China responds in kind, the hit to GDP could be closer to half a percentage point – no longer a mere rounding error.

• Of course, none of the tariffs have been implemented yet and the optimistic case is that the higher stakes will encourage the US and China to push harder for an agreement so that the tariffs can be avoided or at least watered down. This will involve a compromise on both sides. China will need to offer meaningful concessions on market access and intellectual property protections. And the US will have to accept that China isn’t going to abandon its industrial policy overnight, nor will the trade deficit disappear. But while a deal still looks possible, the ratcheting up of trade tensions clearly carries risks. The tariff threats, even if only intended as bargaining tools, will be difficult to back down from if talks fail to deliver results