Forecasts of the impact of a US-China trade war fool markets

Economic models ignore that some industries and regions will be hit more than others

Megan Greene

With Donald Trump poised to deliver on his presidential campaign promises to protect American industries with tariffs, the question is: what does this mean for the world economy?

If you plug the actual and anticipated actions of the US into most models, there is an almost imperceptible annual shift in gross domestic product growth in the US, Chinese and global economies. Despite the sound and fury, the steel and aluminium tariffs, $50bn of tariffs on Chinese goods imported by the US and $50bn tariffs on US goods imported by China add up, based on the models, to the economic equivalent of a mosquito bite.

The impact of a trade war is greatest on the countries directly involved in the tariffs and tends to be felt early on. In this case, the models point to an average of one- to two-tenths of a percentage point drag on growth per year for the US and China over a five-year period.

The brunt of the pain is felt in the first two years, and after five years it is virtually undetectable. This remains true even if the additional $100bn of tariffs on Chinese imports that Mr Trump once threatened are included. The results are similar for most forecasts of the impact of a collapse of the North American Free Trade Agreement on US, Canadian and Mexican GDP (though Mexico would be worse off than the other two).

In the event of a trade war, the models suggest a benign — boring, even — global growth picture. The US would still grow well above its potential GDP growth over the next two years because of fiscal stimulus measures from tax cuts and deficit spending.

China’s GDP growth would still decelerate gradually over the next five years. The EU would see its GDP growth converge with its lower potential GDP over the medium-term. Emerging markets would suffer marginally in the short term because of a stronger dollar.

All this is annoying but not a game changer. These predictions, and Mr Trump’s reputation for backtracking on his bluster, help explain Wall Street’s reaction. The S&P 500 is up almost 4 per cent since the administration began talking up trade wars in March.

However, the models largely ignore that the effects of a trade war would hit some industries and regions harder than others. This will become even more of an issue if President Trump follows through on threats to impose 25 per cent tariffs on imported automobiles. The Canadian, Mexican and German auto industries would suffer significantly, even if the overall impact is muted.

These benign predictions are probably flawed in other ways. First, most models are not granular enough to reflect the disruption in global supply chains that would result from tariffs.

These are likely to provide the biggest drag on growth from the tension over trade. Some car parts cross the Mexican, Canadian and US borders several times before they end up in a finished vehicle. If Nafta collapses, would carmakers raise prices, absorb additional tariffs or find ways to procure all of their parts in one country?

Second, it is difficult to model the impact of trade-related uncertainty on business sentiment.

The stalled Nafta negotiations are starting to affect Canada through lost or deferred business investment.

The trade wars could quickly extend into areas that are even harder to quantify. When the US first threatened an additional $100bn in tariffs on Chinese imports, it became clear that China could not respond in kind; it simply does not import enough US goods. But it could hit back by creating more bureaucratic hurdles for US companies operating in China, and interfering with licensing. The impact of such steps would be hard to measure in economic forecasts.

Finally, the Trump administration’s approach has led to the country’s isolation on the global stage, as highlighted by its refusal to sign the G7 communiqué over the weekend. The economic implications of that are impossible to specify.

A cardinal rule in economics says that, while tariffs create winners and losers in any economy, the latter outweigh the former. The gap is known as “deadweight losses”.

Even though econometric models suggest a trade war will not significantly cut global growth, there is a real danger that investors are underestimating the impact of those deadweight losses, and a world with vastly different rules.

The writer is global chief economist at Manulife Asset Management

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