Deutsche Bank and UBS Explored European Banking Alliance

Deal talks in June never coalesced but show how far European lenders are willing to go to address a punishing banking environment

By Jenny Strasburg


UBS CEO Sergio Ermotti and Chairman Axel Weber at the company's shareholder meeting in May. Photo: arnd wiegmann/Reuters


Deutsche Bank AG DB -2.79%▲ and UBS UBS -1.41%▲ Group AG this year explored ways to combine their businesses, including talks as recently as mid-June to form an unusual alliance of investment-banking operations, according to people familiar with the discussions.

The talks between Germany and Switzerland’s biggest lenders show how far European lenders are willing to go to address a punishing banking environment. Hammered by negative interest rates and slowing economic growth, European banks are struggling to compete globally and fend off encroachments from bigger U.S. rivals on their home turf.



A deal never coalesced, as the two sides failed to sort out thorny issues, including how to structure and allocate capital to any joint operations, the people said. Deutsche Bank and UBS for years have contemplated exploring a merger, the people said. One person who has been involved in multiple deliberations said the talks have been on and off but never fully off the table.

Inside Deutsche Bank, a tie-up was seen as a way to save Germany’s biggest bank from the painful cuts now in motion, the people said. The banks discussed a full-blown merger earlier in the year, a move that would have created a European banking behemoth more able to compete with Wall Street’s most dominant players, such as JPMorgan Chase& Co. and Goldman Sachs Group Inc. Bloomberg reported in May that the two banks briefly explored a merger. The June talks haven’t been previously reported.

UBS has suffered from volatile performance in its investment bank, and shares currently trade near their lowest point since it restructured its business in 2012. Deutsche Bank’s shares trade just above their all-time low hit this month.

The mid-June discussions, held near Milan, included the finance chiefs of both banks, senior investment-banking executives and advisers, some of the people said. The executives discussed ways to swap some operations and intertwine parts of their investment banks but keep the parent companies separate, according to the people familiar with the talks.

The people said a concept behind an alliance was to play to the strengths of both lenders, as Deutsche Bank, which remains a big player in its fixed-income trading and structuring business, would get referrals from UBS, which pulled back from some of those business lines several years ago. Deutsche Bank would feed business into UBS’s more successful equities franchise, the people said. UBS was interested in some of Deutsche Bank’s deal-advisory teams in the U.S., a person briefed on the discussions said.

Such a venture was seen by some involved as a possible test case, some of the people familiar with the talks said. It might have allowed the German and Swiss banks—and regulators, governments and investors—to gauge whether a merger might make sense, without committing to a new headquarters, regulatory regime or full restructuring, the people said.

Deutsche Bank’s then-investment-banking chief Garth Ritchie was at the meeting in Italy, along with Alexander von zur Muehlen, who is Chief Executive Christian Sewing’s top internal adviser on strategy. So was UBS’s Robert Karofsky, co-president of the investment bank, people familiar with the meeting said.


Deutsche Bank CEO Christian Sewing, right, speaks with Chairman Paul Achleitner at the bank’s annual meeting in May. Photo: Alex Kraus/Bloomberg News


UBS Finance Chief Kirt Gardner attended, and Deutsche Bank’s CFO,James von Moltke, dialed in, people familiar with the talks said. Tadhg Flood, a partner with deal advisory firm Centerview Partners, was advising the German bank, the people said. He previously served inside Deutsche Bank and remains a confidant of Mr. Sewing. On the UBS side was Jonathan Wills, the people said, another Deutsche Bank alum who worked this year for consulting firm Oliver Wyman. In June, Mr. Wills joined UBS as head of investment-bank strategy.

Earlier in the year, when Deutsche Bank was in talks to merge with crosstown rival Commerzbank AG, Deutsche Bank had parallel discussions with UBS to combine their asset management arms, The Wall Street Journal and others reported in April.

UBS Chairman Axel Weber earlier this year discussed with German officials the potential merits of a UBS-Deutsche Bank deal, and UBS Chief Executive Sergio Ermottiwas also open to exploring the idea, some of the people said.



The full merger talks went on for weeks, but by May they bogged down over regulation of the investment bank and the location of a combined bank’s headquarters—Zurich, Frankfurt, a third location where neither bank is located, or some combination of the three, according to people familiar with the talks.

By June, Deutsche Bank was running out of time. While talking with UBS, the German bank was planning cuts and discussing with other banks selling off stock-trading technology and pieces of its prime-brokerage franchise, which serves hedge funds. French bank BNP Paribas eventually struck a deal for some of those businesses.

The alliance discussions with UBS were short-lived; UBS walked away after the Milan meeting, some people familiar with the negotiations said. Deep cooperation short of a merger is rare in the banking world. People involved in the talks said the two sides decided they couldn’t quickly sort out how to structure the operation or share capital between the entities. One of the people said the idea was a long shot.

On June 21, Mr. Sewing emailed business heads demanding additional details for executives preparing the “equity story” for a major restructuring, people familiar with the internal communications said.

Some inside the bank said the crunch of hurried decision-making left executives little time to finalize senior management and cost-cutting decisions. They say the impact is still felt, with confusion about what services the bank will keep and how much capital those businesses need.

On the first Sunday in July, Messrs. Sewing and von Moltke laid out a reorganization that included the departure of three management-board members, including Mr. Ritchie, and 18,000 job cuts. There will also be a major pullback from the bank’s Wall Street presence, with an exit from most of its equities business and more investment in its strongest fixed-income and advisory businesses.

Central banks have lost much of their clout

Monetary policy is no longer enough to keep the economy on track

Adair Turner


© Jonathan McHugh


As leading central bankers meet this week in Jackson Hole, Wyoming, financial markets and media anxiously await indications of future policy direction. This year’s topic is Challenges for Monetary Policy and, amid slowing global growth, the talk is of interest rate cuts and clearer forward guidance.

In September, the European Central Bank may commit to keeping rates below zero beyond 2020. Some economists think the Bank of England’s Monetary Policy Committee should make explicit interest rate forecasts, mirroring the US Federal Reserve practice.

Many hope that the Fed’s recent 0.25 per cent rate cut will be the first of many. Governor Haruhiko Kuroda of the Bank of Japan faces calls for action to counter stubbornly low inflation. More quantitative easing is possible.

Given the uncertainty, this year in particular the precise words spoken at Jackson Hole will be scrutinised with great care. But, in reality, what central banks can do alone is no longer very important.

It has been clear since the 2008 global financial crisis that when short and long-term interest rates are already very low, further cuts make little difference to real economic activity. If the BoE now cuts its rate from 0.75 per cent to 0.5 per cent the impact on consumption will be trivial.

Because big German companies can already borrow 10-year money at less than 0.5 per cent, using quantitative easing to reduce that to, say, 0.4 per cent will make almost no difference to their investment plans. Pushing policy rates too far into negative territory could instead reduce growth by limiting bank profitability and lending.

Central banks’ attempts to manage expectations are also ineffective. When German bond yields show that investors expect negative ECB rates for a decade, promising they will not rise until 2021 cannot have more than trivial impact.

Despite all this, a mountain of economic commentary is still devoted to predicting minor shifts in central bank policy, and central bankers still obsess over the effectiveness of their communications. Two factors explain this disconnect between economic importance and the focus of economic debate.

The first is that while minor rate changes matter little to consumers and businesses, correctly anticipating them matters a lot to many asset managers, macro hedge funds, investment banks and their investor clients. Central bank-watching is, therefore, a preoccupation for many professional economists. Central bank announcements, with their ability to move markets and the drama of expectations confirmed or disappointed, also create a media buzz.

For financial investors “mixed messages” from central bank governors can turn potential speculative gains into embarrassing losses. When a member of the UK House of Commons Treasury select committee accused BoE governor Mark Carney of being like an “unreliable boyfriend”, it made for good headlines. But, in an era of structurally low interest rates, uncertainty about the timing of small future changes is just not that important.

Monetary easing can have a significant stimulative effect if interest rate changes drive currency depreciation. But that is a zero-sum game. US president Donald Trump wants a weak dollar, while China is allowing the renminbi to depreciate to offset the impact of his tariffs. No exchange rate policy can stimulate both economies.

The second factor is the fear of what follows if monetary policy has become powerless; for either we can then do nothing to offset potential recessions or fiscal policy must take the strain.

But higher fiscal deficits mean rising public debt, unless they are financed with central bank money, and the latter seems to threaten central bank independence. So, for fear of finding something worse, central bankers cling to the hope that some sophisticated wrinkle of monetary policy will at last be effective.

However, large fiscal deficits and forms of monetary finance are already major drivers of global growth. In the spring of 2016, there were fears that central banks were “out of ammunition”. But, triggered by the Trump administration’s 2017 tax cuts, the US fiscal deficit has risen to today’s 4.5 per cent of gross domestic product.

China’s fiscal deficit has grown from 2.8 per cent of GDP in 2015 to 6 per cent in 2019, with some of this financed by People’s Bank of China lending to state-owned banks to buy public bonds. Japan has run large deficits for a decade, fully matched by Bank of Japan purchases of government bonds, which will never be sold back to the private sector. And while Germany has stuck to the path of fiscal rectitude, its growth has relied on exports to these profligate rule breakers.

It is the eurozone that now faces the greatest danger. The Fed’s funds rate is now at 2-2.25 per cent, so the US can still cut by enough to make some difference — and if the economy continues to slow, the Trump administration will unleash increased spending or further tax cuts.

Meanwhile, China and Japan will continue to run large fiscal deficits indirectly financed by their central banks. For the UK, as a smaller economy, exchange rate depreciation is a more powerful option than elsewhere.

But if global demand and eurozone exports remain subdued — and hardliners continue to block a European version of fiscal relaxation lubricated by central bank government bond purchases — there is no feasible action the ECB can take that will make more than a trivial difference to eurozone growth.

The truth is that, acting alone, central bankers are no longer that important.


The writer is a former head of the UK Financial Services Authority


What a Recession Would Mean for Brazil

The country’s recent economic figures aren’t inspiring much hope that it will return to high growth rates.

By Allison Fedirka

 
It’s easy to see why the estimates are so pessimistic; the country’s economic activity index – seen as an indicator of growth – declined by 0.13 percent in the second quarter, and the economy contracted by 0.2 percent in the first. Another consecutive quarter of contraction would put the country in a technical recession.
Either way, the Brazilian economy is clearly struggling, and the government appears to be preparing for the worst, introducing stimulus measures to try to boost growth.
 
Slow and Painful
Brazil’s modest recovery from its two-year recession has been slow and painful. Since 2017, the government has adhered to budget spending caps and has slashed spending on social programs. Unemployment reached 12.7 percent in the first quarter of this year, and though it has since fallen to 12 percent, it remains well above pre-recession levels, and an additional 28.5 million Brazilians (25 percent of the working-age population) are considered underemployed.
Productivity has dropped as more people settle for informal work or leave the workforce altogether. Research from the Brazilian Institute of Economics found that labor productivity fell 1.1 percent in the first quarter of this year, led by declines in the manufacturing and services sectors.
The deceleration is even more stark when compared to the 2.8 percent increase in productivity in the last quarter of 2018. Real income has also declined throughout the year. In May, the average household monthly real income was 2,280 reals ($560), down 1.5 percent from the previous quarter.

To address these issues, the government of President Jair Bolsonaro has made structural reforms a top priority. The cornerstone of the reforms has been changes to the pension system – including an increase in the retirement age – through which the government hopes to save $800 billion to $900 billion over the next 10 years.
According to the Bolsonaro administration, spending on social security and other social assistance programs in Brazil ranks among the highest in the world, and it’s becoming a bigger burden as the Brazilian population ages and its growth rate declines.
 
 
The government’s structural reforms also include privatization efforts to reduce support of unprofitable companies and public sector presence in the economy. In agriculture, the government has moved away from subsidizing production in favor of new and larger lines of credit for farmers. There are also proposals for modifying labor laws to generate more jobs. It’s hoped that deregulation will make it easier for companies to do business in the country and, therefore, attract more private investment at a time when the government’s own ability to stimulate the economy through spending is limited. To that end, the government has introduced the Direct Investment Ombudsman, whose purpose it is to support foreign investors with general inquiries and questions over legislation and administrative procedures related to investing in Brazil.

Several factors, however, have complicated these reform efforts. Passing social security changes is challenging in any country, but it is especially so in a country as diverse and divided as Brazil. Brazil’s lower house has approved the pension reform bill, but the Senate has yet to vote on it. And as economic growth has stalled, the government has had to repeatedly cut back spending to meet the self-imposed spending cap. It froze $2.2 billion in spending in late May and another $2.3 billion in late July. Despite these cutbacks, the government is at risk of exceeding its budget deficit target of 139 billion reals for the year because of lower-than-expected revenue. It has worked with state-level governments, which are also struggling financially, to harmonize national and state plans and avoid state bankruptcies.
 
 
The U.S.-China trade war is also partly to blame. Exporters and major industries across Brazil delayed or reduced (by hundreds of millions of dollars) investment plans because of the trade war, and there’s growing concern that, as the war escalates, Brazil’s window of opportunity for recovery will narrow.

Meanwhile, the country’s third-largest trade partner – Argentina – is in the middle of a recession, which has naturally hurt bilateral trade. Argentine purchases of Brazilian products fell 41.7 percent to $5.3 billion in the first half of 2019. This has significantly affected Brazil’s automotive industry, and it’s a major reason that Brazil’s manufacturing sector has struggled over the past two years.
 
Introducing Stimulus
The government has therefore introduced some economic stimulus measures. Though it initially wanted to hold off on a major stimulus package until after the reforms were implemented, the government believed it could no longer wait to try to encourage spending. In July, the government loosened rules over when and how workers can access their FGTS retirement accounts. (Previously, these funds could be accessed only in case of retirement, severe illness or to purchase a home.)

The measure is expected to inject up to 42 billion reals into the economy by 2020. Another 21 billion reals were made available through another social welfare fund, but only 2 billion reals are expected to be redeemed. This month, the government also announced plans to reduce the financing rate by as much as half for home buyers. For its part, the central bank said that, for the first time in 10 years, it would sell dollars on the spot currency market because of increased demand for liquidity – a move previous administrations were very reluctant to allow for fear of draining its foreign reserves.
 
 
The government has tried to encourage trade to supplement weak domestic demand. In the past, domestic demand has been a major driver of the Brazilian economy, while exports have accounted for only 15 percent of GDP. But after two years of recession and a weak recovery, domestic demand has slipped, and there’s an increasing need to look to foreign consumers.

But Brazil’s top three export destinations – China (27.6 percent), the U.S. (13.4 percent) and Argentina (4.7 percent) – are all showing signs of downturn. This explains in part why Brazil has worked to loosen trade restrictions within Mercosur – the South American trade bloc consisting of Brazil, Argentina, Uruguay and Paraguay – and why, after 20 years of negotiations, Brazil helped push through a free trade agreement between the European Union and Mercosur. The agreement hasn’t been ratified yet, but Brazil is already pursuing free trade agreements with other partners, including the United States and South Korea, and it reached a trade deal with Mexico on light vehicles, subject to a 40 percent regional content requirement, after six years of talks.

The government introduced several measures to try to recover from its last recession – measures that are now being used to stave off another downturn. It finds itself in the same position as many other major economies trying to avoid recessions of their own. More changes – including another possible stimulus package – may be on the way, and with an interest rate at 6 percent, there’s room for maneuver on monetary policy, too. 

But whether these steps are successful in preventing another major downturn remains to be seen.

The Biggest Migration Since the Barbarian Invasions of Rome

by Doug Casey



International Man: Former Libyan leader Muammar Ghaddafi once warned that "Europe runs the risk of turning black from illegal immigration… it could turn into Africa."

Since the United States and NATO helped overthrow Ghaddafi in 2011, millions of migrants from Africa and the Middle East have poured into Europe. Many transited from Libya.

This is all well known, and all signs point to this trend accelerating. What’s your take on where this is going?

Doug Casey: First, it’s a pity Ghaddafi was taken out. Another disastrous US policy decision.

Not that he was a nice guy—no one running an artificially constructed nation-state can be. But it was at least a stable situation. Now it’s been replaced by a bloody and costly war. And it’s complete chaos. Nice work Hillary and Obama. But let’s talk about Africa at large.

Africa, or at least migration in and out of Africa, is going to be the epicenter of what’s happening in the world for the rest of this century.

Africa has gone from being just an empty space on the map in the 19th century, to a bunch of backwater colonies in the 20th century, to a bunch of chaotic failed states that most people are only vaguely aware of today. Soon, however, it will be continuing front-page news. This is because Chinese are moving to Africa in record numbers while Africans are leaving as fast as they can.

What we’re looking at is actually the biggest migration since the barbarian invasions of the Roman Empire. There will be tens of millions—scores of millions—of Africans trying to get into Europe. I don’t know how the Europeans will keep them out. I used to say Europe was going to be a petting zoo for the Chinese, but it may be more of a squatter’s camp for the Africans.

Africa is the only part of the world where the population is still growing and growing rapidly.

Africa south of the Sahara was about 6% of the world’s population in the ’50s, now it’s about 16%. But by the turn of the century, it’s going to be 45%. Assuming there isn’t some kind of catastrophe. It’s not clear that the Africans can grow enough food for billions more people.

In fact, if the West stops supporting the continent with capital and technology, it could be in for very tough times. Wakanda, the country in "Black Panther", doesn’t exist. On the contrary, the continent is full of Gondwana lookalikes. Gondwana is where most of the action takes place in Speculator, the novel John Hunt and I wrote. It’s the first of seven in the High Ground series.

Few people realize how fast the population is growing, and things are changing in Africa. I ask knowledgeable people what they think the biggest cities in the world will be at the turn of the next century. They all guess cities in China or India.

But that’s not true. Eighty years from now, Lagos, Nigeria, will be the largest city in the world.

It’s on track to have a population of more than 90 million. The world’s second biggest city will be Kinshasa in the Congo with about 80 million people. Dar es Salaam, Tanzania, will be the world’s third biggest city with a population of roughly 75 million people. It’s quite amazing.

When I first visited Dar in the early ’80s, it was a quiet, exotic seaport with old tramp steamers in the harbor.

Now all those people have cell phones, and they’re well aware of the fact that the standard of living is vastly higher in Europe and every other part of the world than in Africa. And they’re well aware of the fact that there are welfare benefits of all types if they can get to Europe.

There are hundreds of NGOs encouraging Africans to come across the Mediterranean to Europe. Or for that matter, flying them to the US. Exactly who paid the airfare and legal and living expenses of the 200,000 penniless Somalis who were transplanted to Minnesota?

It’s a growing tidal wave. With the European population diminishing and the African population growing, you’re going to see Europe basically taken over by Africa in the next several generations.

International Man: What we don’t hear as much about is the massive migration of the Chinese to Africa that’s taking place.

Doug, you’ve spent a lot of time in Africa. What’s going on with all this?

Doug Casey: We’re seeing a veritable recolonization of Africa. Each time I visit Africa, there are more Chinese. It doesn’t matter which country; they’re everywhere.

Rich Chinese are smart to diversify to developed Western countries. Poor Chinese go to backward countries to try to become wealthy. Africa is the prime recipient.

It’s supposed to be official Chinese policy to migrate about 300 million Chinese to Africa in the years to come. They’re employed in building roads, railroads, ports, mines, and other infrastructure. It’s partially driven by their Belt and Road Initiative.

The Chinese are lending billions to African governments. African governments are, by an order of magnitude, the most corrupt in the world. And the people who run these African governments are being well compensated for making deals with the Chinese. And in effect, selling out their countrymen. All these governments are full of people trying to be "Mister 10%."

The worst case for them is to retire as centimillionaires, to live high off the hog in France or Switzerland. So, they’ve got nothing to lose. It’s a fairly unstoppable trend at this point.

Regardless of how much is stolen, however, I expect the Chinese are going to want the money they loaned to the Africans back, with interest.

If bribing or intimidating political leaders proves ineffective in getting it back, it’s possible that they’ll put soldiers’ boots on the ground. They could send in the People’s Liberation Army (PLA) to defend their assets. Or send in assassins to take out recalcitrant African politicians.

I wouldn’t be surprised to find the PLA in Africa in the years to come, physically collecting on those debts. And to make it easier for them, they’re going to be greeted by lots of Chinese already there.

It will be interesting to see what happens when a couple hundred million Chinese are living with a radically expanding native African population.

If the Africans were unhappy with European colonization, I think they’re going to be very, very unhappy with the Chinese colonization. The Chinese will not be "inclusive" and PC like today’s Westerners. It has the makings of a race war a generation or so in the future.

International Man: What about Africa piques the interests of the Chinese?

Doug Casey: It’s important to remember that Africa doesn’t produce anything besides raw materials—and people. There’s close to zero manufacturing—like 1% of the world’s total—in sub-Saharan Africa. And almost all of that is in South Africa.

The Chinese see Africans as no more than a cheap and dispensable labor source. That’s at best. Other than that, they’re viewed as a complete nuisance. Basically an obstacle—a cost—standing in the way of efficient use of the resources of the continent itself.

What do the Chinese people think of Africans? They don’t hold them in high regard. Of course, you’ve got to remember that China has viewed itself as the center of the world since Day One.

They see all non-Han people as barbarians, as inferiors.

That was absolutely true when the British sent an ambassador, Macartney, to open relations at the very end of the 18th century. He was treated with borderline contempt—pretty much the way Europeans and Americans have treated primitive peoples since the days of Columbus.

It’s actually the normal human attitude when an advanced culture encounters a backward culture. The Chinese see their culture as superior to even that of the West and believe—probably correctly—that they’ll soon be economically and technologically superior as well.

International Man: If China comes to dominate Africa and its resources, what does that mean for its rivalry with the US?

Doug Casey: Well, the US government is basically bankrupt at this point. The only thing that the US exports in quantity is US dollars. And sometime soon, the Chinese, the Russians, the Malaysians, the Iranians, and the Indians, among others, won’t need or want US dollars. They don’t want to accept them now, because it’s an asset of their adversary or even their enemy.

They’re unhappy about having to settle accounts in dollars that all have to clear through New York.

So, they’re going to come up with their own alternative. And I suspect they’re going to use gold.

Why? Because they don’t trust each other’s paper currencies. And why should they?

How’s the United States going to react to that?

It’s going to be left out in the cold. No one needs or wants their dollars—they want and need real goods, not the paper obligations of a hostile, unpredictable, bankrupt government. Also, the US isn’t in a position to export people, except for some unwelcome soldiers. The Chinese are in an excellent position to export a couple hundred million spare people. The bottom line is that the Chinese are going to take over Africa financially, and they’re going to take it over demographically as well.

International Man: What kind of speculative opportunities do you think this trend will create?

Doug Casey: Well, I’ve often said that if I were 30 years old today and wanted to make my fortune, I would definitely go to Africa. The reason for that is that you don’t want to be on a level playing field. You want to be on a field tilted in your direction as much as possible.

If a young Westerner goes to Africa and travels around, he’ll find it quite easy to move with the top levels of society. Because he’s unusual. And people are interested in things that are unusual.

The fact that you’re a Westerner means that you’ve probably associated with people who have much more money, much more sophistication, much more knowledge than any of the locals do.

You have unique advantages in Africa. If a young Westerner stays at home, however, he has no marginal advantages.

It’s very hard to vault yourself to the top in a Western society, because there are tens of millions of people just like you with the same education, background, and abilities.

But in Africa, you’re automatically on the top of the heap. And you’re noticeable. So, it’s a great place to go for entrepreneurial reasons.

At the same time, I don’t think Africa is a place to invest unless you’ve got the PLA standing behind you. It’s a place for a hit-and-run type of entrepreneurialism. Or perhaps political entrepreneurialism.

As corrupt as Africa is, the way almost everybody makes money is by getting hooked up with the government. And that’s possible to do. You could go to any number of African countries, hang out there for a month, and be sitting down with the president.

That’s not going to happen if you try to do the same thing in North America or Europe or for that matter even South America or Asia.

International Man: If you were 30 years old and looking for opportunity in Africa, what countries in particular would you be most interested in?

Doug Casey: Well, I wouldn’t jump off the deep end at first. Don’t go to a place like Nigeria to start. Nor is South Africa ideal for this purpose. It’s too developed, and there are too many people of European descent—although that’s changing. White people are making what the Rhodesians called "the chicken run" and for the same reasons. There’s too much anti-white racism in South Africa, and besides, the economy is going into reverse.

I would go to a country like Namibia, which is large, empty, and pretty mellow. I would definitely look at Mozambique. Or Mauritania—a huge country, where nobody goes. São Tomé and Príncipe, an obscure island country off the west coast. If you’re adventurous, the Central African Republic, which is probably the most backward country in Africa.

International Man: Thank you for your insights Doug.

The Real Cost of Trump’s Trade Wars

Economic analysis suggests that bilateral trade wars are unwinnable in an interconnected world. By firing his latest tariff salvo against China, US President Donald Trump has further raised the stakes in an increasingly damaging dispute – and America is likely to emerge as the bigger loser.

Daniel Gros

gros125_GettyImages_yuanoverlayingdollar


BRUSSELS – For a while at least, trade tensions between the United States and China seemed to have settled into a “new normal.” After both countries imposed high tariffs on a substantial proportion of each other’s goods, US President Donald Trump refrained from further escalation. But, following another inconclusive round of bilateral trade talks in Shanghai last week, Trump announced that the US will impose 10% tariffs on a further $300 billion worth of Chinese goods, effective September.

Should this new measure take effect, almost all US imports from China will be subject to tariffs. (The US already levies 25% tariffs on $250 billion worth of Chinese imports.) Although the US has also imposed non-tariff barriers in its trade war with China, reciprocal tariffs are the most visible component of the dispute – and are likely to hurt America more than China.

One way to compare the restrictiveness of countries’ trade policies is to look at their average tariff rates. For the US, this seems to paint a fairly reassuring picture. Before Trump took office, the average US tariff rate on industrial imports was about 2%, somewhat lower than that of China.

Even under Trump, this figure has (so far) not increased that much. Imports from China account for about one-quarter of all US imports, and the 25% tariff affects about one-half of imported Chinese goods. This implies that the average US import tariff has increased by about three percentage points, to 5% or so, which does not appear excessive.

But the average tariff is a misleading indicator. Economic theory suggests that tariffs have disproportionately negative effects on the welfare of consumers and producers. A doubling of a tariff, for example, will lead to more than double the welfare loss. A 25% tariff on a limited share of trade is thus much more serious than an average tariff of 3%.

Many countries have high import tariffs on a certain number of specific products, with a rate above 15% usually considered to be a “tariff peak.” But whereas these peaks apply to less than 1% of total imports for most industrialized countries, they cover a far larger share of US imports.

Moreover, Trump’s tariffs discriminate against China: the 25% tariff is paid only by Chinese producers, not by their European, Latin American, or Asian competitors. Such a country-specific tariff is equivalent to levying a general tariff on all imports while providing a production subsidy for competing producers outside China – with this subsidy paid by US consumers in the form of higher prices.

Because non-Chinese producers can raise their prices by up to 25% and still remain competitive in the US, prices for American consumers are likely to increase on a wide range of goods. The indirect effect of Trump’s China tariffs on consumer prices is therefore likely to be much greater than the recent estimate of a direct impact of only 0.1%. These indirect harmful consequences of country-specific tariffs are the main reason why the “most favored nation” principle has long been a cornerstone of the global trading system.

Moreover, preliminary studies suggest that Chinese producers have not significantly lowered their prices as a result of Trump’s tariffs. And even if they did, the small gain to US consumers from lower Chinese prices would likely be far outweighed by higher prices on competing imports diverted to the US market by Trump’s country-specific tariffs.

Although China previously imposed a reciprocal 25% tariff on many of its imports from the US, the negative impact on the Chinese economy is likely to be limited because US goods account for less than one-tenth of China’s overall imports. Chinese retaliatory tariffs thus have a small impact on the Chinese economy. And China has actually lowered tariffs on its imports from the rest of the world.

Moreover, a large share of China’s imports from the US consists of agricultural commodities such as soybeans, which the country could easily import at a similar price from Brazil if necessary. The US would then presumably export more soybeans to markets formerly served by Brazilian producers, including in Europe. (This would reduce America’s trade deficit with Europe and might ease US pressure on the European Union in that regard.)

The US has also ratcheted up non-tariff barriers as part of its aggressive trade policy toward China. Most notably, Trump has put Chinese tech giant Huawei on the list of entities to which US firms are forbidden to sell American products. True, Trump has also said that for the time being, US suppliers should obtain the necessary licenses to continue to supply Huawei. But from now on, US technology companies will clearly think twice before entering long-term contracts with Huawei or other prominent Chinese firms that might be at risk of being included on the “entities list.”

In parallel, China’s government and businesses will redouble their efforts to become independent from the US in sourcing key technological components. The mere threat of the entities list will henceforth act as a significant hidden barrier to US-China trade. And because this barrier is also discriminatory (directed only at China), it will have the same high costs as country-specific tariffs.

Economic analysis suggests that bilateral trade wars are unwinnable in an interconnected world. By firing his latest tariff salvo against China, Trump has further raised the stakes in an increasingly damaging dispute. And America is likely to emerge as the bigger loser.


Daniel Gros is Director of the Centre for European Policy Studies.