As the trade war worsens, the trade deficit increases

The trade war that the U.S. has unleashed on China continues to ratchet up. The next round of 25-percent tariffs on $16 billion of imports from China will go into effect Aug. 23.

China is committed to retaliate and will implement its own 25-percent tax on $16 billion of imports from the U.S. As the tit-for-tat escalation continues, it is impossible for China to match the U.S. dollar-for-dollar because it imports so much less from the U.S. than it exports.

The next round threatened by the U.S. will cover $200 billion in additional imports. The Chinese announced retaliation will hit a much smaller volume, $60 billion of imports. Still, we are moving toward complete taxation of trade in both directions.

The direct effect of these measures on the Chinese economy is small so far. China’s exports in July were up 12.2 percent over the prior year, ahead of market expectations. The International Monetary Fund’s (IMF’s) updated forecast for China’s GDP growth this year is 6.6 percent, above the target for the year.

Indirect effects are harder to measure but are arguably larger. China began the year in a tightening cycle, trying to rein in the excessive credit growth of the recent past. The regulators were determined in particular to reduce the shadow banking sector and to bring more financial activity back into the formal banking system.

Investment growth has been slowing all year, and the stock market peaked and started falling in January, well before the trade war got serious. The protectionism from the U.S. has contributed to the pessimistic mood in China. Investment growth was practically nil in July, and the Shanghai market is now down 24 percent since the January high.

The July data also show some easing of the tight money policy, though no let-up in the campaign against shadow banking. This suggests that the authorities are worried about the impact of the trade war on growth, but it is also a reminder that China has tools at its disposal.

Aside from monetary easing, the government is also pursuing some modest additional fiscal stimulus. China can afford to spend more public money on education, health and environmental clean-up and can use the fiscal adjustment to its advantage.

Another obvious tool is the exchange rate. Since April, the U.S. dollar is up 8 percent against a basket of major currencies. The Chinese yuan has more or less followed the same trend: It is down 9 percent against the dollar over this period.

This is one reason that China’s exports were buoyant in July. Too much depreciation could set off financial panic, but depreciating against the dollar in line with the other major currencies in the world makes sense in the current environment.

China’s Ministry of Commerce announced this week that Vice Minister Wang Shouwen will visit Washington, D.C. in late August for talks with Treasury Under Secretary David Malpass. It is good that the two sides are talking, but there is not likely to be a negotiated settlement anytime soon.

The Chinese side is confused about what the U.S. wants. It feels that near-agreements were reached twice before only to have the U.S. pull back. What China is ready to offer is clear:

• It will agree to some big headline numbers for purchases of agricultural products and energy, which is more of a publicity stunt than a policy change;
• it is already committed to opening some important markets in China, such as automobiles and financial services; and
• it would agree to some general language about improving intellectual property rights protection and avoiding forced technology transfer.

These talks at the vice minister level should clarify positions, but an end to the trade war will likely require higher-level talks and ultimately a meeting between Presidents Trump and Xi. The next time that the two will meet, barring an exceptional summit, would be at the Group of 20 summit at the end of November in Buenos Aries.

An important obstacle to reaching a settlement is that the U.S. administration has put a big focus on trade balances, and those are very hard to change.

Because of the large fiscal stimulus, the U.S. economy is growing rapidly. Interest rates are rising, as is the value of the dollar. It is natural in this situation for the U.S. trade deficit to widen.

In the first half of the year, the overall U.S. deficit in goods was up 7 percent. The deficit with China was up 9 percent and 16 percent with Europe. Those trends will almost certainly continue in the second half of the year. Protectionism aimed at China will not have any big effect on the overall U.S. deficit.

The protectionism should eventually reduce imports from China, but it will also reduce U.S. exports and increase U.S. imports from other locations. Much of what the U.S. imports from China are intermediate products used by U.S. firms to be more competitive.

Taxing these will naturally result in some lost business for U.S. firms, both in the domestic market and in export markets. If the protection stays in place long enough, global value chains will adjust. Some labor-intensive final assembly will shift to countries like Vietnam in order to avoid the 25-percent tax.

Suppliers such as Japan, South Korea and Taiwan will retain more production at home rather than off-shoring to China. China is likely to remain the center of the Asian production hub, but will concentrate even more than it does now on intermediates and less on final goods for the U.S. markets.

All of this will shift some of the trade deficit away from U.S.-China toward larger trade deficits with the rest of Asia and Europe. But the overall U.S. trade deficit will not change in any significant way.