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How might a trade war play out?

If trade tensions escalate, potential consequences could include stagflation and a stronger US dollar.

4 July 2018

Keith Wade

Keith Wade

Chief Economist & Strategist

The Trump team appears to see trade wars as a central policy rather than a bargaining strategy. With the possible advent of further tariffs on European and Chinese exports, we look at the potential consequences such as higher inflation and lower growth. 

A return to currency wars?

While the US has begun to raise rates, the eurozone is not set to follow suit until “at least” the end of summer 2019 according to European Central Bank President Mario Draghi.

Some of this divergence can be explained by economic activity but it could also be related to a desire to counter the effect of US trade tariffs on financial conditions.

Ending the quantitative easing programme may well prompt a rise in the euro, something which will be unhelpful for the eurozone’s competitiveness in a tough trading environment. The eurozone is braced for more action from the US, with Trump now threatening tariffs on cars.

China too appears to be responding to tariffs by using monetary policy to help competitiveness. 

Both the euro and the Chinese yuan have weakened since the start of the trade tensions, with the yuan currently at its lowest level since last December. Trump's trade wars seem to have opened up a new chapter in the currency wars.

US businesses could be targeted

Regular readers will recall our discussion on "Trade wars: what do they mean for the global economy?" in May 2018. We looked at the potential for China to retaliate to US tariffs by targeting US companies that operate in China in the same way that authorities made life difficult for Korean firm Lotte after South Korea installed a missile defence system. By imposing strict fire regulations, they effectively halted operations and forced the supermarket business to withdraw from China altogether.

Given the significant exposure that the US has to the Chinese market, the US is highly vulnerable to this indirect type of retaliation. For example, data from the Bureau of Economic Analysis in the US show that the US firms in China sold $223 billion in 2015 and $150 billion through exports from the US. General Motors sold more cars in China than in the US in 2017 and there are twice as many active iPhones in China than in the US. 

Although China has not articulated a desire to target US businesses, it remains a powerful tool in their arsenal.

Potential consequences of escalation

  • Inflationary impact: Although current tariffs are hurting businesses in certain sectors (such as auto and aerospace manufacturers etc), further tariffs are likely to be levied on consumer goods such as clothing, footwear and white goods. This risks driving inflation higher as consumers are faced with higher prices on everyday items.
  • Stronger US dollar: As central banks outside the US try to offset the effect of higher tariffs on their exports by easing policy and investors search for “safe havens” as they do in uncertain times, we are likely to see a rise in the value of the dollar. This will hamper trade and impact the emerging markets as their currencies devalue in the face of an appreciating dollar.
  • Lower growth and higher inflation (stagflation): Overall, we may have to raise our inflation forecasts as a result of higher prices on traded goods, and lower our growth expectations as trade slows given weaker demand and a stronger dollar.

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