By imposing tariffs on aluminium and steel imports, the United States fired its opening salvo in the battle to rebalance trade relations with China. Now it has launched an investigation into what it considers to be unfair trade practices by China, under section 301 of the US Trade Act. Regardless of whether this results in the US taking punitive action against China or not, it marks a new phase of the trade dispute between the two nations. We believe that, unlike previous periods of trade tensions, this time is qualitatively different and could have significant and lasting implications for companies in China, certain sectors in the US and global investor portfolios.
In 2017, markets were focused on the protectionist threat of the Trump administration. While President Trump did pull out of talks for the Trans-Pacific Partnership (TPP) and triggered a renegotiation of NAFTA, US protectionist actions were actually fewer in 2017 than in the final years of the Obama administration. This year, however, looks markedly different, with Trump slapping tariffs on steel and aluminium in March 2018 under section 232 of the Act. Under this rule, the target imports are very narrowly defined while the target countries are very broad. The tariffs affected not just China but a range of countries; many have since sought an exemption, which the US may grant provided those countries stand with it against China.
If the US were now to go a step further and enact punitive measures under section 301 of the Act, there would be different, potentially more serious, implications. First, the 301 clause is defined as a response to foreign trade barriers. Second, it is typically country-specific. And third, it provides the US Trade Representative (USTR) with wide latitude of penal actions, including tariff imposition, setting quota limits or placing restrictions on business activity in the US. However, before any punitive action is imposed, there must be a bilateral negotiation to resolve the differences. Given that US-China trade falls under the auspices of the World Trade Organisation (WTO), the US would also need to submit a claim to the WTO dispute settlement process. In practice, however, the WTO will be a sideshow to the US-Chinese negotiation.
In the case of the US and China, it is important to note that section 301 would be triggered based on allegations that China’s treatment of US intellectual property (IP) amounts to unfair trade practice. The core claim is that China unlawfully tilts its domestic market in favour of Chinese companies, forces technology transfer of US companies doing business in China or engages in outright theft of IP. More generally, a USTR report on WTO Compliance has accused China of running a state-led economy where the state’s role has increased in the last five years, of having little or no intention of complying with WTO regulation and of ambitions to dominate international markets in the future, as part of its Made in China 2025 strategic plan.
Any actions under section 301 will therefore be used to send a strong message to China. Peter Navarro, the President’s special advisor on trade, has said the USTR is “working to address IP theft head on” as well as “working to restructure the trading environment that works not just for Americans but for the rest of the world”.
Possible Trade Actions
For the Trump Administration, the main goal of trade negotiations with China is a reduction in the bilateral trade deficit – with a USD 100 billion reduction being the PR-friendly headline used. This gives both parties plenty of negotiating room to arrive at such an outcome without descending into a trade war. And there is good historical precedence for this. In the early 1990s, for example, the US launched multiple, section 301 IP-related actions against China, each ending in a bilateral deal within a year without having taken real effect.
However, the actions are likely to be announced before the negotiations begin. We believe these could take various forms and be revealed soon. The most likely enforcement actions under section 301 would be denying access to investment in US assets (see Figure 1) and targeted tariffs being applied to industries where China has a comparative advantage such as electronics, machinery, apparel, toys, furniture and lighting, and where supply chains could be re-routed. If these are successful, Chinese industry could be hit hard.
Figure 1 outlines the industries that could be affected by Section 301, as well as the other industries highlighted in the report which USTR says are affected by market-distorting practices. USTR adds that China’s disregard for WTO rules means the US may decide not to automatically resort to the WTO dispute settlement mechanism to resolve the situation.
China has a plethora of options when dealing bilaterally with the US. On the conciliatory side, it could pursue the “shopping list” approach and commit to Chinese purchases of US goods, helping to boost US exports. It could permit greater foreign competition in certain sectors, i.e., introduce liberalizing market reforms. Such reforms are underway regardless of US trade talks, so China could skillfully present them as a concession to the US, particularly if they occur in sectors with strong US companies. However, USTR would need to be persuaded that this constituted real change; some US officials view the shopping list approach as allowing China to escape adopting better practices.
Similarly, the authorities in Beijing could comfortably choose to escalate the dispute. It could resort to a range of retaliatory measures, including the imposition of counter tariffs (presumably on the most economically and politically concentrated US imports such as soybeans or aircraft). It could delay scheduled Chinese purchases of US goods and services, penalise US businesses active in China, grant preferential treatment to non-US competitors or restrict Chinese travel to the US (i.e. equal to a tariff on US service exports).
Market and Economic Impact
Aside from these tactical trade measures, China could also attempt to retaliate through financial markets. It could, for example, contemplate reducing its significant holdings in US Treasuries or delink further from the US dollar. However, we think both these actions are unlikely, given that they have multilateral ripple effects and bear risks for the Chinese economy. Foreign exchange and bond markets should therefore remain quiescent.
Higher tariffs will, however, affect equity markets. US retailers that rely heavily on imports from China will be impacted the most, but the full ramifications of these measures will only be known once they come into force. For example, higher television prices could perhaps mean Chinese-made televisions are substituted for Taiwanese sets. On the other hand, if a Sony TV is partly made in China and partly made elsewhere, it may be that the tariff would apply only to the value-add in China. The impact on supply-chain linkages is therefore the most difficult to estimate and there could be unintended collateral damage to other countries and companies.
Overall, the negative impact on China’s real GDP growth is estimated by most economists as limited to between 0.2% and 0.4% of GDP, depending on the scale and targeting of the tariffs. However, there could be second-round effects and, for the Chinese, a politically difficult impact on employment. Moreover, this dispute is not going away. The US has designated China as a strategic rival and shown that it is prepared to act unilaterally, irrespective of WTO conventions. And it is not the only country with concerns about China’s IP practices or the way it has treated overseas companies and investors over the last 30 years. If the European Union and Japan were to initiate similar proceedings to those engendered by section 301, possibly even through the WTO, China would be hard pressed not to change its behaviour under threat of restricted access to its major markets. In the meantime, global investors will need to keep a close eye on how this upheaval is affecting companies’ share prices and which sectors may be more or less in the firing line from both sides.
With contributions from John Flynn, Global Equities Portfolio Manager, and Laura Ostrander, Emerging Markets Macro Strategist
*Made in China 2025 Target Industries
Automated machine tools and robotics
Aviation and spaceflight
Maritime engineering and high tech vessels
Advanced rail transit equipment
New energy vehicles
The views expressed in this material are the views of Elliot Hentov and Esther Baroudy through the period ended 3/20/2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk including the risk of loss of principal.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed.
There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
The information provided does not constitute investment advice and it should not be relied on as such. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
United States: State Street Global Advisors, 1 Iron Street, Boston, MA 02210-1641
State Street Global Advisors Global Entities
© 2018 State Street Corporation - All Rights Reserved
Expiration Date: 3/31/2019