Trump shows he still doesn't grasp who bears the brunt of tariffs

Trump shows he still doesn't grasp who bears the brunt of tariffs
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Benefitting from a deceptively solid 3.2-percent real GDP advance in the first quarter (Q1) and a strong April jobs report, President TrumpDonald John TrumpConway defends herself against Hatch Act allegations amid threat of subpoena How to defuse Gulf tensions and avoid war with Iran Trump says 'stubborn child' Fed 'blew it' by not cutting rates MORE and U.S. Trade Representative Robert LighthizerRobert (Bob) Emmet LighthizerChinese, US negotiators fine-tuning details of trade agreement: report The Trump economy keeps roaring ahead Trump says no discussion of extending deadline in Chinese trade talks MORE announced fresh tariffs on China before the end of the week.

While the threat rattled markets that had been lulled into a false sense of comfort, it is a characteristic move in the final stages of trade negotiation.

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Importantly though, with China refusing to back down, the threat represents a non-negligible risk for the U.S. economy at a time when the fiscal stimulus is dissipating and activity is cooling.

While I continue to believe in the possibility of a trade “deal” in the coming weeks, a long-lasting comprehensive trade agreement looks increasingly unlikely.

In a surprise move on Sunday afternoon, Trump threatened to raise existing China tariffs from 10 percent to 25 percent on $200 billion of imports on Friday. He added that tariffs would also “shortly” be imposed on $325 billion of imports currently free of duties.

Chinese authorities were swift to react, stating that Chinese Vice Premier Liu and his accompanying 100-person delegation were considering cancelling the trade talks in D.C. this week.

President Trump’s Twitter announcement underscored that the U.S. administration continues to misrepresent the effect of tariffs stating that the “tariffs paid to the USA have had little impact on product cost, mostly borne by China.”

We know, however, that the U.S. tariffs are ultimately borne by U.S. consumers and businesses facing higher input costs.

What's more, the U.S. economic performance of late has been restrained, not facilitated, by tariffs. The decline in bilateral trade has reached $25 billion, or about 0.5 percent of world trade, over the last three months.

U.S. merchandise exports to China were down 21 percent year-on-year (y/y) in the first two months of the year while U.S. imports from China were 12-percent lower than a year ago.

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While the GDP growth impact of existing tariffs on $250 billion of imports is expected to be modest — a drag of 0.1 percentage points in 2019 — an escalation of trade tensions would more than double the hit on the economy.

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Indeed, the tariffs on China along with the negative confidence shock to financial markets represents a significant risk for U.S. households and businesses at a time when global headwinds remain a lingering concern and fiscal stimulus is dissipating.

With the economy seen cooling from a misleadingly strong 3.2-percent y/y pace in Q1 to around 2.2 percent y/y by Q4, rising trade tensions could slow the pace of activity to less than 2 percent by year-end.

While no one wins trade wars, sectors where diversification is easier and faster tend to see more significant swings in trade flows. As an illustration, imported goods affected by the first tranche of tariffs (25 percent on $50 billion) were predominantly agricultural goods, and they have fallen about 50 percent y/y.

The $200 billion tranche, meanwhile, has witnessed a 24-percent y/y collapse in imports from China. These numbers aren’t surprising when you consider the relative ease in diverting imports for agricultural products versus machinery and equipment where supply chains are more specialized and slower to adjust.

Financial markets did not digest the tariffs announcement with ease: The Shanghai composite fell 6 percent, the yuan fell to its lowest level in four months, 10-year U.S. Treasury yields slipped 6 basis points, and U.S. stock prices dropped 0.5 percent (after opening 2-percent lower on Monday morning).

This isn’t surprising since markets had become numb to the risks of escalating trade tensions and were mistakenly assuming that a comprehensive U.S.-China trade agreement was about to be signed.

President Trump’s credible threat to impose higher tariffs on China along with the negative confidence shock to financial markets represents a significant risk for U.S. households and businesses at a time when global headwinds remain a lingering concern.

While the administration is certainly riding on two solid economic reports — 3.2-percent Q1 GDP growth and nonfarm payrolls rising 263,000 in April — it is important to caution that domestic momentum is cooling as the fiscal stimulus’ impulse is dissipating.

As I have highlighted over the past few months, a trade deal in which China promises to import more agricultural products, works toward a stable currency and reinforces intellectual property rights protection remains a possibility.

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However, I don’t foresee a significant rollback of existing tariffs, and I see underlying tensions regarding China’s strategic ambitions, its industrial policy, technological transfers and “verification and enforcement” mechanisms remaining in place.

In particular, the U.S. administration’s desire to have unilateral authority to impose new tariffs should China fail to comply with the terms of the agreement and not reach time-sensitive benchmarks after 90- and 180-days is something China will continue to resist.

As such, it appears that an escalation in trade tensions will be a necessary first step before the conclusion of a trade deal and truce between the two economic giants. 

Gregory Daco is the chief economist at Oxford Economics.