China’s Trade War Tools and Their Effects on the US Economy

Multiple shots have now been fired in the US-China trade war. Immediately after the United States slapped 25% tariffs on $34 billion of Chinese exports, Beijing retaliated in kind on $34 billion of US exports. Just four days later, the Trump administration followed through on its pledge and announced an additional 10% tariff on $200 billion of Chinese exports. Now the tariff list effectively covers 50% of all Chinese goods destined for the United States.

As many observers have rightly pointed out, China technically won’t be able to counter with symmetrical retaliation simply because the United States exports far fewer goods to China—a mere $130 billion in 2017. Others have also noted that facing domestic economic uncertainty, Beijing may be more cautious and dial back its response or rely on tactics such as offering market access to US companies’ European competitors.

What the Chinese government ultimately decides to do may be harder to ascertain at the moment, but do not be surprised if the momentary calm is punctured as Beijing reverts back to retaliation mode. In fact, one day after US Trade Representative’s (USTR) announcement of a new round of tariffs, China’s Ministry of Commerce (MOFCOM) retorted that “US escalation by imposing new tariffs is completely unacceptable.” A day later, MOFCOM published another lengthy and vitriolic statement, refuting USTR’s Section 301 report’s main findings. In its latest move, MOFCOM filed a complaint to the World Trade Organization against the 10% tariff on $200 billion of goods.

Although Beijing and Washington seem willing to negotiate something of a truce in the near term, that could easily evaporate depending on how each side responds. In the event China reverts back to serious retaliation, it’s important to understand the retaliatory tools Beijing can wield and how each measure potentially affects the US economy.

To that end, I’ve set up three hypothetical but reasonable scenarios for Chinese retaliation and determined their corresponding effects on the US economy. Each scenario is explained in more detail below, but a quick look at the different impacts on the US economy are as follows:

Scenario 1:

• Chinese retaliatory action: A 25% tariff on $100 billion of US goods exports

• Impact on US economy: Total US goods export value will decrease by $38 billion

Scenario 2:

• Chinese retaliatory action: A 25% tariff on US services exports

• Impact on US economy: Total US services export value will decrease by $37 billion

Scenario 3:

• Chinese retaliatory action: Severely disrupting US companies’ operations in China

• Impact on US economy: US companies experience revenue loss of $73 billion

The Bottom Line: If all three scenarios come to pass, combined they would likely cost the US economy $148 billion, or 0.74% of GDP.

Scenario 1: Double Down on US Goods Exports

Currently, Beijing has imposed a 25% tariff on $50 billion of US goods. If China decides to continue to target US exports, it could extend the scope of tariffs to as much as $100 billion of US goods.

Among the $130 billion goods China imported from the United States in 2017, airplanes, soybeans, semiconductors, and automobiles top the list (see Figure 1). It is relatively easier to find substitutes for US soybeans (Brazil) and cars (South Korea). But for products like semiconductors and airplanes—which China imported a combined $25 billion worth from the United States in 2017—China will have a harder time switching to substitutes because they involve long-term contracts and a handful of US companies dominate those markets. Take aircraft for example, a duopoly of Boeing and Airbus. China’s projected demand for new airplanes exceeds the capacity of a single manufacturer to meet, particularly as aircraft are sophisticated products with long lead times. Moreover, Beijing will be wary of allowing either Airbus or Boeing to gain too much market share, preferring to maintain the duopolistic status quo.

Figure 1. Top 10 US Exports to China in 2017
Source: US Census Bureau.

Additional tariffs from China will raise the cost of US goods and thus discourage demand from the importing country. But other factors can also influence the cost of export goods, such as the depreciation of the US dollar against the Chinese yuan, which could actually offset some of the tariffs’ effect. Furthermore, some US firms might be able to internalize higher costs and keep consumer prices relatively stable.

Given these moving pieces, a precise determination of the tariffs’ impact on the US economy is difficult to come by. But one way to arrive at a reasonable estimate is to look at the price elasticity of exports—the more elastic demand is for US exports, the larger the decrease in demand resulting from a price increase, which in turn leads to a concomitant decline in total US export value. (Price elasticity of exports is contested territory among economists, though estimates put the US export price elasticity between -1.5% and -4%.)

Using the more conservative price elasticity of -1.5%—meaning that for every 1% price increase in exports, the US’ gross export value drops by 1.5%–China’s imposition of a 25% tariff on $100 billion of US goods would lead to a reduction in the value of US exports by roughly $38 billion. As such, US domestic economic output, ceteris paribus, will also decrease by an equal amount.

Scenario 2: Targeting US Services Exports

Beyond goods, China can slap additional tariffs on $50 billion of US services exports. Although the Trump administration seems to only care about the bilateral goods deficit, Beijing would be willing to target services if it came to that. This is feasible since the United States exported $58 billion in services to China in 2017, running a surplus of $40 billion. More than half of US services exports are tourism and education (see Figure 2).

Figure 2. US Services Exports to China by Industry
Source: US Bureau of Economic Analysis (BEA).

If Beijing were to target US services exports, the impact on affected sectors would be greater than the tariff on goods. This is because it takes years for an industry to establish its supply chain, and it takes time to adapt that supply chain to disruptions brought by tariffs. In other words, the adjustment cost is high in the near term, which means many Chinese importers that have come to rely on US goods may have little choice but to absorb the higher cost in the short run.

But for services, there are plenty of near-perfect substitutes. Take tourism for example. Instead of a summer vacation in Napa, Chinese tourists may now find Tuscany just as appealing and even cheaper. Moreover, China has been fond of using boycott diplomacy during its previous spats with South Korea, Japan, and the Philippines. That is to say, Beijing can simultaneously implement explicit measures, such as taxing US services exports, and take indirect actions, such as engaging in negative social media campaigns to drive Chinese demand away from US services.

Moreover, the impact of tariffs on services will be felt more immediately because services are generally produced at the time of demand, or what supply chain management experts define as the simultaneity of production and consumption. That means if the price of a certain service rises suddenly because of tariffs, service providers will feel the pinch immediately. The pain on restaurants, travel agencies, wealth management companies, and educational institutions could be acute.

One can, in fact, already see traces of this trend from data. Based on the latest monthly visa issuance data from the Bureau of Consular Affairs of the United States, non-immigrant visas issued to Chinese nationals reversed its longstanding upward trajectory, dropping by 11.4% in May compared to the same period in 2017. The single largest drop is seen in the business and tourism visa category (B-1/B-2)—about 20,000 fewer in May alone. Each of these Chinese tourists, for business and leisure, spends an average of $8,146 during their trip to the United States, according to MacroPolo’s “The China Footprint.” Similar patterns can be seen in education-based visa issuances. Both student and scholar visa (F-1/J-1) issuances witnessed decreases, according to the Bureau of Consular Affairs.

Because of these factors, a 25% tariff on $50 billion of US services exports will likely lead to a much more immediate and significant drop of such exports. Based on my back-of-the-envelope estimate, such a tariff will cause a total loss of $37 billion in revenue across US services industries.

Scenario 3: Putting a Serious Squeeze on US Companies

Many observers have already pointed out that Beijing could, and may already have, put pressure on American companies with significant exposure to the China market, either directly or indirectly through granting favors and other incentives to their competitors. But rather than one-off anecdotes, let’s look at the overall potential loss for American companies should Beijing choose to meaningfully retaliate via this route.

Figure 3. US Companies’ Revenue in China, by Industry
Source: BEA.

Since the 1990s, American companies have entered the China market through direct investments or partnerships. Those US companies operating in China today (including their subsidiaries, joint ventures, and other business units) have achieved total annual revenue of $500 billion, annual profit of $31 billion, and hold over $600 billion in assets, according to BEA (see Figure 3).

Among US companies operating in China, only 20 have earned more than $2 billion in revenue from the China market (see Figure 4), according to financial data provider FactSet. Collectively, these 20 companies constitute roughly a third of total sales revenue of all American firms operating in China. Although Beijing will likely stay away from US companies such as Intel or Boeing, because China cannot easily find substitutable products (computer chips and airplanes) as explained above, there are still many consumer companies and manufacturers that China could easily target in the near term. Out of the top 20 companies, eight fall into this “easy target” category, ranging from Apple and Starbucks to P&G and Nike.

Figure 4. US Companies’ Revenue in China Market

Note: Green highlight indicates companies that are potential targets of China’s retaliation.
Source: FactSet.

Although unlikely, if tensions escalate into a full-blown trade war, and the Trump administration takes the nuclear option of taxing $450 billion of Chinese goods, Beijing will likely have little choice but to put a serious squeeze on these US companies. Beijing could employ an array of tactics, including promoting negative media coverage, manufacturing public outrage, ginning up economic nationalism, interrupting or even stopping operations altogether.

This may seem far-fetched at the moment but these sorts of scenarios have played out before—namely against Japan during the heated dispute over the Senkaku Islands in 2012. At the time, Chinese protestors broke into Japanese clothing stores, set cars on fire, and some Japanese automakers saw their sales in China plunge by nearly half. Now that foreign companies are already under more scrutiny, such a scenario could come to pass against US firms, depending on how far the trade war goes.

Of course it is inherently difficult to know exactly what tactics Beijing will employ and which and how many US businesses will be affected. But let’s assume conservatively that only US consumer companies and non-chip or airplane manufacturers will be affected—specifically their sales revenue in China drops by 20% as a result of Chinese retaliation. In this hypothetical case, based on my estimate, that’s still $73 billion in revenue loss for US companies.

If all three of these scenarios were to materialize as the trade war escalates, the US economy could see total potential loss of $148 billion, or 0.74% of GDP.


Get Our Stuff

SHARE THIS ARTICLE