It is not just Donald Trump’s return to the presidency that raises the risk of a full-blown trade war. Restrictions on trade have been proliferating for some time, and the US is not the only country driving this trend. But Trump will soon lead the world’s biggest economy, which is also its biggest importer.
So, what the US does has an outsized impact on the rest of the world. The risk is all the greater because Trump is a true believer in tariffs (which he terms the most beautiful word in the world). His first term saw a huge increase in tariffs against China and many other countries. He is likely to re-appoint Robert Lighthizer, his former Trade Representative, to his old position. Lighthizer is not only a fervent supporter of using tariffs but also adept at the technical details of tariffs; he can make sure the aggressive tariff policy is actually implemented.
The experience of the 1930s warns us to take this risk seriously. Then, the US Congress passed the Smoot-Hawley Act, which raised already high tariffs by 20%. Virtually all the major economies of the day retaliated, and world trade plummeted, tipping an already fragile global economy into a major depression.
Whether this happens again depends on several factors: how much Trump actually raises tariffs, other countries’ retaliation and whether policy interventions counter the depressive effects of the trade war. Overall, these factors point to a bad outcome next year.
Trump means business
Some believe that Trump will not follow through on his trade and that he will negotiate hard but avoid extreme tariff hikes. While he is not likely to immediately impose the 60% tariff on China he has threatened, Chinese goods will certainly face sharp tariff increases. His administration will also impose a modest universal tariff on all other countries’ goods. The US Congress could also pass legislation that has already been drafted to deprive China of “most favoured nation” status, which would automatically raise tariffs on all Chinese goods. A review of the US-Mexico-Canada trade agreement will also be demanded.
There are many reasons why he would move aggressively. First, the US trade deficit on goods and services is already at a record level if one excludes the huge deficits during the pandemic period. Trump and Lighthizer believe that such deficits are the product of unfair policies pursued by its trading partners, which justifies aggressive counter-measures.
See also: Trump says he could hit China with 10% tariff from next month
Second, China has become highly competitive in future industries such as electric vehicles, batteries and solar panels. A period of tariff protection is seen as necessary to allow American firms to increase their competitiveness in these strategic areas. President Joe Biden has used tariffs in a limited fashion, preferring to use industrial policies such as subsidies to firms investing in such areas to counter China. However, Trump has said he will abolish most of Biden’s initiatives, leaving tariffs as the only tool he can use.
Third, American trade negotiators know that the US is the only large economy that is currently vibrant, leaving exporting nations highly reliant on it. The European economy is struggling, hit by high energy prices, tighter monetary conditions, domestic political uncertainty and the spillover from the Ukraine war. Japan’s weak economy now has the added burden of political uncertainty. The Chinese economy may be stabilising but remains fragile and unlikely to add much to import demand. America is thus in a strong position to demand trade concessions.
Fourth, Trump also plans major tax cuts that will reduce government revenues. Although Trump’s allies promise dramatic cuts in government spending, no one seriously expects these to materialise — the political opposition will be too great.
See also: Gold advances as Trump stands by plans for Mexico, Canada tariff
Thus, he needs new revenues to avoid destabilising budget deficits. Although most economists estimate that tariffs are unlikely to generate enough revenues to offset the tax cuts, Trump believes they will.
Finally, since most of America’s trade partners rely on the US security umbrella except China, Trump’s team believes that Europe and Japan will cave in to Trump’s demands once tariffs are raised.
Other countries will retaliate
China has repeatedly stated that it will retaliate against any US tariff hike with trade restrictions of its own. Europe and Mexico have also publicly expressed their resolve to oppose the US. For his part, Trump has indicated that such retaliation will be met with even more aggressive trade restrictions. The major global trading powers will be hurling tariffs and counter-tariffs against each other for many months or more.
The reasons are straightforward. None of these countries will want to roll over and accede to American pressures simply. Moreover, caving into a bullying US will harm President Xi Jinping’s position in China, undermining his claim to be a great defender of Chinese interests. Imposing tariffs on the US will also give these countries some bargaining power against the US.
But it won’t just stop there. Recall that protectionism is already rife in the world economy. The World Bank reports that the number of trade restrictions, such as tariffs and export bans, has quadrupled since 2020, reaching record highs in 2022 and 2023. Once it is clear that the US is throwing caution to the winds and resorting to massive tariffs, many other countries with a protectionist bent are likely to jump on that bandwagon.
China is at particular risk. Its share of world exports has continued to grow while its share of world imports has peaked and is coming down – that makes it seem to be pursuing unfair practices. Its trade surplus is also surging –2024 is likely to end with a record Chinese trade surplus of around US$1 trillion ($1.3 trillion). Moreover, the massive industrial investment currently underway in China will result in industrial capacity being well in excess of likely domestic demand in China in the coming years. Exports will continue to surge, further inflaming sentiments against China. The trouble is China’s uniquely efficient eco-system makes Chinese exports super-competitive, and the sheer scale of its economy means that such export surges can be very damaging to competitors in importing countries.
This is why a wide range of countries, including Thailand, Indonesia, Brazil, Mexico, and South Africa, have resorted to trade restrictions on Chinese exports in recent months. Many of these countries are friends of China. But when their domestic producers in sectors such as steel or consumer goods suffer losses, political leaders feel they must react to protect their own interests. In short, there is every reason to believe that we will soon be in a global trade war.
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What are the implications of a trade war?
How badly the world economy will be hit by expanding protectionism will depend on three factors — how vulnerable the world economy is, the strength of offsetting factors that could boost growth, and how much policy space governments have to use domestic stimulus to counter the downturn in trade.
The world economy is not robust, and a trade shock could cause a painful slowdown.
It is not clear that the American economy’s extraordinary resilience can be sustained, even if the tax cuts that Trump has promised help boost demand. The monetary tightening of the past two years will exert a drag as more companies find they have to refinance loans at much higher rates. Furthermore, Trump’s tariffs and loose fiscal policy are likely to raise inflation. So, the Federal Reserve will not cut rates as much as once expected. Moreover, other radical moves planned by Trump, such as a crackdown on illegal immigrants and unwinding Biden’s massive incentives for re-industrialisation, will generate great uncertainty, which in turn would cause capital spending to weaken. Trump’s tax cuts are also likely to widen the budget deficit and push up bond yields, raising borrowing costs and slowing the economy.
The Chinese economy appears to be finally stabilising in response to stepped-up support measures. However, the recovery is limited, and strong headwinds remain from the property market shakeout and despondent consumers and companies that are cutting back borrowing rather than taking out loans to expand capacity.
As discussed earlier, Europe and Japan remain quite weak as well.
Some positive forces might support growth, but we wonder whether they will be enough. For example, oil prices have eased recently, providing a respite to oil-importing countries through a fall in energy costs.
However, whether oil prices can continue to help global growth hinges on a stable Middle East. If, as we believe likely, an escalation in the conflict between Israel and Iran is on the cards, we could see oil prices spike.
The boom in AI and the high returns offered by other advances, such as in biomedical science or renewable energy, are also encouraging impressive capital spending. However, companies may well choose to wait and see how the trade wars unfold before committing to such investment.
And then, of course, governments may respond to a trade-induced slowdown by cutting interest rates and ramping up fiscal spending. China still has substantial room to increase public investment and provide incentives to consumers to spend more. Whether the amount of fiscal stimulus that is practically possible will suffice to overcome what is likely to be a very sharp trade shock is, however, moot.
The risks are to the downside
In essence, we believe that Trump is serious about employing aggressive and wide-ranging tariffs, that this will spark retaliation and a trade war and that the offsetting factors that could mitigate the impact on the world economy are probably not strong enough.
The potential damage to countries in our trade and investment-dependent region will be considerable. The US is likely to target countries such as Vietnam, which has seen a big surge in exports to the US.
Given how fraught with risks the coming year will be, a strong response is vital. First, as tariffs are used to intimidate countries into making concessions, organising a collective response will help — there is, after all, strength in numbers. Asean needs to overcome differing views within the region on trade policy and promote a joint response. It can then leverage the region’s strategic importance to the US and China to push for better trade treatment.
Second, individual countries need to use fiscal policy aggressively to bolster demand. Central banks could ease monetary policy, but we suspect that there is limited room for rate cuts because of currency risks: As tariffs are employed against China, the Chinese yuan is likely to weaken. That will create even more downward pressures on the regional currencies — not a promising backdrop for central bank easing. Thus, the burden will have to fall on fiscal policy.
Finally, regional policymakers should extend efforts to ensure that foreign investment continues to flow into the region. The trade conflicts will probably accelerate the relocation of production out of China. Southeast Asia has already seen a rise in foreign investment. But more needs to be done to make doing business easier and strengthen each country’s ecosystem with better infrastructure and better-trained workers if more countries in the region are to benefit from this reconfiguration of supply chains.
In other words, it is going to be a rough ride, but the region is not without agency. Concerted policy actions can help the region buy time and absorb the trade shocks.
Manu Bhaskaran is CEO of Centennial Asia Advisors
