Yesterday saw the long-awaited announcement by the US government of a further $200bn of tariffs on imported goods from China. This instantly quadrupled the amount of tariffs previously implemented.
But even more serious was the pledge that the current 10 percent tariff level would rise to 25 percent on January 1 2019 unless China was to back down in the escalating trade war.
Late last month, KPMG Australia published a report Trade wars: there are no winners that analysed three scenarios.
The first scenario became reality today with the $200bn tariffs. Our modelling predicts this will hit the Australian economy by $36bn over the next decade – a GDP reduction of 0.3 percent.
The second scenario will come true on New Year’s Day, as things stand, with the higher rate of tariffs. This, we predict, will cost Australia $58bn – a GDP hit of 0.5 percent – over the next ten years.
The third, dreaded, scenario is when activity does not remain limited to the two protagonist countries, but where other worried nations start to take retaliatory action and an all-out trade war begins.
This could end in a world recession, with the global economy being hit by more than 3 percent. Over five years national income would reduce by about $350 bn that in present value basis equates to about 40 percent of national income in 2018.
Why would other countries want to join in? Not for any sense of misplaced bravado but simply because the excess goods, that build up in the US and China when they cannot trade with each other, have got to find a home. And with free trade arrangements, those goods could easily end up being imported cheaply by other countries – good for their consumers but bad news for domestic producers.
It is clear governments would come under internal pressure to take action and the obvious way to do so would be to raise their own import duties.
While the trade balances between the US and China are largely unaffected so far by the skirmishes, we are already seeing business inventories in both countries take a slight uptick in July, reflecting an increasing level of caution and the first signs of the trade wars influencing business activity.
This increase in inventory build-up in China has occurred despite the Chinese Yuan falling around 6.5 percent since mid-June 2018, theoretically making its exports cheaper.
It is important to stress that KPMG’s modelling is conservative. We have assumed rational behaviour in the financial markets – but a disorderly reaction by the world’s financial markets would worsen the situation considerably.
It seems US financial markets have not, so far, adjusted the interest rate premium applied to businesses – this being the difference between US 10 year BBB corporate bonds and US 10 year government treasury bonds.
But our analysis shows for every 1 percent increase in this interest rate premium, world GDP growth slows by around 1.3 percent. To the extent this premium gets adjusted upwards to reflect greater business risks, then economic outcomes accordingly worsen more than we’ve already predicted.
As a small, open economy anything that negatively influences our trading with other countries is a bad outcome for Australia. The European Union and Japan for example will be affected less than Australia by today’s announcement or the promised tariff hike on Jan 1.
We must hope that some sort of accommodation is reached between the US and China in the next 3 months. Reaching Scenario 1 is bad and scenario 2 will be worse. Scenario 3, we don’t wish to contemplate.