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Trump Trade War Risks

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During the presidential campaign Donald Trump threatened to drop out of trade deals such as the TPP, renegotiate NAFTA, and impose import tariffs of 35% on Mexico and 45% on China. The post-election financial markets rally and increase in business confidence are based on expectations that Trump’s threats on trade policy were not credible, especially given the strong pro-trade positions of Republicans in congress.

However, President Trump has significant powers to unilaterally raise trade tariffs without congressional approval. Both the Trading with the Enemy Act of 1917, and the International Emergency Economic Powers Act of 1977 allow the president to impose unlimited tariffs. According to legal experts, the current war against various terror organisations would be sufficient grounds to use the Trading with the Enemy Act, and there is no need for an actual war against a country to impose tariffs on it. The International Emergency Economic Powers Act could also be used, if president Trump declares the ongoing loss of jobs in manufacturing as an emergency. Congress and court challenges may ultimately reverse usage of these acts to raise tariffs, but these challenges could take years to succeed if at all.

Our baseline forecasts assume modest increases in tariffs on specific industries, together with continuing pressure by President Trump on individual companies and industries to maintain jobs in the US. However, we have added a new Trump Trade War scenario to quantify some of the risks of Trump’s protectionist policy proposals. In this scenario, the US raises tariffs on Chinese imports to 45%. Trump pulls the US out of NAFTA and renegotiates a separate trade agreement with Canada, keeping relatively low US-Canada trade barriers. However, he raises tariffs on Mexican imports to 35%.

Trump and members of his cabinet have also singled out other Asian countries as responsible for the continuing US trade deficit and declining manufacturing employment. In our scenario, this leads to large but smaller tariff increase on other Asian economies to an average of 15-20%. The countries subject to higher US tariffs retaliate with approximately symmetric tariff increases on US imports.

The higher tariffs directly raise US import prices and lower imports. However, lower US demand for foreign currencies leads to a USD appreciation (by 11% against the Mexican Peso and by 5-7% against Asian currencies), and exporters to the US absorb some of the extra costs through lower profit margins. These effects dampen the rise in import prices for US consumers and the decline in imports. The USD appreciation and the retaliation tariffs on the US from Asia and Mexico lead to higher US export prices. As a result, US exports decline, and the change in the trade deficit after 2-3 years is close to zero.

Source: Euromonitor International Macro Model

Higher import tariffs reduce US consumer spending and increase distortions in the economy by forcing households and businesses to switch to more costly domestic substitutes. The reduction in potential export markets, lower competition from foreign firms and lower incentives to innovate decrease long-term productivity levels. Higher production costs and lower exports lead in turn to a decline in business investment.

The extra tariff revenues are used to cut income and corporate taxes and increase government spending, offsetting some of the negative effects of the tariffs. However, US annual GDP growth still declines from 1.8% to 1.4% in 2017-2021.

Asian economies and Mexico suffer significantly from declining exports to the US, despite the depreciation of their currencies against the USD and some substitution into other markets. Business investment and household consumption also decline due to lower exports revenue. The imposition of higher tariffs on US imports counters some of these effects by increasing demand for domestic output, but at the same time it reduces consumer spending even more.

Lower exports also reduce long-term labour productivity in Asian economies, through reduced incentives for business and product innovation, and a reallocation of economic activity from high productivity export sectors to lower productivity domestically focused sectors. China’s annual GDP growth in 2017-2021 declines from 5.9% to 4.9%. The impact on other Asian economies is more moderate, but by 2021 GDP levels are lower by 2-3% relative to the baseline forecast.

Source: Euromonitor International Macro Model

In Mexico, the rise in trade barriers to the US causes a more general loss of confidence in the economy and a spike in the country risk premium. The Banco de Mexico responds to the resulting devaluation and higher inflation through large interest rate increases. Rising costs of borrowing and foreign debt repayment, combined with lower private sector confidence, cause a sharp contraction in consumer spending and business investment. As a result, Mexico enters a deep recession, with GDP falling by almost 10% below the baseline forecast after five years.

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