Donald Trump’s latest threat to raise tariffs on $US200 billion in Chinese imports from 10 per cent to 25 per cent starting on Friday and to impose a 25 per cent tariff on a further $US325 billion "shortly" thereafter should unsettle financial markets.
Many will view the threat as Trump seeking to maximise US leverage as the US-China trade talks grind on. But the latest tariff threat further complicates the negotiations. A key sticking point has been under what conditions the existing tariffs will be lifted.
The US wants to reserve the right to maintain, unilaterally re-impose or increase existing tariffs until China is deemed to be compliant with the deal, without any corresponding rights or recourse by China.
If the final deal makes provision for unilateral snap-back tariffs at the discretion of the President in response to Chinese non-compliance, then the uncertainty unleashed by the Trump's tariff war will be largely unresolved, with tit-for-tat tariffs becoming a permanent feature of US-China trade relations.
The US-China negotiations were always going to be tough and the original March 1 deadline unrealistic. A relevant comparison is the 10 years it took Australia to conclude a free trade agreement with China. What the US is seeking is far more comprehensive than anything Australia tried to negotiate.
Trump has been preoccupied with a market access deal for Chinese purchases of US goods, applying over as many years as it takes to generate a large headline number designed to flatter the deal and window-dress the US-China trade balance.
But the President is the only person preoccupied with the bilateral trade balance. Increased Chinese purchases of mostly fungible US commodity exports will come at the expense of non-US producers, who will then find other markets apart from China.
The more important issues are the long list of structural changes the US is asking China to make, changes that go to heart of the Chinese Communist Party’s control over the economy. These include access to Chinese markets by US firms, protection of intellectual property rights from forced technology transfers, exchange rate management, subsidies and lending to state-owned enterprises.
Much of what the US is asking for is actually in China’s long-term economic interests. However, under President Xi, the Communist Party has prioritised the power of the party-state over economic growth, one of the reasons why China’s economy is slowing.
The Party is willing to sacrifice economic growth to maintain control, although it also faces the dilemma that weaker economic growth will further undermine the legitimacy of the regime.
China could easily neutralise US tariffs by allowing greater flexibility in its exchange rate. Recognising this threat, the US has sought commitments from China to maintain a steady exchange rate, effectively demanding that China maintain a managed exchange rate regime.
The US is now willing to let China manipulate its own currency, so long as it does so in a way that protects US interests, a radical departure from the traditional US advocacy of flexible exchange rates.
For its part, China sees the exchange rate and the associated capital controls as a key instrument of state control. Ironically, the managed exchange rate invites speculative capital flight, as Chinese citizens seek to pre-empt the possibility of future depreciation or devaluation. A floating exchange rate would eliminate the incentive for pre-emptive capital flight, but the Communist Party is reluctant to give up its control over the currency, and now has the blessing of the US government to maintain that control.
While conventional wisdom holds that both sides have a strong incentive to conclude an agreement, financial markets should not underestimate the potential for the talks to end in failure. Even if a deal is struck, the threat of higher US tariffs will be an ongoing issue.
The President started his trade war with the rest of the world with no clear off-ramp or end-game. The US-Mexico-Canada Agreement (USMCA) still has to make its way through Congress, with US steel and aluminium tariffs remaining in place against the other parties to the agreement. Key Republican Senator Chuck Grassley has said USMCA is dead in Congress if the steel and aluminium tariffs are not lifted.
The US-EU and US-Japan trade talks are still in their early stages, with the threat of increased tariffs hanging over them.
The President has until May 18 to respond to a Department of Commerce investigation – requested by Trump – into the national security case for increased automotive tariffs, further muddying the global trade outlook and threatening multi-billion dollar global supply chains.
Australia exported $214 million in automotive-related goods to the US in 2018. While Australia escaped the steel and aluminium tariffs through some deft diplomacy, we may not be so fortunate when Trump turns his attention to cars.