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The global economy was on a roll. Then the U.S. started a trade war with China, and it’s only getting nastier. Now, the stability of the world economy hangs in the balance

Eric Chow/Eric Chow

In the spring of 2018, a lot of things looked right in the global economy.

World gross domestic product was growing at its fastest pace in six years, and looked to still be accelerating: The International Monetary Fund’s World Economic Outlook projected growth of nearly 4 per cent in each of the next two years. What’s more, the growth looked “synchronous,” as the economists put it – not just strength here and there, but a broad swath of the world simultaneously on the upswing. The value of global trade was expanding at a healthy 6-per-cent annual clip.

Central banks – including those of the United States and Canada – were raising interest rates, in recognition that their economies, already running at full speed, no longer needed the stimulation that low rates had long been providing. After a decade of ups and downs, the world finally looked to be in a (more or less) full recovery from the 2008 financial crisis.

That’s when the world’s biggest economy, the United States, fired the first shots in a trade war with the world’s second-biggest economy, China.

In the ensuing 16 months, as each side has raised tariff walls against each other and China-U.S. trade talks have gone nowhere, the dispute has cast an ominous cloud over that once-bright outlook. Optimism has been replaced with fear. Synchronous growth has been supplanted by synchronous slowdown. It’s increasingly apparent that this dispute threatens to knock the wind out of the global economy and financial markets. And while Canada’s economy has so far held up better than most, there’s little doubt our heavily trade-dependent economy stands in the crossfire.

Over the past week the gloom took its darkest turn yet: U.S. President Donald Trump threatened a new round of sweeping tariffs against Chinese goods, China responded by allowing its currency to devalue, and the U.S. formally declared China a “currency manipulator” – opening a dangerous new front in the war.

The fear sparked in global financial markets was visceral. Bond yields plunged to record lows, commodity prices tumbled, stock markets whipsawed and currencies gyrated violently. By the time the dust had settled, the inversion of the U.S. yield curve – in which yields on short-term bonds are higher than longer-term bonds – was the deepest in nearly two decades. That’s an emphatic signal that the markets are bracing for a recession, with the trade war as the catalyst.

At the root of this increasingly worrisome feud is a Trump administration that views China as its economic enemy, and looks determined to pursue a Chinese trade policy based more on confrontation than co-operation. This fear of China, and a determination to rein it in, have led us to this high-stakes game of chicken. The stability of the global economy hangs in the balance.

Donald Trump, then a presidential candidate, delivers a speech at the Alumisourse Building in Monessen, Penn., in June, 2016.Louis Ruediger/Reuters

The battle begins

Underpinning the Trump administration’s trade issues with China is a belief among the President and his key advisers that the United States made a big mistake nearly two decades ago, when it orchestrated China’s entry into the World Trade Organization. Hardliners led by senior trade adviser Peter Navarro, along with U.S. Trade Representative Robert Lighthizer, are convinced China’s centralized government never intended to pursue truly free markets and fair trade. They see a Chinese economy that has grown into a major U.S. competitor by exploiting the trade liberalization afforded it by WTO membership, and at the expense of U.S. manufacturing jobs. They now appear intent to put the genie back in the bottle.

But this runs deeper than simply levelling the trade playing field. There’s a sense it has more to do with the United States feeling its place at the top of the global pecking order threatened – a desire to halt China’s march to supplant the U.S. as the dominant world power, abetted by a permissive world trade order that has allowed it to manipulate its gullible Western counterparts.

“There are a lot of people in Washington who have become convinced that they’re in some sort of existential struggle with China,” says international trade veteran Robert Wolfe, a professor at Queen’s University in Kingston.

(Indeed, Mr. Lighthizer last year called China’s trade policies around intellectual property an "existential threat to America’s most critical comparative advantage and the future of our economy: our intellectual property and technology.”)

Mr. Trump’s zeal to launch a tariff war was aided by his confidence that the U.S. could win in short order. China, after all, is a much more trade-dependent economy than the United States; China’s exports are the equivalent of about 20 per cent of its GDP, compared with about 12 per cent for the U.S. What’s more, China exports four to five times as much to the United States as the U.S. ships in the other direction. The assumption was that China, which would feel more pain from the trade war, would blink first and make concessions to strike a deal.

U.S. President Donald Trump meets with China's President Xi Jinping at at the G20 leaders summit in June, 2019.Kevin Lamarque/Reuters

That was a serious miscalculation of the Chinese mentality, says Paul Blustein, author of the new book Schism: China, America and the Fracturing of the Global Trading System.

“Surrendering and kowtowing to foreigners is just unthinkable," Mr. Blustein says. "They’d rather ‘eat bitterness’ – that’s the Chinese term for accepting some kind of lower living standards, if you have to, in order to keep your national pride.”

Mr. Trump’s latest volley in the trade war will shift the bitterness closer to home. The U.S. tariffs imposed so far, on US$250-billion a year of Chinese goods, have focused on imports that don’t hit U.S. consumers directly – they’re mostly intermediate inputs in the manufacturing process. But the additional US$300-billion a year of Chinese goods that Mr. Trump has threatened to hit with tariffs beginning Sept. 1 (starting at 10 per cent and eventually rising to 25 per cent) represent everything else China sends to the U.S. market – including consumer products such as electronics, toys, sports equipment and clothing that dominate U.S. retail shelves.

“The White House now appears prepared to impose increased and visible costs directly on its voting base,” Bank of Nova Scotia economists Brett House and Juan Manuel Herrera say in a recent research report.

Meanwhile, many observers worry that this week’s clashes between the United States and China on the currency front opens a dangerous new avenue in the dispute – one where the two countries race to devalue their respective currencies to make their exports more price-competitive, in order to counteract the damage from the tariffs. A wave of what trade experts refer to as “competitive devaluations” – involving not only the key U.S. and Chinese currencies, but quite possibly triggering similar keep-pace moves by other countries – would introduce a new and highly destabilizing component to world finances.

“If this is the beginning of a new and dangerous phase of the trade war, then all bets are off,” IHS Markit chief economist Nariman Behravesh said in a research note. “The ensuing financial fire storm could push the U.S. and global economies into recession.”

Canada vulnerable

The basic economic math surrounding tariff wars is pretty simple. A tariff increases the cost of importing a good, and that increased cost could either take a bite out of an importer’s profits, or be passed along to the importer’s customers in the form of a price increase. Either way, the tariff eats into disposable income and discourages consumption, while increasing inflation. Done enough times with enough products in enough markets, the cumulative impact is to slow economic activity and decrease trade. When that involves economies as big as the United States and China, in a global economy that has become highly integrated, the drag on their activity is certain to spill over to other trading partners, too, leading to a generalized slowdown.

Sixteen months in, the U.S.-China dispute has already demonstrated that effect. World GDP has slowed appreciably, with waning export demand cited repeatedly as the biggest drag on growth. The IMF has steadily lowered its forecasts, recently reducing its 2019 growth projection to 3.2 per cent. World trade growth has evaporated; new orders for future exports are in decline, implying further slowing to come. The newest U.S. threats to greatly expand its tariffs against China – and the near-certainty that China will retaliate – will only deepen and extend the slowdown.

While the whole world will pay a price for this trade war, Canada looks particularly exposed. Not only is the Canadian economy heavily dependent on trade – exports are equivalent to nearly one-third of Canada’s GDP – the United States and China are Canada’s two biggest trading partners, accounting for a combined 80 per cent of Canada’s exports and 70 per cent of its imports.

The ties are, of course, particularly tight with the United States, with which Canada shares its only border and fully 70 per cent of its total two-way trade. Scotiabank’s Mr. House says Canada will chiefly feel the impact of the tariff war through its drag on U.S. growth, which would translate to slower U.S. demand for Canadian exports; the upward pressure from the tariffs on U.S. inflation and how that could affect U.S. interest rates; and the resulting impact on the exchange rate between the Canadian and U.S. dollars.

Canadian goods exports by destination

Percentage of total value in June, 2019





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Canadian goods exports by destination

Percentage of total value in June, 2019





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Canadian goods exports by destination

Percentage of total value in June, 2019





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On one hand, it’s hard to see how even the latest prospect of greatly expanded U.S.-China tariffs would send Canada’s economy anywhere near a recession. Scotiabank calculated that the near-term direct economic impact of this latest threatened round of U.S. tariffs would shave a modest 0.11 percentage point off Canadian GDP growth in 2020. If Mr. Trump followed through on his threat to gradually increase those tariffs to 25 per cent from an initial 10 per cent, Scotiabank estimated the hit at more like 0.28 percentage point.

With the Bank of Canada projecting last month that the economy would grow by about 1.9 per cent next year, the damage from another U.S.-China tariff escalation would be meaningful, but not enough to grind growth to a halt. And if the Canadian economy is feeling the pressure, it has a funny way of showing it: Estimates suggest that the second quarter was Canada’s strongest quarter for growth in two years.

However, other less-direct economic consequences are harder to quantify – and potentially more serious. Economists worry that business and consumer confidence, not just in the United States and China but around the world, could be profoundly shaken with further escalation, especially the longer the dispute drags on with no signs of a resolution. If rising uncertainties cause consumers to retrench, and cause businesses to put off investing in new equipment and facilities, the resulting slowdown in economic activity could dwarf the more direct impacts of the tariffs.

The introduction of the currency wild card this week has added a highly unpredictable, and potentially highly disruptive, new element to the situation. It was perceived as a major step up in risk by the financial markets, which some observers have felt have been too complacent about the trade war until now. The resulting plunge in bond yields around the world – including in Canada, where the 30-year government bond hit a record low of 1.48 per cent – and the deep inversion of yield curves effectively signal that the global bond market now sees the risk of a global recession as very real.

For Canada, how the market drama played out in the commodities sector was a particularly dire warning. Oil prices slumped 13 per cent in a few days, leading a generalized slide in commodity prices, reflecting fears that a deeper global slowdown would gut demand for raw materials – not the least from the United States and China themselves, who are the world’s biggest commodity consumers. Given Canada’s position as a major exporter of a wide range of commodities, and oil in particular, the commodity slump played out in its currency, too, as the Canadian dollar lost a full cent against its U.S. counterpart.

The Bank of Canada will be under increased pressure now to follow other central banks that have begun moving swiftly, and in growing numbers, to cut interest rates to shore up their economies against the rising risks. The U.S. Federal Reserve cut its key rate by one-quarter of a percentage point last week, prior to the latest escalation in trade tensions, citing trade risks as a key concern. Following the new actions, New Zealand’s central bank raised the bar by cutting a half percentage point this week. The market has now priced in about an 80-per-cent likelihood that the Bank of Canada will cut its rate by a quarter-point before the end of the year – up from a 20-per-cent chance just 10 days ago.

What’s striking, Scotiabank’s Mr. House says, is that this rapid slide into talk of recession is coming at a time when, at least in Canada and the United States, there are few if any economic indicators pointing to a downturn. Both countries have solid growth and full employment.

“We wouldn’t be talking about recession at all in Canada and the United Sates, were it not for those trade battles,” he says. “It’s really an ‘own goal’ that’s being kicked here by the White House.”

“It makes no sense to be doing what [Mr. Trump] is doing.”

Trade War Timeline

March 1, 2018: Trump announces upcoming tariffs of 25% on steel imports and 10% on aluminum imports.

March 22, 2018: Trump unveils plan to levy tariffs on up to US$60-billion of Chinese goods.

April 4, 2018: China publishes list of U.S. imports it would target in retaliation.

July 6, 2018: First wave of U.S. and Chinese tariffs go into effect.

July 10, 2018: The U.S. unveils plans for 10% tariffs on US$200-billion of Chinese imports. They take effect Sept. 24, 2018.

Aug. 1, 2018: Trump orders an increase on those tariffs to 25%. They are later scheduled to take effect Jan. 1, 2019.

Dec. 1, 2018: The U.S. and China agree to 90-day halt to new tariffs as they negotiate. The U.S. delays its incoming tariff hike.

May 8, 2019: With trade talks faltering, the U.S. issues formal notice the delayed 25-per-cent tariff will take effect May 10.

May 17, 2019: U.S. reaches deal to lift steel and aluminum tariffs on Canada and Mexico.

June 29, 2019: At the G20 meeting, the U.S. and China agree to restart trade talks.

Aug. 1, 2019: After little progress, Trump says the U.S. will levy 10% tariffs on an additional US$300-billion of Chinese goods. This could take effect Sept. 1.

Aug. 5, 2019: The U.S. designates China a currency manipulator, shortly after China let its renminbi weaken beyond 7 per U.S. dollar.

Approaching the edge

By the same token, what the U.S. President does next is equally hard to predict – especially with its decision to formally label China a currency manipulator.

“It’s a dangerous move on the part of the United States that’s not been thought through,” says Tom Bernes, Distinguished Fellow at the Centre for International Governance Innovation in Waterloo, Ont., and a former senior official at the International Monetary Fund.

A logical next step would be to petition the IMF – which, among other things, polices currency manipulation – to investigate China’s actions in currency markets. But the IMF as recently as last month concluded that China’s currency was fairly valued – effectively a determination that China hasn’t been artificially driving its currency lower for its own economic gain, the basic definition of manipulation.

Since Mr. Trump has open disdain for multilateral economic institutions such as the IMF anyway, he may take matters into his own hands. He may use the currency-manipulator label as justification to have his own government intervene in currency markets, either to push China’s yuan higher or to devalue the U.S. dollar. Such a move would risk seriously destabilizing financial markets, which would have deep concerns with the government imposing its will on the currency market.

But many observers viewed China’s decision this week to allow its currency to fall as essentially a shot across the bow – calculated to show the United States how easily it could devalue its currency if pushed to do so, and perhaps to roil financial markets in the process. Mr. Trump has always been highly sensitive to downturns in the stock market; the market turmoil triggered by this week’s currency spat may convince him that further moves on the currency front would jeopardize the healthy markets that he cherishes, especially with the presidential election year fast approaching.

Similarly, some observers question whether he will go through with his threatened next round of tariffs, given the likely negative reaction the voting public to the resulting jump in prices for popular consumer goods. Rather, they believe the threat is aimed at turning up the heat on China to strike a deal – typical of Mr. Trump’s negotiating style.

“Ultimately, the failure to reach a trade deal would weaken the U.S. economy, undermining Trump’s re-election prospects. ... He does not want that,” writes Peter Berezin, chief global strategist at BCA Research, an independent economic and financial-markets research firm based in Montreal.

Bad precedents, frayed relationships

Regardless of whether the United States and China can find a way to dial down their tensions or even reach some sort of trade agreement, a dangerous precedent has been set. Mr. Trump’s distaste for key international institutions, and the global rules-based multilateralism that they engender, has led the world’s most powerful economy to toss aside the global trade rule book and wield tariffs as a weapon in pursuit of “America First” self-interest. What’s more, he has brought China outside the rule book with him – and so far, China has been willing to come along.

But the lessons of 20th century history have shown that tariff wars and other forms of beggar-thy-neighbour economic aggression have not only proven to be economically destructive. They have contributed to the build-up of ill will that, ultimately, fuelled two world wars.

“I don’t think disputes over trade lead to war, but they can certainly add to add to mutual hostility and tension,” says historian Margaret MacMillan, whose book The War That Ended Peace chronicled the deteriorating geopolitical relationships and economic aggression that preceded the First World War. After all, she reminds us, “Before the First World War, Britain and Germany were each other’s biggest trading partner.”

Ms. MacMillan worries that perhaps the most troubling aspect of this trade war is the distrust it is fostering between the world’s two superpowers.

“You’ve got people on both sides now saying that the other is an enemy – or hostile, or at least not a friend,” she says. “That is worrying, because once you begin to say it, then you begin to take it for granted. It’s a sort of self-fulfilling thing – if China sees the U.S. as its opponent, then everything the U.S. does starts to feed into that, and vice versa.”

“It’s adding up to a rather troubled relationship.”

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