Storm Over The Pacific: US-China Trade by Benjamin Tal and Katherine Judge

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1 In Focus July, 8 <T_E> <T_S> ECONOMICS <P_E> <P_S> Avery Shenfeld () 9-7 avery.shenfeld@cibc.com Storm Over The Pacific: - Trade by Benjamin Tal and Katherine Judge Benjamin Tal () 9-98 benjamin.tal@cibc.com Andrew Grantham () 9-9 andrew.grantham@cibc.com Royce Mendes () 9-7 royce.mendes@cibc.com Katherine Judge () 9-7 katherine.judge@cibc.com is less vulnerable to a trade war than it was a decade ago. But it is still no match for the. Regardless of how you look at it, will be the biggest loser. It still relies heavily on demand while its retaliation arsenal is lighter than its counterpart. And with the directly targeting s soft spot, its aspiration to become a dominant high-value-added manufacturer is in jeopardy. Our base case scenario is that and the return to the negotiating table as opposed to engaging in a full-blown trade war. The global economy and can live with that scenario. The alternative, however, is not so pretty. The Current Landscape In April, - tensions resulted in the early stages of a trade scuffle and intensified on July th when the Trump administration imposed tariffs on an additional $ billion in Chinese exports. That prompted to implement tariffs on an equal value of goods. While not entirely unexpected given the exchange of rhetoric in early April, subsequent threats made by President Trump suggest that the scale of tariffs has the potential to hit $ billion in Chinese goods, covering virtually all of the goods that exports to the. The recent tariffs imposed by Trump steer clear of most finished consumer products aside from vehicles, but American manufacturers will see input costs rise on account of tariffs on capital and intermediate goods. Namely, the goods that aimed to expand production of under the Made in plan have been targeted. American producers will also see demand dented by s retaliatory tariffs imposed on $ billion of goods. The production of those goods is skewed towards Republican states, with meat and agricultural products, aircraft and vehicles comprising most of the list. Recent turbulence related to the operation of tech companies in each country has also seen computer chips added to that list. However, doesn t have the scope to match the dollar-for-dollar on tariffs. Indeed, currently Chinese-imposed tariffs represent less than two-tenths of a percent of GDP, something that will limit the impact of s actions on the economy. So, will be forced to look at more creative ways of retaliating given that the total value of goods imported amounts to only about one-quarter of total Chinese exports to the. That could mean a boycott of brands regardless of where the products are produced or using a devalued currency to boost competitiveness. CIBC Capital Markets PO Box, Bay Street, Brookfield Place, Toronto, MJ S8 CIBC () 9-7

2 Chart Intermediate Goods Dominate Global Trade Chart is Less Export Dependant But is Still No Match for 8. $ Trillion Primary Intermediate Consumer Capital Exports as a % of GDP Share of total exports, % Level, 7 exports to exports to Source: World Bank, CIBC Source: ITC, World Bank, CIBC A Trade War A Bad Idea First let s establish that trade wars are not bullish for global growth. There is ample evidence in the literature for the growth benefits of enhanced trade, and numerous studies showing that rampant protectionism served to deepen the Great Depression. We also should establish that trade wars make little sense in a world in which the largest and fastest growing stage of processing in global trade is intermediate goods (Chart ). Higher tariffs interfere with smoothly running supply chains and exacerbate the damage of protectionism on global growth. One more thing to establish is that when it comes to trade with, Trump is right. There are legitimate grounds for questioning aspects of Chinese policy. The issue is not only a lack of reciprocity and market access, but also the absence of a level playing field in for American investors and allegations of intellectual property rights violations. Some examples: imposes a % tariff on new car imports from the while facing only a.% tariff. A company offering cloud services to Chinese users must store the data in and use a Chinese partner to operate the servers. And s main sectors such as cars, telecoms, IT and healthcare are basically off limits to any company. Damage Assessment oriented, with exports accounting for close to % of GDP almost half the share seen a decade ago. But that s still high when compared to the % level seen in the. What s more, the accounts for 9% of s exports while accounts for only 8% of exports (Chart ). Furthermore, the composition of trade surplus appears to show that recently, s dependency on the has been on the rise, as the was the only major region seeing an increase in net imports from in 7. Another dimension of Chinese vulnerability is that corporate, facing heightened domestic competition, has been relying more heavily on foreign revenue. By some estimates, foreign income now stands at close to % of total revenue almost double the share seen a decade ago. Retaliation of course can retaliate, but the more you look at it, the more you realize that Beijing does not have many options. To be an effective retaliatory weapon, the targeted export products should be those that rely heavily on Chinese demand, and at the same time, are easy enough for to replace with other markets. That s a tough combination. For the vast majority of products, the has a broad destination base, making it very difficult for to find products that can notably damage the (Chart, left). The impacts of a tit-for-tat tariff war would be asymmetrical, with more vulnerable than the. Yes, s economy is now much more domestically The combined value of export products that rely on for more than % of its shipments amount to less than % of total exports (Chart, right), and

3 Chart Doesn't Dominate Exports for Many Products Chart Targeting Made in 's share of exports for highest products, 7 % Level Exports to as a share of total exports to World, 7, % Level Made in Next-generation information technology (IT) High-end numerical control tolls and robotics Aerospace equipment Ocean engineering equipment and high-tech ships Advanced railway equipment Energy saving and new energy vehicles % 7% Products where has >% share in exports Products where has <% share in exports 7 Power equipment 8 Agricultural machinery 9 New materials Biomedicine and high-performance medical devices Share of "Made in " covered by targeted products The rest Source: ITC, CIBC Source: TR, Natixis, CIBC a much lower share of that already tiny segment have reliable substitutes elsewhere. Aviation is of course a candidate for retaliation, with accounting for no less than % of exports in that sector, but there could be issues with delivery times. Agriculture, where accounts for % of exports is another choice and it s no surprise then that those products dominate s retaliation list. But by doing so, the Middle Kingdom may have fired its last bullets. will be in an even more precarious position if other countries joined forces with the against its practices. That motivation is mostly behind the Administration s official complaint to the WTO, accusing of IP theft and blocking companies from competing in its market. The EU and Japan made their support conditional on the including the WTO in its trade dispute strategy. Beyond tariffs, can make it difficult for businesses operating in by tightening regulations. But pushing too hard here will lead to a similar move by the, as well as encourage multinationals to accelerate the process of migrating to other lower cost countries. is not ready for that. It would work to undermine its domestic financial stability and challenge growth targets, in turn jeopardizing commitments to structural reforms and economic rebalancing. The Real Agenda And those structural reforms are America s prime target. Out of the, products that are subject to a tariff increase as announced by the Administration, close to 7% are high-end exports. Those are directly related to s grand project Made in, aimed at moving the country s manufacturing base up on the value-added ladder by becoming dominant in advanced industries by (Chart ). But reaching that ultimate goal still requires a high volume of Western technology exports ( imports north of $ billion in semiconductors and integrated circuit boards while 7% of global industrial robot shipments go to ), suggesting little ability to retaliate in that space. A big part of s high-value-added aspiration also calls for a large-scale purchase of foreign companies. No surprise then that the Administration is making it increasingly more difficult to make acquisitions. The Committee on Foreign Investment, with its recently enhanced power, has already blocked north of six billion dollars worth of takeover proposals over the past year alone. And a side bonus of such a targeted approach is that the can avoid a broadly based tariff increase, thus limiting the damage of such a move on American consumers. Of course, can always use its treasury holdings as a weapon but as we outlined in our March 9 th issue of The Week Ahead, that treasury holding is not an act of charity, but an element of exchange rate policy. So when Wilbur Ross stated recently that he perceived the strong stance on trade as a pressure tactic on to bring concession without escalating into a broader

4 conflict, surely he had s limited ability to retaliate without inflicting notable damage to its own economy in mind. Chart a Crucial Market for s Pork (L), Producers May Face Increased Competition in (R) Protectionism is No Zero-sum Game for Yes, the far surpasses in terms of its share of Canadian exports, but the Chinese market has accounted for a growing share of Canadian goods. And while the implementation of tariffs on American goods in could divert demand towards Canadian goods in theory, displaced American exports could result in increased competition for Canadian goods elsewhere. But the negative impact on consumption in the is muted as the goods facing tariffs are less than % of GDP. Agricultural Exports Have Little Room for Expansion.. 9. % share of growth in pork imports, $Bn Possible increase in competition from producers Pork Exports Source: ITC, CIBC has gained market share in Chinese imports of agricultural goods, one of s prime tariff targets, at the expense of the. Any price increase in American seeds and grains could cause substitution towards Canadian goods. But even when accounting for industry estimates of soybean production capacity, which is expected to double over the next decade, Canadian production won t even come close to replacing American grown soybeans (Chart ). And, American soybeans could be diverted to the Canadian market, harming domestic soybean production. In the same vein, tariffs on American pork also present limited upside potential for Canadian producers, given their outsized reliance on the market for demand. Over one-third of Canadian pork exports are -bound. If American pork floods the market, % of Canadian pork exports could face increased competition in the (Chart ). Production Capacity Constraints Are a Concern Even if were to levy tariffs on other American goods that overlap with Canadian exports there, would stand to gain little due to a lack of available production capacity (Chart 7). Specifically, has lost market share to American producers of plastics, autos and aircraft. Even if the tariffs are high enough to cause substitution toward Canadian goods, subdued business investment prospects would limit any near-term response by producers. Chart Has Little Room to Ramp Up Soybean Exports to 8 oil seeds and grains imports, $Bn. 7 7 Billions of bushels of soybeans produced 7 7 Capacity Chart 7 Competes With the in (L), But Has Little Production Upside (R) % Growth in Chinese Imports, 7-7 Capacity Utilization, % Q -8 Avg. Source: ITC, Statistics, DA, Soy, CIBC Source: ITC, Statistics, CIBC

5 Limited Exposure in the EU The may divert exports to the EU, where over threequarters of Canadian exports compete directly with the, but the effects on would be minimal because agriculture and aerospace products destined for the EU make up less than % of s overall exports. Indeed, has been sending a smaller share of goods to the EU since, and the newly minted CETA deal with the EU will enhance our competitive advantage in that market. There May Be Some Wins in the Canadian producers could stand to gain market share in industries that have dealt with increasing Chinese competition in the. Much of the trade that conducts with the deals with intermediate and capital goods, but in recent years, has gained notable market share in imports of capital goods, at the expense of. This is true in both the machinery and electrical equipment industries, which face potential tariffs (Chart 8). Although capacity utilization remains strained in the former industry, electrical equipment producers have room to ramp up production by 9% relative to the previous expansionary peak capacity utilization level. Chart 8 's Exports to the Have Suffered From Chinese Competition Change in % share of imports, ppts, -7 Autos Aerospace Total Pharma Elec. Equip Machinery Source: Census Bureau, CIBC Still, our discussion of the impacts of a lasting trade war looks at what we see as a less-than-likely scenario. With vulnerable to such a trade war expect Beijing to ultimately seek a mediated truce with the on some of America s most pressing concerns. CIBC World Markets Inc., CIBC World Markets Corp., CIBC World Markets Plc., CIBC Australia Limited and certain other corporate banking and capital markets activities of Canadian Imperial Bank of Commerce operate under the brand name CIBC Capital Markets. 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