5 October 218 4:33PM EDT The Trade War: Bigger Numbers, Same Conclusion n n n n n n Our perspective on the short-run macro effects of higher trade barriers has been sanguine. This was an easy call earlier this year, when the tariff announcements were tiny relative to US and global GDP. But the numbers have grown substantially in recent months. The US has already imposed tariffs on about $3bn of imports, and this amount is likely to double to $6bn under our assumption that the US ultimately hits all imports from China. It could even climb further to $9bn if the US also imposes auto tariffs not our baseline but very possible. Increasing tariffs and the associated price increases for imported goods have three main economic effects. First, they shift demand toward domestically produced goods. Second, they siphon off real income (assuming the tariff revenue is not recycled via tax cuts or increased spending). Third, they might lead to tighter monetary policy and correspondingly tighter financial conditions if the central bank responds to the (temporary) increase in inflation. Our analysis suggests that even the bigger tariff numbers are likely to have fairly limited macro effects. The hit to the US in our baseline is less than.1%, as a positive trade effect partly offsets the negative income and FCI effects. The hit to China is about.25% in our baseline and.4% in a more adverse scenario of a 25% tariff rate on all US imports from China. Not surprisingly, the numerical results are sensitive to the assumptions we make. On the one hand, the negative US income effect might be smaller than assumed if some of the tariff revenue is recycled into tax cuts or spending. On the other hand, the US trade impact could be more negative if US import demand is less price-sensitive than Chinese import demand. And of course, a sharp drop in US equity prices in response to the trade war or a sizable hit to business sentiment would also take a bigger toll. Our bottom line is that the short-run macroeconomic impact of the trade war is likely to remain manageable. China is moderately exposed but is already trying to offset the hit with easier monetary and credit policy. And the US is unlikely to see a big hit unless the stock market takes a much more negative view of the trade war than what we have seen so far. Jan Hatzius +1(212)92-394 jan.hatzius@gs.com Goldman Sachs & Co. LLC Sven Jari Stehn +44(2)7774-861 jari.stehn@gs.com Goldman Sachs International Nicholas Fawcett +44(2)751-8321 nicholas.fawcett@gs.com Goldman Sachs International Manav Chaudhary +44(2)751-363 manav.chaudhary@gs.com Goldman Sachs International Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html.
We have argued that the trade war poses a manageable downside risk to the global growth outlook. 1 An important reason has been that the implemented tariffs were very small in the early stages of the trade war (Exhibit 1). Investors appear to share this view and the market response to the tariff announcements has generally been quite subdued. 2 Exhibit 1: A Rising Tariff Threat Billions of dollars Billions of dollars 1 8 Proposed Implemented US Imports Subject to Proposed vs. Implemented Tariffs Additional China 31 China 31: Remaining imports 1 8 6 Sec. 232 Autos 6 4 2 Steel & Alum China 31 Tariffs Announced ($5bn) Additional China 31 Steel and aluminum China: +$34bn China: +$16bn China: +$2bn imposed Sept. 24 Washing Machines & Solar Panels Jan Feb Mar Apr May Jun Jul Aug Sep Oct 4 2 Source: USITC, Department of Commerce, Goldman Sachs Global Investment Research The tariff numbers have recently risen quite quickly, however, and we now expect that all Chinese exports to the US will ultimately be taxed. 3 Some analysts have argued that the tariffs will have sharply negative effects on the world economy. ECB economists, for example, estimate that a severe global trade war could hit US real GDP by more than 2% after one year. 4 Bank of England Governor Mark Carney has argued that the effect might be as large as -5%. 5 We therefore take another look at the global economic repercussions of the trade tensions. Large Dollar Numbers We begin with a summary of where the trade war stands and where we might be headed. Exhibit 2 shows the tariffs that have already been implemented, the additional tariffs President Trump has proposed, and our assumptions of how China might respond to such further tariffs. We display the effective dollar value of the tariffs to capture both 1 For the latest discussion, see Sven Jari Stehn and Manav Chaudhary, The Trade War: An Update, Global Economics Analyst, June 25, 218. 2 See Brian Chen, Blake Taylor and David Mericle, Market Reactions to the Trade War in the US and Abroad, US Daily, October 4, 218. 3 See Alec Phillips and Blake Taylor, Why Further Trade Escalation Looks Likely, US Daily, September 2, 218. 4 See Allan Gloe Dizioli and Björn van Roye, Macroeconomic implications of increasing protectionism, ECB Economic Bulletin, Issue 6/218. 5 See From protectionism to prosperity, speech, 5 July 218. 5 October 218 2
the tariff rate and the scope of goods covered (i.e. the product of the tariff rate and the value of goods to which it is applied). So far, President Trump has imposed a 25% tariff on $5bn and 1% on another $2bn in imports from China, in addition to a range of goods-specific duties. 6 We expect him to raise the tariff rate on the $2bn tranche to 25%, as already scheduled for January, and see about a 6% chance of a 1% tariff on the remaining $267bn of imports from China. The resulting effective dollar value of tariffs is around $1bn in our baseline expectation, but it could rise to about $18bn if Trump raises the rate on the remaining $267bn of Chinese imports to 25% and if he also hits auto imports with a 25% tariff as threatened in the past. 7 China retaliated proportionally to the first $5bn with a 25% tariff rate but has responded less than proportionally to the next $2bn, with only a 5-1% rate on $6bn. We would expect the Chinese government to respond less than proportionally to any further increases in tariffs, for example, doubling the tariff rate to 1-2% if the US government goes to 25% on the $2bn and taxing the remaining imports from the US at a 5-1% rate if the Trump administration puts trade restrictions on the $267bn of Chinese exports. We see in Exhibit 2 that these assumptions lead to a much smaller increase in the tariff values levied on imports into China. Exhibit 2: The Tariffs Are Large in Dollar Terms USD, (billions) 2 18 16 14 12 1 8 6 4 2 Tariff Values Plus Autos at 25% Plus $267bn at 25% Plus $267bn at 1% Plus $2bn at 25% Implemented Total: All Threatened Total: Baseline US CN US CN Import Tariff Value Export Tariff Value USD, (billions) 2 18 16 14 12 1 8 6 4 2 Source: USITC, Haver Analytics, Goldman Sachs Global Investment Research Although the dollar figures are large, they are less dramatic when scaled by GDP because both the US and China are very large economies. Indeed, Exhibit 3 shows that the tariffs on US imports are worth only.5% of US GDP and the tariffs facing US exporters are less than.2% of GDP. For China, the tariffs on imports are smaller in our central scenario than the duties facing exporters (at.2% vs.7% of GDP). The trade restrictions are negligibly small for the remaining countries in our baseline, and even if 6 These include tariffs on washing machines, solar panels, steel and aluminum. 7 We exclude Canada and Mexico due to an exemption under the revised NAFTA treaty (USMCA). 5 October 218 3
the Trump administration implements auto tariffs, the tariffs facing Japan are only worth about.3% of GDP. Exhibit 3: But Modest in of GDP of GDP 1.2 Import Tariff Value of GDP 1.2 of GDP 1.2 Export Tariff Value of GDP 1.2 1.8.6 Plus Autos at 25% Plus $267bn at 25% Plus $267bn at 1% Plus $2bn at 25% Implemented 1.8.6 1.8.6 Plus Autos at 25% Plus $267bn at 25% Plus $267bn at 1% Plus $2bn at 25% Implemented 1.8.6.4.4.4.4.2.2.2.2 US JP CN EA BR CA GB RU MX IN CN US JP EA BR CA GB IN MX RU Source: USITC, Haver Analytics, Goldman Sachs Global Investment Research Manageable Effects We then use our global macro model to simulate the economic repercussions of these tariff scenarios. 8 The model is highly stylized, but captures a number of important transmission channels. In particular, domestic demand growth depends on changes in financial conditions; trade flows are determined by demand at home and abroad, as well as exchange rates and tariffs; inflation is driven by slack and pass-through from import prices; and financial conditions are determined endogenously in the model (for example, with a Taylor rule for policy rates). Our model includes five advanced economies (US, Euro Area, Japan, UK and Canada) and five emerging economies (China, Brazil, Russia, India and Mexico). We start by simulating the economic effects of the tariffs that have been implemented so far. In these baseline simulations we abstract from risk premium shocks i.e., we allow equity prices to respond to growth and interest rates but do not impose any additional weakness beyond that and assume that the receipts from the tariffs are not recycled back into the economy via lower taxes or higher spending; this means that tariffs act as a form of fiscal tightening. Exhibit 4 shows the simulated total effects on the level of real GDP after three years in the US, China, the Euro area, Japan and the world. We also show the transmission channels of the tariffs in our model, broken into 1) trade, 2) the erosion of real incomes, and 3) tighter monetary policy and financial conditions. 8 These simulations update our earlier analysis, see Sven Jari Stehn, Nicholas Fawcett, Manav Chaudhary and Jan Hatzius, Trade Wars: The Big Picture,, March 11, 218. 5 October 218 4
Our results suggest that the growth effects of the implemented tariffs are negative but very small. The trade effects increase US growth slightly (as imports slow more than exports) but the income and FCI effects more than offset this boost. The trade restrictions weigh somewhat on Chinese activity (as exports are hit more than imports) and this drag is reinforced by the effects of higher inflation on household spending. The effects on the Euro area and Japan are negligibly small. Exhibit 4: A Small Drag from the Implemented Tariffs.5 Real GDP Level Effect of Implemented Tariffs (After Three Years).5 -.5 Income Financial Conditions Trade Total -.5 -.1 US China Euro area Japan World -.1 Source: Goldman Sachs Global Investment Research Exhibits 5 and 6 show how the effects on real GDP and core inflation evolve as trade tensions rise further. Our simulations suggest that the negative effects on US GDP are likely to remain very small (less than.1%) even if all tariffs are implemented. The intuition is that two offsetting forces are at play. On the one hand, rising tariffs and falling trade volumes provide a boost to growth, as the US is a trade deficit country. On the other hand, higher inflation weighs on household incomes and leads to higher interest rates (and thus tighter financial conditions more broadly). The net effect is a small drag on US growth and a boost to core inflation (with the level of core PCE up about 2bp in our baseline and roughly 35bp if all tariffs are implemented). 9 9 These effects on inflation are similar to the estimates of our US team. See Alec Phillips and Blake Taylor, A Two-Track Trade Policy, US Economics Analyst, September 8, 218. 5 October 218 5
Exhibit 5: More Tariffs Would Start to Matter for Growth.1 Real GDP Level Effect of Alternative Tariff Scenarios (After Three Years).1 -.1 -.2 -.3 -.4 Plus autos Plus $267bn at 25% Plus $267bn at 1% Plus $2bn at 25% Implemented Total: Baseline Total: All Threatened US China Euro area Japan World -.1 -.2 -.3 -.4 Source: Goldman Sachs Global Investment Research The effects on China, however, are more sizable. Our simulations point to a real GDP drag of.25% under our baseline expectation and.4% if all threatened tariffs are implemented. The reason China is hit more by the trade war is that China is a trade surplus country both overall and versus the US which means that the Chinese government can only retaliate partially against the US tariffs (as assumed in our simulations). The trade war has limited implications for the rest of the world, including the Euro area and Japan, because it currently looks so focused on US-China trade. The auto tariffs would be somewhat of a drag on activity, but only slightly so according to our model. This is because auto exports account for a surprisingly small share of GDP, even in the Euro area and Japan. The Euro area, for example, exports $4bn to the US per year, implying that a 25% tariff would be worth less than.1% of GDP. 5 October 218 6
Exhibit 6: and Push Up Inflation.4.3.2.1 Consumer Price Effect of Alternative Tariff Scenarios (After Three Years) Plus autos Plus $267bn at 25% Plus $267bn at 1% Plus $2bn at 25% Implemented Total: Baseline Total: All Threatened.4.3.2.1 US China Euro area Japan World Source: Goldman Sachs Global Investment Research How robust are these results? Exhibit 7 compares our baseline simulations of the real GDP effects with three alternative scenarios. The first considers the implications of recycling the tariff revenues back into the economy through higher government spending. We see that this limits the negative consequences of the higher tariffs in China and actually raises real GDP in the US. 1 The second explores the implications of alternative import price sensitivities. Our baseline simulation uses the same import price elasticity for all economies, assuming that import volumes fall by.5% for every 1% increase in import prices. A few studies suggest, however, that Chinese imports might be more price sensitive than US demand. 11 Exhibit 7 shows a simulation in which Chinese demand is three times more price elastic than US imports. We see that introducing such differences in price sensitivity raises the negative effect on the US (as consumers find it hard to substitute away from more expensive Chinese goods) and limits the costs for China (as consumers purchase goods from other countries). The effects, however, are still small unless one adopts extreme assumptions (e.g. that US demand is completely price inelastic and Chinese imports are completely price elastic). 1 The fiscal multiplier is less than one after three years because monetary policy responds to the fiscal expansion. 11 See, for example, Jean Imbs and Isabelle Mejean, Trade Elasticities, Review of International Economics, November 216. 5 October 218 7
Exhibit 7: How Things Could Get Worse.4.3.2.1 -.1 -.2 Real GDP Level Effect of Alternative Tariff Scenarios (After Three Years).4.3.2.1 -.1 -.2 -.3 -.4 -.5 -.6 US Baseline With Fiscal Recycling With Inelastic US, Elastic China With Equity Drop (1%) China -.3 -.4 -.5 -.6 Source: Goldman Sachs Global Investment Research The third variation on the baseline simulation assumes that global equity prices drop by 1% (on top of the decline associated with higher interest rates). We see that this raises the output costs of the trade war substantially and that the effects are larger in the US than China, given the greater importance of equity wealth holdings in the United States. However, it is important to keep in mind that there is an element of assuming the answer in this simulation any shock can be made to look costly from a GDP perspective if we exogenously assume a sharp tightening in financial conditions. And at least so far, the equity market effects have been much more benign than assumed in our 1% scenario. 12 Our stylized global macro model does not capture a number of other mechanisms that could shape the cost of a global trade war in a more negative or less negative direction. A downside risk is that disruption of global value chains leads to sharper increases in production costs and declining productivity. However, an upside risk is that trade diversion simply re-routes Chinese exports to the US via third countries to avoid the tariffs with little net effect on the world economy. The US authorities would presumably aim to prevent this type of behavior, but it is unclear how easy it is to police. The conclusion of our updated analysis remains broadly unchanged. While further escalation of the trade war would have negative effects on global growth, these are likely to be quite manageable. China is clearly most vulnerable, but even there the GDP hit is only.25% in our baseline scenario and.4% in a worse-case scenario with a 25% US tariff rate on all imports from China. However, the Chinese authorities are already trying to offset the hit via lower interest rates, increased bank lending, and the 12 A similar conclusion applies to the risk of a sharp drop in business sentiment and an associated hit to capital spending. This is potentially a risk, but it is also a somewhat arbitrary assumption and not really visible in the strong recent US business confidence data. 5 October 218 8
lagged effects of the earlier renminbi depreciation, and we expect only a gradual further deceleration in Chinese growth in the next year. Sven Jari Stehn Jan Hatzius 5 October 218 9
Global Economic Forecasts Real GDP Growth (YoY) 216 217 218 219 Core CPI Inflation (YoY) 216 217 218 219 World 3.1 3.8 3.9 3.8 G3 Advanced Economies 1.7 2.4 2.4 2.2 United States (core PCE) 1.7 1.6 1.9 2.2 Emerging Markets 4.5 5.1 5.3 5.2 Euro area.9 1. 1. 1.1 G3 Germany 1.1 1.3 1.2 1.4 United States 1.6 2.2 2.9 2.6 France.6.6.9.6 Euro area 1.9 2.5 2.1 1.8 Italy.5.8.7 1. Germany 2.2 2.5 2. 1.9 Spain.7 1.2 1.2 1.6 France 1.1 2.3 1.8 1.7 Japan (ex freshfood) -.3.5 1. 1.1 Italy 1. 1.6 1..9 Advanced Economies Spain 3.3 3. 2.6 2.2 Norway 3.1 1.4 1.4 2. Japan 1. 1.7 1.1 1.2 United Kingdom 1.3 2.4 2.1 1.9 Advanced Economies Australia 2.6 2.2 3.1 2.8 Canada 1.4 3. 2.1 1.8 New Zealand 4. 2.8 2.8 3.1 Norway.9 2.4 1.5 2.1 Policy Rate (%) 216 217 218 219 Sweden 2.5 2.4 2.7 2.3 G3 Switzerland 1.4 1.1 2.2 1.9 United States.5 1.3 2.4 3.4 United Kingdom 1.8 1.7 1.3 1.2 Euro area.... Asia Japan -.1 -.1 -.1 -.1 China 6.7 6.9 6.6 6.1 Advanced Economies India 7.9 6.2 7.8 7.6 Australia 1.5 1.5 1.5 1.8 CEEMEA Canada.5 1. 1.8 2.8 Russia -.1 1.5 2. 2. New Zealand 1.8 1.8 1.8 2. Turkey 3.2 7.4 3.1-3.4 Norway.5.5.8 1.5 Latin America Sweden -.5 -.5 -.3.3 Brazil -3.5 1. 1.2 2.5 Switzerland -.8 -.8 -.8 -.5 Mexico 2.9 2. 2.2 2.8 United Kingdom.3.5.8 1. Asia China 2.6 3.1 2.3 2.5 India 6.3 6. 6.5 7.3 CEEMEA Russia 1. 7.8 7.3 6.8 Turkey 8. 8. 24. 15.5 Latin America Brazil 13.8 7. 6.5 8.3 Mexico 5.8 7.3 7.8 6.5 Source: Goldman Sachs Global Investment Research 5 October 218 1
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