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Untangling the US and Chinese economies will cost both dearly

Posted By on May 28, 2019 @ 06:00

US tariffs on Chinese goods are approaching the levels that applied during the trade war of the 1930s but they’re being imposed on a much more complex set of trade and business relationships.

As much as 80% of global trade now takes place within corporate groups and is organised in ‘value chains’, where high-value work, such as research and marketing, is conducted in advanced countries and low-value assembly work is done in low-income developing nations.

In the 1930s, a company would consign goods to a shipping agent and an importing business would take delivery at the other end. International trade was a relatively small part of the global economy, accounting for around 10% of total output. However, the elevation of trade barriers, which started in the US with the Smoot-Hawley tariffs of 1930, nevertheless deepened the Depression as trade plunged to 5% of global GDP.

The recovery was slow, and trade didn’t get back to pre-Depression levels until the mid-1970s. But a series of developments from the mid-1980s onwards led to an explosion in trade volumes.

The major changes included the advent of shipping containers, huge improvements in communications technology, the breakdown of fixed exchange rates, the formation of the World Trade Organization and a global reduction in tariffs.

Trade reached an unprecedented peak of 27% of world GDP in 2008 on the eve of the global financial crisis. Trade volumes grew at double the rate of economic growth overall, and lifted prosperity across the world.

Literally billions of people from the developing world were drawn into the market economy as global businesses found ways of breaking the manufacture of complex goods into components that could be produced in different countries to maximise productivity while minimising labour cost.

The latest iPhone, for example, draws on components produced by 785 suppliers in 31 countries. Around half those suppliers are in China, while 60 are based in the US, including the American affiliates of foreign multinationals.

Many of the components supplied by US companies also use supplies from China and other Asian nations such as Taiwan, South Korea and Japan.

The Hong Kong–based company Li & Fung was a pioneer in using the power of communications and logistics management to distribute manufacturing operations across the Asian region, but most global firms were doing the same.

A Brookings Institution study shows that the increasing specialisation brought huge advances in productivity. Between 1995 and 2009, productivity in the US information technology industry rose by 200% as the share of its workforce with tertiary education rose from a third to half. As the US role in the industry shifted from production to design, the share of work carried out by low-skilled staff dropped from 10% to 5%.

In China, over the same period, productivity in the IT industry soared sixfold. Around 90% of the work was done by low- and medium -skilled labour, but the big gains in productivity were made possible by advanced capital equipment. The labour share in value-added dropped from more than 40% to about 30%.

The Trump administration is focusing on the gap between US exports to and imports from China and aspires to repatriate US investment abroad. However, business groups in the US and elsewhere have been driven by the profits to be won from a global market by using a global platform for production.

US firms employ a staggering 1.75 million staff in China, which is about 40% more than they have in either Mexico or Canada. They have committed US$400 billion to investments in China.

US affiliates in China are producing supplies for both global markets and the Chinese domestic market. Their total sales of US$345 billion are twice the size of US exports to China. The only countries where US multinationals have larger sales are Canada and Ireland, with the latter reflecting tax advantages.

Chinese firms have also invested heavily in the US with total assets of US$215 billion. They have gone to the US to access both its sophisticated market and its design and technology strengths. Their total workforce numbers only 80,000.

Analysis by the Peterson Institute for International Economics shows that average tariff levels on US imports from China have risen from 3.1% in 2017 to 18.3% now.

The latest measures proposed by the Trump administration would lift average tariff levels to 27.8%, which compares to levels of around 30% during the Depression.

Until now, most of the US tariffs have been on capital goods and ‘intermediate’ goods, or components used by industry. The latest round includes most of China’s vast array of consumer goods and is expected to add around 0.5 percentage points to US inflation. The price of an iPhone in the US is expected to rise by about US$160, according to a Morgan Stanley report.

The tariffs on capital and intermediate goods are effectively a tax on US industry and reduce its competitiveness.

Modelling suggests this loss of competitiveness would reduce US exports by 6% over the next decade, quite apart from the loss of bilateral trade between China and the US.

Companies are working to reorganise their supply chains to avoid the impact of the tariffs. A survey by law firm Baker McKenzie found that 18% of multinationals in China were completely shifting their supply and production from China and a further 58% were making major changes. Many are moving production to other countries in Southeast Asia, including Cambodia, Indonesia and Vietnam.

Companies exporting from the US to China are also having to reconsider their operations. China’s 25% retaliatory tariff on US motor vehicles will affect annual sales of around 270,000 vehicles, with the US subsidiaries of German manufacturers accounting for US$7 billion of the US$11 billion of total vehicle exports.

The OECD argues that the best measure of trade flows looks at the value added in the exporting country, rather than at the gross sales proceeds. If China exports an iPhone worth $1,000, but $900 of the value contained within it comes from the US, the OECD would credit China with only $100.

The OECD estimates that 12.6% of the value added to the US economy from its exports comes from its sales to China, more than any other country. For China, the US delivers just under a quarter of the wealth it obtains from exports.

Unscrambling the linkages between the US and Chinese economies is likely to come at a heavy cost to both.

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[1] Smoot-Hawley tariffs: https://www.theaustralian.com.au/business/counting-the-cost-of-trade-war-and-rising-protectionism/news-story/8f6730e7cb9ecdb975a64541a418119a

[2] Brookings Institution study: https://www.brookings.edu/blog/order-from-chaos/2017/07/10/global-value-chains-shed-new-light-on-trade/

[3] Analysis: https://piie.com/blogs/trade-investment-policy-watch/trumps-2019-protection-could-push-china-back-smoot-hawley-tariff

[4] expected to rise by about US$160: https://business.financialpost.com/technology/apples-tariff-tradeoff-raise-iphone-prices-or-suffer-a-big-hit-to-profits

[5] survey by law firm Baker McKenzie: https://www.bakermckenzie.com/en/newsroom/2019/04/the-age-of-hypercomplexity

[6] estimates: https://www.oecd.org/sti/ind/measuring-trade-in-value-added.htm#country-notes