How will U.S.-China relations impact markets?

The U.S.-China relationship has been oscillating between provocations and signs of rapprochement. While the new U.S. administration has been clearly outlining its domestic priorities and bolstering relationships with key allies, investors haven’t had much sense of how  Biden would approach trade policy, particularly regarding tariffs and the trade deal inherited from the Trump White House. In a speech this week by U.S. trade representative Katherine Tai, we learned some new details, but many aspects are still unclear.

While many details on trade policy remain unknown, the speech painted a more coherent vision of how trade strategy could shape up. The speech argued that decoupling “is not a realistic outcome.” Instead, the U.S. should try to figure out the “goals we’re looking for in a kind of recoupling,” where U.S. firms occupy “strong and robust positions” in global supply chains in which China is also a major player, and where the U.S.-China economic relationship is defined by “trade” rather than “dependency.”

This could mean the administration might spend less energy in efforts to get U.S. companies to exit the China market, or to get China to change the structure of its economy. Instead, it will support U.S. firms with industrial policy of its own, and pressure China where it can to improve market access for U.S. firms.

Our main takeaway is that trade relations may not be a pressure point for U.S.-China relations in the near term. But we also learned that U.S. trade policy is not facing any dramatic shifts. The Biden administration is largely keeping the structures and stance that it inherited from the previous administration. In the near term, the priority appears to be engaging with China to ensure that it delivers on the commitments it made as part of the Phase One Deal.

So what concrete policies emerge from this stance? 1) the Phase One deal will remain in place – and we’ll likely see more engagement on this front, including a potential meeting between Biden and Xi; 2) We could see marginally lower tariffs - the U.S. will start a new tariff exclusions process, but broader tariff relief was not discussed; 3) Industrial policy will be a key issue for future trade talks - the U.S. expressed concerns with China's state-owned enterprises and non-market trade practices, which are not covered in the Phase One Deal; and 4) International collaboration with allies will be a priority - the U.S. Trade Representative (USTR) is working through trade differences with the EU and UK, such as aircraft subsidies, so that they can join an alliance pushing against China’s non-market practices.

A review of U.S.-China trade relations: where do we stand after the trade war?

The last few years have been a volatile period in bilateral trade relations. At the end of the two-year-long trade war in 2019, around 66% of China’s exports to the U.S. (in value terms) have had higher tariffs added to them. Retaliatory tariffs from China covered 58% of all U.S. exports to China. In 2019, bilateral trade between the U.S. and China declined by 13%, largely on account of the tariff shock, but also against the backdrop of deteriorating global growth. As shown on the below chart, China exports to the U.S. diverged from China’s overall exports in 2019, suggesting that the tariffs and the associated uncertainties have hit the bilateral trade relationship.

But by 2020, the impact of the COVID pandemic has caused a rebound in China’s export sector across the board - including to the U.S.. China exports to the U.S. rose by 7.9% in 2019 and 33% year-on-year so far in 2021. The pandemic had the effect of concentrating the global production in China, given industrial production normalized there faster. This pandemic effect more than washed out the impact of the tariffs. Recently, due to the impact of the Delta variant, production across emerging markets has suffered further disruptions, and China’s exports to the U.S. have accelerated again. And indeed, as long as the pandemic continues, particularly in Asia, the overall reliance on China’s supply chain will probably continue. Nonetheless, as the world continues to move ahead with vaccinations, the economic impact of the virus should gradually diminish. So over time, the impact of the punitive levels of tariffs, assuming they remain in place, will mean that trade between the U.S. and China will likely grow more slowly than these two economies’ trade with the rest of the world.

As for the question of who bears the tariff cost, the answer will depend on price elasticity, which can change depending on circumstances. The below chart shows China’s exports to the U.S. across a few tariffed product categories as a share of total exports to the U.S.. Broadly, the share of these product categories dropped in 2019, implying that the tariffs did impact demand. But some of these, such as transport equipment and miscellaneous manufactured products (which contains many household goods like furniture etc.) rebounded during the pandemic, despite the tariff rate and rising shipping cost, suggesting that price sensitivity dropped, likely because China was the only producer. It’s likely that in these categories, consumers ended up bearing most of the cost. In industrial machinery, however, we observe a further drop after some stabilization in 2020, suggesting that price sensitivity is sufficient to put continued pressures on demand.

Phase One deal: impact and future

In January 2020, President Donald Trump signed the U.S.-China Phase One agreement. The deal committed China to purchase an additional $200 billion of U.S. goods and services—relative to 2017 levels—with specific amounts split across 2020 and 2021. Through August 2021, China had purchased only 61% of the U.S. goods expected at that point. Put differently, China is cumulatively about $107 billion behind in its expected purchases of U.S. goods so far. 

In this sense the deal has been a failure from the U.S. standpoint. From the agreement's early days, China has never been on pace to meet the goods purchase commitments, but there were several factors at work. The deal's implementation in its first year was marred by the economic impact of COVID-19. China's economy rebounded in 2021, but despite this improvement, China has not been able to catch up, still running at 62 percent of the target for 2021. This lack of follow-through is something the Biden administration appears intent to focus on.

Beyond the so-far unsuccessful purchase commitments, the trade deal has had two other effects. One, it appears to have structurally reduced U.S. demand for Chinese-produced goods. U.S. imports from China as a share of overall imports have remained below pre-trade war era levels, even with the recent surge in demand. The impact of tariffs and other measures to diversify and divert supply has led to less demand from China and increased demand from the rest of the world.

Second, by mandating bilateral purchase commitments in certain product categories, the trade deal redirected some Chinese demand away from other trading partners to the U.S.. In this sense, the U.S. deal has hurt the trade prospects for many of its allies, notably European countries, but especially Australia, where the U.S. serves as a substitute for many agricultural products. This beggar-thy-neighbor bilateral approach was a source of strain between allies, and a key driver behind the European push for a separate Europe-China bilateral trade and investment deal. Of course, much of Australia’s export slowdown is unrelated to the Phase One deal specifically, but enforcing bilateral purchase agreements with China while trying to rebuild alliances contains some contradictions. 

Where trade policy goes from here depends initially on how China responds under the agreed structure. If there is no progress, or if there are continuing concerns on key issues, the U.S. could eventually take action - whether that means new agreements, or a new Section 301 action. Another key question for future trade talks is how the U.S. approaches concerns about China's industrial policy. The U.S. has limited tools to address these concerns, and has its own plans to pursue a similar form of industrial policy to support domestic manufacturing, which could be construed as contradictory. While many details remain unclear and the recent speech left areas open for continued negotiation, it does appear the Phase One deal will stay for now and its enforcement will be a key U.S. priority. Beyond that, near term trade actions or a rise in trade tensions appear less likely. In conclusion, there are a number of headwinds to the China outlook, but at least in the near term, trade tensions are likely not one of them. 

All market and economic data as of October 8, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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