The economic costs of a trade war between the US And China: what do the financial markets tell us?

It is difficult to predict the overall economic effect of tariff protection in the world of global value chains.

Friday, August 31, 2018

The Trump administration raised the stakes in a trade dispute with China by proposing 10% tariffs on US $200 billions of Chinese goods on July 10, 2018, in addition to the $50 billion of tariffs that were officially imposed on China. The Ministry of Commerce of China responded immediately warning of similar reprisals. In the latest Perspectives on the economy, the IMF estimates that the world economy will be 0.5% (or approximately US $430 billion) less by 2020 if the various tariffs threatened by the United States, China, Europe, Mexico, Japan and Canada are implemented.

In the world of global value chains, companies are intertwined in input-output relationships. Although tariffs can reduce competition from foreign companies in the country, the costs of imported inputs for domestic companies will also increase and, therefore, will be counterproductive. Domestic consumers and businesses that depend heavily on goods produced in a foreign country suffer the most. In addition, the costs of import tariffs on production can be amplified as the tariff-induced increases in input costs combine along supply chains to the final stage when goods are sold to producers. Therefore, it is difficult to predict the overall economic effect of tariff protection in the world of global value chains.

Around March 22, 2018, the date on which the Trump administration made the first announcement that triggered a sequence of commercial events between the two nations, US companies that have imports or exports to China experienced relatively lower share returns, weaker bond yield and higher default risks. Specifically, in a three-day period around March 22, we found that after controlling the standard features at company level, an increase of 10 percentage points in a company’s share in sales to China is associated with cumulative performance lower average of 0.8%, while companies that direct inputs from China have an average accumulated return 0.8% lower than those that do not. In addition, companies that are more exposed to trade experienced higher default risks measured by the growth rate in the implicit CDS distributed over the same three-day period.

We also find that the indirect exposure of a company through global value chains is important. In particular, an industry that has an average 10% higher share of imports in its upstream industries is associated with an average cumulative gross return of 1.2% lower, which suggests significant indirect effects of the increases induced by (perceived) tariffs in the costs of inputs.

The effects are equally significant in the Chinese financial market. Chinese listed companies that depend more on sales in the US tend to have lower accumulated returns around March 22. Chinese companies that import from US do not experience lower returns on stocks. We find in the stock markets of the two countries the same patterns of heterogeneous responses of the markets of the companies to the announcement of the government of the EE. UU June 18 on additional increases in tariffs applied to Chinese products.

The fact that a company wins or loses during the commercial war between US and China depends on the extent of its participation in the global value chains shared by the two countries. Although the increase in the prices of imported products may transfer profits from foreign to domestic companies, our study shows that this benefit is largely outweighed by the (perceived) increases in the costs of inputs. Given the complex structure of trade between US and China, most companies in both countries would not be isolated from such negative cost shocks. In DICEX we keep abreast of everything that is happening around foreign trade to inform and support our customers and strategic partners and thus their operations have their normal course.