As every student of economics or history show know, free trade is a win-win. The escalation in the tariff war between the US and China will therefore be a lose-lose for both parties. Nonetheless, China is more likely to come out on top.
This may seem counter intuitive. After all, China benefits from a huge trade surplus in goods with the US, which was worth nearly US$300 billion last year, driven by exports of US$440 billion. These exports could easily halve as tariffs bite. In turn, this might knock more than 1% off China’s GDP, other things being equal.
However, even a hit this large would not be a game changer. For a start, the official data suggest that China’s economy grew by 5% last year. The true figure may well be lower, but a sharp drop in trade with the US alone is unlikely to tip China into recession.
Moreover, there are several ways in which Beijing could limit the damage.
One is simply to reroute more exports to the US via third countries. The US will of course be alert to this and will attempt to tighten up the ‘rules of origin’ which determine the tax due on each shipment. But it will be almost impossible to enforce a regime with so many different rates on different goods coming from different countries.
Beijing could also refocus on selling to other markets. Officials in the EU have already raised concern about the prospect of a flood of cheap imports, as Asian producers divert goods that that can no longer sell in the US.
Even if other countries resist this, perhaps with additional ‘anti-dumping’ tariffs of their own, China has the firepower to support the economy with looser fiscal and monetary policy.
Admittedly, China’s public finances are already deteriorating, which has recently prompting a ratings downgrade from Fitch. Government borrowing could be twice the target of 4% of GDP this year. Nonetheless, China’s public debt is still relatively low – below 70% of GDP – and there is plenty of room for it to rise further.
China’s inflation is also subdued. Consumer prices actually fell by 0.1% year-on-year in March, and producer price inflation has been negative since late 2022. Deflation is far from ideal, but it does at least mean that the monetary authorities can do more to boost growth without worrying about the implications for inflation. And unlike in most Western countries, officials in China can largely dictate what big banks do, as well as prop up the markets in other ways.
Contrast this with the position in the US, where tariffs have done down badly both with equity and bond investors.
The flipside of China’s huge trade surplus is that US businesses and consumers have come to rely on relatively cheap manufactured goods from China, as well as the rest of Asia. These supplies cannot easily be replaced.
Indeed, it would be practically impossible to replicate Asia’s low-cost manufacturing model in Ohio, even if this were desirable. Basic economics tells us that the US will always run deficits in goods with countries such as China, and Vietnam, because America’s comparative advantages lie elsewhere.
There are problems nearer the top of the value chain too, prompting US tech companies to force Trump into another U-turn. This weekend the US backed down by exempting a wide range of electronic goods and components from tariffs, including those imported rom China, in yet another example of the total incoherence of the grand plan.
It is not just US business and investors who are pushing back. The latest polling for the University of Michigan suggests that the average American consumer understands the economic risks from tariffs far better than the President, or his advisors, including the threat to US jobs. Inflation expectations have jumped again as well.
The scope for US fiscal and monetary policy to offset a trade shock is more limited too, partly because the public finances are in an even worse state (the US budget deficit will probably also be close to 8% of GDP this uear, but the stock of debt is over 100%).
Some hope that the new tariffs might raise as much as US$700 billion a year for the US Treasury. But this assumes that these tariffs will do little harm to trade, to the wider economy, or to revenues from other taxes. In reality, most of the economic burden of higher US tariffs will be borne by US taxpayers.
Another flipside of the large US trade deficits is that other countries have accumulated large holdings of US assets. In particular, China is the second largest foreign holder of Treasury securities, after Japan.
Speculation that China is already accelerating its diversification away from US assets has already contributed to a rise in Treasury yields. While there is no real evidence for this, the speculation alone is another useful weapon for Beijing.
The US also has less scope to loosen monetary policy. The Fed is still more likely to keep US interest rates higher for longer as inflation picks up. At the same time, a sharp fall in the value of the dollar could further undermine the greenback’s status as the world’s reserve currency, increasing the US government’s cost of borrowing further.
Finally, the geopolitics matters as well – and China should win here too.
Many smaller emerging economies will be hit especially hard by US tariffs, combined with cuts in in US oversea aid. This provides another opportunity for Beijing to gain more influence.
There may even be some in the West who are grateful to Beijing for ‘taking one for the team’. China’s forceful retaliation against the US has rattled the markets so much that others have not had to join in.
In contrast, the US administration seems determined to lose friends and allies, whether in economic policy, foreign affairs, or defence.
This is already having some real costs, including a collapse in the number of overseas visitors to the US from Canada and Europe. Some Trump supporters may not care what other countries think of the US, or even accept that services are exports too, but a slump in tourism is not going to help the US trade deficit.
The upshot is that President Trump has started a war that he almost certainly cannot win. And remarkably, he may even have made President Xi Jinping look like the ‘good guy’ in the process.
This is an extended version of a piece first published in the Daily Telegraph on 12 April 2025
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