Can China Withstand Tariff Pressure?

The early days of the Trump administration have brought little clarity on trade and tariff policies, but the direction is clear: trade restrictions are likely to increase, with China as a primary target. Despite the lack of specifics on these policies, we think there’s enough information to soften the global outlook. As trade tensions rise, China faces a shifting economic landscape that could redefine global trade dynamics. What will it mean for the future of international commerce?

Trade Tensions Heighten Geopolitical Risks

Over the longer term, increased trade tensions raise even greater risks.

Ongoing trade tensions reflect the deglobalization trend we’ve discussed over the past several years. Deglobalization raises not only economic risks but also geopolitical ones. Trading partners have strong incentives to maintain stable diplomatic relationships to protect their mutual economic interests. Without shared interests in strong relations, global competition could become more pernicious.

Even if severe outcomes are avoided, countries may find themselves having to choose sides between the US and China, potentially accelerating deglobalization further.

To be clear, we believe we are far from the most severe outcomes. Our base case is that trade tensions remain more tension than conflict, and that restrictions slow but don’t stop the global economy. However, as tensions rise, there will likely be consequences, particularly for China.

China’s Trade Dynamics Are Shifting

The US and countries siding with it will likely raise trade barriers to Chinese goods to protect domestic jobs, to address trade deficits or for national security reasons. But unlike in 2018, China today is less reliant on the US and less vulnerable to economic disruptions from trade wars.

China holds an even higher share of global manufacturing than it did in 2018, accounting for 32% of the world’s total.* Since 2018, China’s exports to the US as a percentage of its total exports has fallen from nearly 20% to less than 15% (Display, left), and exports to the US now contribute only 3% to China’s GDP (Display, right).

And, while some Chinese goods are being rerouted and still end up in the US, the nature of China’s exports is changing. Products like mobile phones, electric vehicles and 5G equipment, which are not sold in the US, now make up a substantial share of China’s exports.

These shifts in China’s trade dynamics indicate a strategic adjustment to global trade tensions.

Picking Sides: A Double-Edged Sword

The critical question is what happens when trading partners are compelled to take sides, risking their bilateral trade agreements with the US. Recently, we have seen Mexico and South Korea indicate their intention to curb China’s backdoor entry for exports before entering trade negotiations with the US.

This complicates the identification of goods meant for re-export versus those intended for local demand. Countries might simply decide to deny all Chinese goods, which in our view would significantly impede Chinese growth. In this case, we would need to assess the impact of each country’s decision to reduce trade with China.

However, choosing sides in this way is a double-edged sword. Countries that have benefited from acting as intermediaries in the rerouting of Chinese goods would also suffer unless they can achieve full localization, including the transfer of intellectual property and increased local content. Asian countries that will need to make decisions include Vietnam, Malaysia, Singapore and South Korea.

Given its manufacturing capabilities, China’s economy is heavily reliant on exports. Yet China currently accounts for only 12% of global consumption. Unless China can significantly increase its share of global consumption to absorb its manufacturing output, it will need to persuade trading partners to maintain their trade relationship.

This is particularly relevant for countries in the southern hemisphere, where China’s trade surplus has grown the most in recent years. Nearly 50% of China’s US$1 trillion trade surplus is with countries in the global south, with US$200 billion of that increase occurring in the past three years alone.

Not all this increased trade with the global south is due to rerouting. Chinese companies have been proactively exploring new markets and seeking new demand for their products to mitigate the impact of trade barriers and diversify their export destinations.

Another potential strategy companies might consider involves moving their entire supply chain, including intellectual property and operations, away from China. This strategy, similar to Japan’s strategy in the 1980s, would be especially important for companies focused on exports rather than on serving the domestic market or serving markets still receptive to Chinese goods.

Shaking Up the World Economy

Under deglobalization, trading relationships and even economic cycles are becoming increasingly disconnected and isolated. A less harmonized global regime, in which economic cycles vary more significantly across regions than they have in decades, suggests to us a less efficient world economy. Further, the trade-off between growth and inflation may become less favorable as trade wars progress. More inflation relative to growth would be unwelcome to central bankers and investors alike.

In our view, companies will need to carefully consider which markets to focus on, as well as decide on the technology, supply chains and materials they will use. Fractious trading relationships, brittle global supply chains, volatile inflation and growth dynamics, and potentially divergent monetary policy paths will likely complicate corporate investment decisions. In this environment, we expect companies to find targeting a global audience challenging. 

Seeking a New Equilibrium

While the direction seems clear, the speed and magnitude of the journey are uncertain. Encouraging signs of technological innovation may offset some damage caused by trade wars. Policymakers currently pursuing trade wars may eventually conclude that the damage is too severe to continue, leading to greater stability over time. And we should not underestimate the resilience of the private sector and its ability to find solutions to new problems.

Though the near-term outlook appears challenging, we urge investors to maintain perspective. Deglobalization and trade tensions are not good for the global economy, but they need not be catastrophic. After more than 20 years of deepening ties, it may be inevitable that the world moves in the other direction for a time.

While periods of friction may be tough for the world economy and uncomfortable for investors, we believe that a new equilibrium will eventually be found.