Why imposing trade tariffs backfires in an interconnected world

The ongoing trade conflict between the US and People’s Republic of China (PRC) was supposed to be a way of protecting domestic industries. But it is backfiring in large part because of the vast global interconnections in production and trade.

A three-month truce reached by the leaders of the US and PRC at the G20 meeting may provide some time to calibrate, particularly in light of new evidence that the conflict is having a negative impact on the 2019 economic outlook.

Take steel nail production as an example. A vibrant factory producing steel nails based in Pittsburg in the US used to buy steel from the PRC. As a result of the recent 25 percent tariff, steel is now costlier and the factory can’t find manufacturers in the US that can produce the right type of steel at the same cost.

Unfortunately, the factory owner decided to let go of some workers to keep overall costs the same as before and maintain its competitiveness in steel nails. Luckily, the US subsequently slapped a tariff on steel nail imports from the PRC, reducing competition. That allowed the factory to raise nail prices and hire back a few of the workers that were laid off and still maintaining profits. Even so, some workers lost their jobs and the outlook is uncertain since the factory is dependent on tariffs continuing to give it a slight and temporary market advantage.

Meanwhile, a steel nail producer from the Republic of Korea already looking to expand its business has set up a factory in the US using imports of steel from Korea which are subject to a quota but not tariffs. With its cheaper nails and many buyers abroad that also do business with the PRC, the Korean factory expands its business. Nail exports from the US still expand but benefit the Korean not the US factory. On the other side of the world, large US-owned corporations have taken advantage of the PRC opening up—when it became a member of the World Trade Organisation in 2001—to set up shop within the PRC, producing electronic goods for exports and remitting profits back to their home company.

They provide a large source of income to the US economy. Many are investing in transport machinery and smart phone technology in Asia, goods likely to be subject to US import tariffs.

At the same time, the 25 percent Chinese tariffs on imports of American soybean products are hitting US soybean farmers hard as they’ve lost a lucrative market: soymeal is used as pork feed, thus impacting Chinese pork prices.

These examples show how imposing tariffs in an interconnected world backfires. No longer do we live in a world where the majority of exports are final goods for consumption in foreign countries. Rather, 81 percent of developing Asia’s trade is in capital and intermediate goods and final consumption goods are the minority.

The world is now better described as a series of production units scattered geographically, each unit contributing perhaps only a small amount to the value of the final product and all production units interconnected through complex global value chains. This has provided enormous benefits for consumers all over the world.

Uniqlo, a Japanese fast-fashion retailer that produces most of its garments in developing Asia and the Middle East, sells exactly the same line of clothing today in the chic outlet in Manila, the Philippines as in the one in Tokyo or in Orlando, Florida – all made in the same factories. The BMW auto plant in Spartanburg in the US state of South Carolina, one of the largest in the world, can assemble 480 thousand cars annually for domestic consumption and export using inputs from more than 300 suppliers, including hi-tech parts from Germany and Thailand and electronics from the PRC and Malaysia.

Production value chains like the ones in this graphic will be severely affected by the trade conflict, both directly and indirectly. Their successful model built over years is unexpectedly facing new artificial costs.  

For an upcoming Asian Development Bank (ADB) working paper, my colleagues and I disentangled these production chains to show how the spillover and trade redirection effects are impacting all sectors, including non-traded services such as retail trade and the financial sector in developing Asia. We find that the PRC economy will be the hardest hit but so will the US.

Moreover, the uncertainty is already beginning to affect business confidence, posing an important downside risk for the global economy in 2019. Fortunately, developing Asia has important buffers such as high reserves and other policy tools at its disposal.

For example, the PRC is providing temporary fiscal stimulus to ease the adjustment of affected businesses and reducing reserve requirements of banks to counteract the negative effects on the economy. Exchange rates have already moved in their favour with weaker currencies making their exports more attractive. 

However, the short-term macroeconomic effects are just the tip of the trade conflict iceberg. Consequential changes in investment decisions will surely follow in the form of less investment abroad and the severing of global partnerships and business networks built over years to the benefit of everyone. 

Very few come out of trade conflicts unscathed.
(Valerie Mercer-Blackman is Senior Economist, Economic Research and Regional Cooperation Department, ADB)