April 5, 2018 / 11:54 AM / 22 days ago

COLUMN-Markets underestimate risk of an accidental trade war: Kemp

(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, April 5 (Reuters) - In a round of interviews and media briefings on Wednesday, Trump administration officials downplayed the risk of a U.S. trade war with China, insisting tariff threats are just the first round in negotiations.

The concerted attempt to calm market nerves came after the two countries each published a list of potential targets for higher tariffs in a dispute over intellectual property and technology transfer.

“There’s no trade war here,” the U.S. president’s top economic adviser Larry Kudlow said in an interview with Fox Business Network (“Kudlow: there is absolutely not a trade war”, Real Clear Politics, April 4).

“What you’ve got is the early stages of a process which will include tariffs, comments on the tariffs, then ultimate decisions and negotiations. There are already back-channel talks going on,” Kudlow said.

“These are just the first proposals ... we’re putting it out for comment, it’s going to take a couple of months, I doubt there will be any concrete action for several months.”

The same talking points were echoed by other senior officials including Trump’s press secretary, his commerce secretary and his hawkish foreign trade adviser.

The soothing message appeared to work, with U.S. equity indices reversing earlier losses as investors concluded the risk of threatened tariffs actually being imposed was low.

But investors and traders are probably underestimating the difficulty of the negotiations and the risk the United States and China could drift into a damaging confrontation by accident.

NEGOTIATING STRATEGY

The threat to impose additional 25 percent tariffs on imports from China worth up to $50 billion fits with the Trump administration’s typical negotiating pattern.

In general, the administration starts by making an aggressive and openly controversial announcement to drive an issue up the agenda, control the framing, and create leverage, before settling down to negotiate the details in private.

It has already employed this approach by threatening to leave free trade agreements with Canada, Mexico and South Korea, as well as with steel and aluminium tariffs.

Outside the trade area, it has used the same strategy to demand changes to the nuclear agreement with Iran, denuclearisation of North Korea, more burden-sharing by NATO allies, a border wall with Mexico, and to deal with the problem of undocumented child migrants.

So far the results have been mixed. The South Korea free trade agreement has reportedly been renegotiated with some minor changes and there has been some progress with NATO, but none of the other negotiations has yet reached a successful conclusion.

In employing the same tactics with China, the administration has picked a much more formidable negotiating adversary and opened up a more complicated set of issues.

There is no guarantee the negotiations will reach a successful conclusion and avoid imposition of the threatened tariffs.

So while negotiations may be able to avert tariffs, there is a non-zero probability that they will fail to achieve a solution.

The process itself is likely to be a source of considerable uncertainty for businesses in both countries as well as third parties in their supply chains for months.

Most market participants are probably underestimating how difficult the negotiations will prove and the risk of failure or at least repeated bouts of tension.

The administration’s mixed messages are themselves a source of confusion.

Senior U.S. officials are trying to convince investors tariffs are unlikely to be imposed so as not to trigger a fall in equity prices or business confidence.

But for its hardline negotiating strategy to work, the administration must convince China and other countries the threat to impose tariffs is very real.

NARROWING DIFFERENCES

The United States has presented a long list of grievances as part of its Section 301 investigation into technology transfer (“Notice of determination”, United States Trade Representative, April 3).

But it is part of a wider set of disputes between the United States and China that cover intellectual property, subsidisation, dumping, government ownership of enterprises and restrictions on market access as well as the overall trade imbalance.

U.S. policymakers have questioned almost every aspect of China’s economic model, which is in turn deeply embedded in the country’s social and political system.

Achieving wholesale change will not be possible. No country would allow another to impose changes to its fundamental social-economic-political model (short of defeat in war).

So the United States will have to narrow its demands to a list of specific and realistic steps that China will be able to take.

Washington will also need to provide reassurance that once a deal is done, it will not be re-opened in future with demands for even more concessions.

PLAYING CHICKEN

Critically, any deal must allow both sides to save face and avoid the appearance China is making unilateral concessions under pressure.

Even before the tariffs were announced, China and the United States had been trying to negotiate a deal over technology transfer, intellectual property and other issues.

By increasing the political temperature, the reciprocal tariff announcements have probably made it harder rather than easier to achieve an outcome acceptable to both sides.

China has already reiterated it will not negotiate and make concessions under external pressure (“China says it never backs down in the face of threats after trade salvos with U.S.”, Reuters, April 4).

U.S. President Donald Trump and China’s President Xi Jinping have each cultivated an image as a strong leader so neither can afford to back down and be seen as weak in front of a domestic audience.

The two sides are engaged in a dangerous game of chicken (“China trade brinkmanship: Beijing’s retaliation for Trump’s tariffs hits Trump’s voters hard”, Wall Street Journal, April 4).

The negotiating process could easily drag on for six months or more, creating significant uncertainty for business in the meantime and complicating investment decisions.

Businesses will have to start to plan for the imposition of tariffs on their supply chain even if they are never imposed. Even the threat of tariffs has real consequences for investment and trade flows.

While the most likely outcome is probably a deal, there is a non-zero and probably significant risk of breakdown.

For the moment, markets are assuming the negotiations will succeed, but investors should probably start to take more seriously the possibility of failure and price it in.

Related column:

“With trade war, U.S. and China stumble into the Thucydides Trap”, Reuters, April 4 (Editing by Catherine Evans)

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