Impact of the US–China Economic Conflict on Trade and Investment Flows in Asia
A new era of protectionism
The longer trade conflict between the US and China goes on, the more it looks like a new and enduring feature of the global economy rather than a temporary aberration. Over the last two years President Donald Trump has targeted various restrictions at China, aimed in part at curbing the US’s yawning trade deficit with its Asian rival. The impact of these policies is now being felt, hitting growth forecasts globally as well as in both the US and China. Threats to domestic prosperity might eventually push the two parties towards a deal to defuse some of these tensions in the short-term. Even so, their recent disputes have revealed wider geopolitical rivalries and competition for global technological leadership that are likely to fester for years to come. After decades of successful economic liberalization these forces are pushing the world towards an era of protectionism.
The prospect of ongoing and potentially rising trade tensions will be especially damaging for Asia, hitting investment flows into the world’s most trade-dependent region, and economic development overall. Estimates suggest $150 billion could be wiped off global gross domestic product if the US implements the tariffs that it notified the WTO of in 2018, around one-third of which would come from the Asia-Pacific region.
Increasing trade costs, for instance by making Chinese goods more expensive for US companies, will nonetheless produce winners and losers. As a result, there has been a good deal of recent speculation about which countries might gain from a period of prolonged trade conflict. Specifically, if multinational companies shift production away from China and begin to seek new production locations, some analysts suggest that various trade-dependent Southeast Asian nations could, perversely, end up benefiting from trade restrictions elsewhere. Unfortunately, this image of trade war ‘winners’ is misleading.
This chapter highlights three ways in which an ongoing trade war is likely to be negative for Asia’s future growth. First, a period of growing trade uncertainty will dampen investor confidence in Asia as a whole. At the same time, a likely slowdown in global growth will hit trade-dependent Asian exporters in particular. These broad negative effects are likely to outweigh any narrow positive gains that could arise as investment patterns shift away from China. Second, rising trade costs are likely to push multinational companies (MNCs) to reshape their global production networks, making them generally less reliant on outsourced production in Asia. Finally, trade tensions are likely to make it harder for poorer developing countries around Asia, notably India, to follow the path of integration into global supply chains, which previously helped East Asian nations to rapid economic development.
Background to Asia’s trade war
Rapid international integration helped to propel Asia’s rise over recent decades, leading to what trade economist Richard Baldwin dubs a ‘great convergence’ between rich industrial nations and a select few emerging exporting economies. Improvements in communications technology allowed MNCs in the US, Europe and Japan to move production to countries like China, using basic tools like e-mail and spreadsheets to manage ties with distant foreign suppliers. More liberal trade laws helped too, as rules governed by institutions like the WTO made it cheaper and easier to move goods around globally. For around two decades after the end of the cold war global trade roared ahead, often expanding at twice the rate of the overall world economy.
For around two decades after the end of the cold war global trade roared ahead, often expanding at twice the rate of the overall world economy.
Asia’s rise was aided by the creation of ‘global value chains’ (GVCs), a term used to refer to complex production networks involving everything from basic components to high-end services in areas like IP and product design. During this period of rapid trade expansion, often known as the decades of ‘hyper globalization’, GVCs grew ever more intricate. Industries like car manufacturing and electronics developed complex production networks in which intermediate goods crisscrossed borders in emerging markets before being assembled – often in China – and shipped overseas for sale in rich industrial economies. As well as making consumer goods cheaper, GVCs allowed exporters in developing economies to play a larger role in the global economy, increasing sales, raising productivity, and helping to boost growth in their home nations. The likes of Taiwan, Singapore and South Korea prospered during the early stages of this era of new global connections, although China was the most notable beneficiary of all. Today, Chinese growth remains heavily tied to global production networks: last year 43 per cent of its exports were made by foreign-invested enterprises.
The 2008 global financial crisis brought this period of ever-closer integration to a halt. Global trade growth stalled after the crash, expanding more slowly than the world economy as a whole for many years. Foreign direct investment (FDI) flatlined. Restrictions on trade began to tick up, too, as policymakers lost their taste for global trade agreements. It was only after Trump’s victory in 2016, however, that this period of relative trade stagnation took a fully protectionist turn.
The US moved first to introduce restrictions on goods like solar panels and washing machines. Then in 2018 it began targeting China with repeated waves of restrictions. By the end of 2018, the US had placed tariffs on $250 billion worth of Chinese imports, and threatened imports worth a further $257 billion. By early 2019, US tariffs alongside the retaliatory responses from other affected nations, had hit nearly $430 billion of global imports, or more than 2.5 per cent of global goods trade. These restrictions have already pushed the WTO to downgrade its trade growth outlook repeatedly. Similarly, the IMF cited the trade war for its decision in 2019 to cut its global growth outlook, the latest in a succession of downward estimates.
The myth of trade war winners
There can be little doubt that an escalating trade war will dent growth in the US and China, as well as the wider global economy. Yet this downbeat prospect will at least be partially offset when companies, and indeed some countries, pick up business resulting from restrictions introduced by the US and China.
Two kinds of shifts will affect Asia, both linked to the impact of tariffs on China. The first involves short-term changes in trade from one country to another, as happened for instance when China stopped buying soybeans from the US and sourced them from Brazil instead. In Asia, this is likely to have an effect as US companies seek to replace tariff-hit Chinese goods with cheaper products sourced from elsewhere around the region. Researchers from Nomura, a Japanese bank, created an ‘import substitution index’ to examine which countries might benefit from these kinds of short-term movements, considering factors ranging from their comparative advantage in particular industries to their distance from the US and China. In the short-term, they found that Malaysia is the most likely trade diversion beneficiary, in part because of its vibrant electronic and communication equipment industries. Japan, Pakistan and Thailand are also likely to gain in industries ranging from car parts to cotton yarn.
The second shift is longer-term and more significant, as companies look to shift some of their production away from China. This could happen either by companies seeking to source products from new suppliers in other countries, or by replacing factories they operate in China with new facilities elsewhere in the region. A second Nomura ‘production relocation index’ examined countries that might take advantage of this, with a particular emphasis on those that showed a similar exporting profile to China and those likely to attract FDI. According to this index, Vietnam was the ‘clear standout beneficiary’, followed by Malaysia, and then Singapore and India.
In the same vein, a recent report by the Economist Intelligence Unit suggested that both Vietnam and Malaysia were also likely to see ‘strong benefits’ from trade restrictions, given both were already home to production facilities for big companies like Dell and Samsung, which would allow these firms to shift production from their facilities in China. These theoretical estimates chime with media reports suggesting that a number of big suppliers of Chinese-made goods are indeed pondering relocation to Vietnam in particular, not least iPhone-maker and electronics contract manufacturer Foxconn.
Yet this talk of trade war winners is still misleading. Any prolonged trade war will indeed produce investment shifts between countries. Some nations in Southeast Asia will find themselves winning business as anxious companies, for example in the smartphone sector, hedge their bets and move production away from China. At present, though it does not appear likely that the US will target countries like Vietnam with trade restrictions that could change in the future. Yet overall, these benefits must still be weighed against the broader impacts of the trade war – and here the omens are much less positive.
For starters, Asian countries are likely to win some portion of Chinese production only to see this effect counterbalanced as Chinese companies hit by tariffs purchase fewer products. Most Asian value chains pass through China at some point, as intermediate goods traverse the region prior to final assembly. Chinese exports are already falling fast, dropping by 4 per cent in December 2018, their largest decline in more than two years. Further declines during the first half of 2019 are likely to have a knock-on effect across the continent. Almost all Asia’s exporters face risks here, although Taiwan and South Korea are especially vulnerable given the quantities of electronics they export to China.
Even worse could be the effect on global investor confidence. Rather than suddenly building new factories in countries like Malaysia and Vietnam, many global companies could simply decide to delay or pause investment in the face of rising uncertainty. Here the effects of the trade war are also combining with deeper structural changes, for instance the fact that automation is making it more attractive to move production away from countries with low labour costs and towards markets that are closer to final consumers. Changes in China’s economy, such as rising wages, are part of a similar trend. Either way, there is already ample evidence that the trade war is hitting global FDI flows, which fell by nearly a quarter in 2017, and then by one-third again in the first half of 2018. This picture is not uniform: FDI flows into Southeast Asia rose slightly over that same period, with Thailand and the Philippines the major gainers. Yet the wider risk remains that, if the trade war continues, FDI to the region could quickly dry up.
The risk to Asia’s value chains
The broader worry is that an ongoing trade conflict will begin to shift the direction of globalization. For the best part of a generation, MNCs have constructed longer and more elaborate chains of production around the world. Today about half of world trade passes through production networks that are owned or directed by global companies. Yet a combination of geopolitical uncertainty and rising trade costs are now set to reduce the advantages of making goods overseas. In turn, MNCs are likely to shorten and simplify their supply chains, with potentially wide-ranging implications for Asia.
These changes are in part the result of a dramatic shift in American policy, based on concerns about predatory Chinese manufacturing policies and the risk China poses to US technological supremacy. Previous US governments had broadly supported moves by American companies to produce abroad, particularly in China. However, recent years have seen a shift in thinking in Washington on the potential risks of producing goods in China, many of which relate to the country’s state-led economic model. Some critics cite a lack of reciprocity, in which US companies in China face more stringent business restrictions than Chinese companies operating in the US. In March 2018, US trade representative, Robert Lighthizer produced a lengthy report claiming widespread problems relating to the theft of technological know-how from US companies. Elsewhere Lighthizer has highlighted the risk that China might use US trade links as a weapon in a period of future geopolitical competition.
Global production by US companies has become a focus for Trump and some of his allies. In a tweet last year, Trump called on companies such as Apple and Ford to begin undoing the worldwide production networks that they had spent many decades constructing. ‘Make your products in the United States instead of China’, he wrote. Trump’s one-time policy adviser Steve Bannon has been even more explicit, saying repeatedly that US policy now aimed specifically at curbing China’s ability to be a location to produce goods for US companies. ‘China has always been taking advantage of the rules’, he said last October. ‘This is not about a trade war. This is about the realignment of the global supply chain’. Essentially, the US under Trump is seeking a trade war not simply against China, but also against its own multinational companies.
Global production by US companies has become a focus for Trump and some of his allies. In a tweet last year, Trump called on companies such as Apple and Ford to begin undoing the worldwide production networks that they had spent many decades constructing.
Even if US policy was neutral on production locations, MNCs themselves are already reacting to the prospect of higher future trade costs. Long, complex value chains that organize production across different locations are economically efficient but also vulnerable to arbitrary trade restrictions. MNCs producing abroad enjoy benefits of scale and low labour costs. But in competitive industries with thin margins these advantages can be overturned by small increases in trade costs or political risks.
This is not to say that many MNCs will choose suddenly to reshore production back to their home markets in North America or Europe. Companies source products from China not only because of low costs but also because of its complex ecosystem of skilled labour and quality producers. This mix cannot quickly be replicated in countries like the US, as Tim Cook, CEO of Apple, has noted. Nonetheless US companies facing rising trade costs are likely to try to reduce their reliance on complex foreign sourcing arrangements. Some might pull production closer to home, for instance by producing in Mexico. Others could develop regional trading networks to service particular parts of the world, following the strategy of regional production ‘localization’ adopted by companies like General Electric, the US industrial group.
For Asia, this is one of many possible outcomes of the trade war. It is at least possible to imagine a more dramatic scenario, in which ongoing trade belligerence from the US alongside further statist turns in China’s economic model gradually push the world’s two largest economies to decouple from one another. Such a scenario could see a larger change in trade patterns affecting Southeast Asia in particular, with US companies seeking to replicate its Chinese outsource production capabilities in the region. Yet there are good reasons to be sceptical about this possibility, too, given the odds that the world will in effect split into two trading zones – with one linked to the US, and the other to China – remain slim.
Equally, were this decoupling to come to pass, nations in Southeast Asia might in effect be forced to choose between trading ties with the US and China. It is by no means clear they would pick the US. China is already the largest trading partner for nearly all Asian nations. As China continues to grow, ever-more Asian exports will end up serving Chinese domestic consumption, rather than the US. In much the same way, as China’s trade within its own region has increased, its reliance on the US has gradually shrunk. In 2015, the US accounted for just 5 per cent of China’s GDP, roughly half the level at the turn of the millennium. In this sense, a growing trade schism between the US and China is likely to have two unintended long-term effects. First, it will make China less reliant on trade in general, as its economy seeks to replace imported goods with those produced domestically. And second, China’s economy may well end up more closely integrated with its Asian neighbours, not less.
The trade war and Asia’s economic development
Whatever else happens as the trade war develops, an era of rising trade restrictions is likely to make it more difficult for poorer Asian nations – from Bangladesh and India to Cambodia and Myanmar – to develop deeper connections to global markets. In turn this is likely to make it harder for countries to follow the path first pioneered by richer economies in East and Southeast Asia like Japan and South Korea, whose development models relied in part on rapid growth in developing exporting industries. More recently economies like Thailand and Malaysia have achieved some measure of the same success, if not by developing full exporting sectors of their own, then at least by plugging their companies into existing global production networks.
This model of economic integration is far from a guaranteed path to development. Relatively few emerging nations have managed to mimic the export-led path charted first by Asia’s pioneers, a point made by economist Dani Rodrik and others. So far perhaps only Vietnam among today’s lower middle-income Asian economies shows signs of repeating the trick. Even so, many such economies around Asia harbour hopes that they might soon be able to integrate their domestic producers with global markets. However, the higher trade restrictions become, the less likely this is to happen. East Asia grew prosperous against a benign backdrop of spreading globalization. South Asia, in particular, is likely to have to chart its development path in less auspicious circumstances.
Worse still, without remedial action, the risk is that the trade war will spread both in its scope and geography. So far, US trade restrictions have almost entirely hit trade in goods. But if tensions with China deepen, this could easily spread to include restrictions targeting services, or indeed high-profile companies, such as Huawei on the Chinese side or Apple on the US side.
Equally, a prolonged trade war is likely to spread to other countries too. Just as China has responded to US restrictions ‘tit for tat’, so other nations are soon likely to begin to follow their lead. Previous eras of trade restrictions suggest that domestic pressure builds quickly to replicate trade restrictions introduced by other nations. This risk is most pronounced in countries with a history of activist trade policies like India, which has already introduced various kinds of import controls over the last year.
Rising anti-trade sentiment is also likely to be reflected in higher non-tariff barriers, from subsidies and government procurement rules to other less obvious trade restrictions, all of which have been increasing over recent years. Here Asia’s trading economies are potential victims, given their exports are often hit by restrictions from other less efficient markets. But they are perpetrators too: around one in three discriminatory trade measures affecting economies in the region last year were introduced by other Asian nations, according to data from the UN.
China’s outbound FDI to the US and Europe plunged in 2018 as the trade war began to bite. But it is also at least possible to imagine that its investments around Asia might increase over the coming years, as it seeks new trading partners and potentially expands its giant BRI.
The wider geopolitical ramifications of the trade war are hard to predict. Continued US–China tensions are likely to complicate trading relationships, for instance as tussles over companies like Huawei or issues like IP force countries to pick sides. In some cases, it is at least possible that political and investment relations around Asia could improve, however. This has been true of late in China’s case, as deteriorating US ties pushed Beijing to improve ties with countries like Australia, Japan and India. These moves may even spur investment increases in some cases, for instance if China decides selectively to make its economy more open to companies from countries like Germany or Japan. China’s outbound FDI to the US and Europe plunged in 2018 as the trade war began to bite. But it is also at least possible to imagine that its investments around Asia might increase over the coming years, as it seeks new trading partners and potentially expands its giant BRI.
The odds that the US and China can return to normal trading relations are slim. America’s complaints about Chinese behaviour are deeply rooted in China’s state-led economic model, which shows no signs of changing under President Xi. If some kind of trade deal were to be struck, it is likely that it would only act at best as a temporary reprieve on rising tensions. Equally an agreement to monitor and manage what the US perceives to be Chinese transgressions in areas like IP theft or state support for domestic industries will in itself only likely become a recipe for further wrangling in future.
That said, there are at least some ways in which the two countries might more successfully manage their developing rivalry. Changes to international trade rules, especially in contested areas like IP, could help to alleviate some US complaints that prompted the trade war in the first place. Much the same is true with China’s domestic reforms, where President Xi could decide to use the tension created by the trade war to justify a gradual return to market-based reforms in specific sectors, for instance by introducing long-awaited reforms to Chinese state-owned enterprises. And, of course, there is always the chance that Trump might lose the 2020 presidential election, which while it would not herald a dramatic improvement in US–China ties it would at least make a further deterioration less likely.
Even if none of this happens, there are steps that countries around Asia can take to counteract the trade war’s effects by promoting steps to greater regional integration. The WTO remains in crisis, meaning there is almost no chance that it will develop a new global trade liberalization agenda. But the passage of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) in 2018, even without US participation, proved there was still life in regional trade deals in Asia. In the same vein the eventual passage of the 16-nation Regional Comprehensive Economic Partnership (RCEP) deal would provide a welcome fillip to integration attempts. As it faces the new reality of US trade policy, China at least appears to be more willing to push forward both with plans to strike new bilateral and regional deals.
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