China’s growth in case of a full-scale trade war

19 Sep 2018

Know thy self, know thy enemy. A thousand battles, a thousand victories.  Sun Tzu

The US announced on 17 September new tariffs on USD200 billion of imports from China, starting with an initial rate of 10% on 24 September and rising to 25% in January 2019.  The move came two months after the implementation of the 25% tariffs on USD50 billion of imports from China.  Mr. Trump also threatened to impose more tariffs on another USD267 billion of Chinese exports to the US if China retaliates.  That would put all Chinese exports to the US under punitive tariffs.

In the worst-case scenario of a fill-scale trade war, where the US levies hefty (say 25%) tariffs on all Chinese exports to the US[1] and China retaliates, how bad would it be for China’s growth?  The Chinese stock market seems to be pricing in an economic hard-landing since June 2018 when the trade war fear intensified.  But what do economic theory and evidence tell us?


Gauging the tariffs impact on China

We can use two key economic parameters to gauge the direct impact of US tariffs on China: the tariff pass-through rate and the price elasticity of demand.  The former measures the possible effect of tariffs on the price of the traded goods, and the latter estimates the change in demand due to the tariff-induced price changes.

Under a tariff shock, an exporter may or may not fully pass through the tariff-induced price increase to the local price.  In case of a partial pass-through, a Chinese exporter will absorb part of the tariff through lower profit.  In the US, when Chinese import price increases because of the tariff, the resultant decrease in US consumer demand for the product will depend on the price elasticity.  An elasticity coefficient that is bigger than minus one means a one-percent increase in price will lead to a more-than-one-percent drop in demand.

Empirical studies show that the tariff pass-through rate ranges between 10% and 30% and the price elasticity of demand coefficient ranges between -2 and -7.  Let us take the mid-points of these estimates, i.e. 20% for tariff pass-through and -4.5 for price elasticity, for our analysis of the full-scale trade war scenario.

[1] IMF data shows total Chinese imports by the US was USD 505 billion in 2017, while Chinese data shows total exports to the US amounted to only USD433 billion.

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