A China-US trade war carries very high risks, as Brian Caplen explains.

US president-elect Donald Trump’s latest comments on China – that he sees no reason to be bound by a decades-old 'One China' policy under which Washington does not recognise Taiwan as a sovereign state – has added to fears that China and the US are about to embark on a diplomatic and trade war. 

From every angle this looks ugly. Mr Trump’s scepticism on globalisation may carry resonance with voters but imposing it on a highly interconnected world has huge ramifications. 

Quite simply, the US and China are joined at the hip and any measures and counter-measures they take against each other could escalate into a unique 21st century trade war. 

Let’s start with finance. The logic of Trumponomics is that the US's massive debt pile will expand even further due to a combination of infrastructure spending and tax cuts. Furthermore, interest rates are set to rise so making this even more burdensome. 

Not a good time therefore to upset your major creditor. China holds $1.22trn of US government debt out of a total of $19trn, which in itself amounts to more than 100% of GDP. 

A trade war in which China started dumping treasuries could cause all kinds of problems for the US. On the other hand China’s large-scale holdings of US treasuries mean it is highly vulnerable to shifts in the dollar-renminbi exchange rate. 

Right now a strengthening dollar is good for China’s investment returns but a battered US economy and dollar – and let’s face it, Mr Trump’s economic plans take no account of the medium term – would have the opposite effect. 

Interestingly, China has spent almost one-quarter of its reserves preventing the renminbi from depreciating too fast over the past 18 months – a factor that Mr Trump overlooks with his charges of China being a currency manipulator by undervaluing its currency. 

Then there are flows of physical goods. If China disrupted the parts of the supply chain that it controls this could severely hamper the activities of US multi-nationals. 

In a report released before the US election, the Peterson Institute for International Economics suggested that the “iPhone could be China’s secret weapon in retaliation” for any tariffs imposed on Chinese exports to the US. “Cutting off supplies to Apple could severely disrupt the availability and increase the price of a beloved consumer product,” says the report. 

All the same, things do not look good for avoiding conflict. China has launched a complaint to the World Trade Organization against the US and the EU for classifying it as a non-market economy in terms of calculating anti-dumping duties. Hard to see how this stance is likely to change in the current environment and China’s response could be even more dumping.

Brian Caplen is the editor of The Banker.

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