US trade tensions with China risk unleashing economic havoc

Financial Times describes in its article that escalating tensions between the US and China could lead to a broader economic confrontation if the current trajectory continues, especially if Donald Trump returns to the White House.

In a long-awaited move, the US has updated its export sanctions against China, specifically targeting high-bandwidth memory chips and semiconductor manufacturing equipment. Additionally, Washington has placed another 140 Chinese companies on the Commerce Department’s “entity list,” making it significantly more challenging for US companies to supply them with technology.

As it has since 2018, China has quickly retaliated, this time by restricting or banning US purchases of several critical minerals and tightening controls on graphite. These retaliatory measures are highly strategic, impacting key US industries such as semiconductors, satellites, infrared technology, fiber optics, lithium batteries, and solar cells. China’s actions mirror Washington's "small yard, high fence" approach, which seeks to limit foreign access to essential US technologies.

This serves as a reminder that retaliation often fuels the escalation of conflict. In US policy circles, there's a common misunderstanding that China is overly dependent on external demand and US technology, which overlooks the other side of the equation. The US is heavily reliant on affordable Chinese goods to meet the needs of income-constrained consumers, Chinese surplus savings to compensate for the US domestic savings gap, and on China as its third-largest export market. This codependency means the US is just as dependent on China as China is on the US.

Trump rejects this perspective. During his first term, US tariffs on Chinese goods were increased from 3 per cent in 2016 to 19 per cent by 2020. Trump mistakenly believed there was a bilateral solution to America’s multilateral trade deficit with 106 countries.

That approach backfired. Over the following years, the US merchandise trade deficit grew from $879 billion in 2018 to $1.06 trillion in 2023. As expected, in response to tariffs, China’s share of the U.S. trade deficit dropped from 47 per cent to 26 per cent over that five-year period.

However, that shift simply redirected the trade imbalance to countries like Mexico, Vietnam, Canada, South Korea, Taiwan, India, Ireland, and Germany. More than 70 per cent of the trade diverted from China went to higher-cost or similarly priced nations, highlighting that trade diversion functions like a tax hike on US businesses and consumers.

We can expect similar dynamics if Trump returns to office for a second term. As US actions escalate, China’s retaliatory measures are likely to intensify. For instance, China’s recent moves on critical minerals could signal broader restrictions on rare earth elements, which are of immense strategic importance to the US.

Moreover, there’s the ultimate financial leverage—China’s $1 trillion in US Treasury securities, including $772 billion held by the People’s Republic of China and $233 billion by Hong Kong as of September 2024. Many Americans dismiss this threat, assuming that China would never resort to it, fearing it would hurt them more than the US.

But is that true? There are a couple of "nightmare" scenarios to consider: China could halt its purchases during upcoming Treasury auctions or, more drastically, begin selling off its massive holdings as America’s second-largest foreign creditor. Either of these actions could wreak havoc on America’s already fragile economy, destabilizing the US bond market and causing significant turmoil in global financial markets. While it may seem implausible—almost suicidal—for China to trigger such a financial crisis, it’s equally reckless to ignore the potential risks of provoking a desperate adversary.

By Naila Huseynova