Why Trump's tariffs on China will put Australia in a vulnerable position

A new round of trade war has begun. Financial professionals and most large investors originally believed that Donald Trump would only create noise and not stir up real trouble.

As early as mid-December last year, Deutsche Bank conducted a survey of major global financial institutions, asking them about their biggest concerns for the coming year. The survey results showed that the top concern was a global trade war triggered by tariffs imposed by the new US president, followed by a global stock market crash, as the stock market had been pushed to high levels and was likely to fall at any time.

In the past few days, we have already witnessed the beginning of these two major concerns. Many believed that the new president would use the threat of tariffs long-term to suppress competitors and force them to submit. However, he directly opened fire with heavy artillery, launching the first round of attacks. Instead of primarily targeting China as he did during his campaign, he attacked the United States’ closest allies and neighbors, Canada, and unsurprisingly targeted Mexico, imposing 25% import tariffs on both countries.

Trump accused these two neighbors of fueling the severe fentanyl addiction and death wave in the United States, despite the fact that the US Drug Enforcement Administration has identified China, and recently India, as sources of fentanyl. Fentanyl is mainly manufactured in Mexico and then shipped to the US and Canada, but the latter two receive less. China seems to have only been punished with a 10% tariff, while India has escaped punishment entirely, indicating that the tariffs have little to do with the drug trade.

In Trump's worldview, Canada committed an "original sin" because it is resource-rich, geographically close, and unwilling to accept the idea of becoming the 51st state of the United States. As for Mexico, he failed to complete the construction of the border wall during his first term. Some wonder if we have narrowly escaped. The answer is no.

Australia escaped the tariff sanctions, and Canberra breathed a sigh of relief, but the market was alarmed. The benchmark stock index fell by 2% in early trading and barely recovered, while the Australian dollar fell to a four-year low, barely holding above US$0.61. Since last November, the Australian dollar has fallen by nearly 10%. Meanwhile, government ministers continue to emphasize that the US trade surplus with Australia has persisted for decades.

But things are not that simple. Firstly, the new US president does not seem to value old alliances. Furthermore, it would be naive to think that the 10% tariff imposed on China is just the beginning. And our dependence on China makes us vulnerable. China accounts for one-third of our entire export business, and we export approximately A$220 billion worth of iron ore, natural gas, coal, and agricultural products to China each year.

It doesn't take Sherlock Holmes to see the connection. Just as China is our largest customer, Beijing's largest market happens to be the United States, exporting over US$550 billion (approximately A$895.8 billion) worth of manufactured goods to the US annually. A major structural flaw in China's once "miracle" economy is that its own consumption capacity is far less than its production capacity. Due to an imperfect social security system, most Chinese citizens save a large portion of their income for retirement. This means that the country is overly reliant on exports. Any restrictions on trade will harm the Chinese economy, which in turn will reduce our national income and lower our standard of living.

So, who bears these costs? The new US president believes that he can replace income tax with the windfall he gets from foreign countries, which will lay the foundation for him to achieve his vision of a new golden age. But he is terribly wrong. The additional costs imposed by the US on Chinese goods will immediately be borne by the businesses or individuals who import the goods into the US, and in most cases, these businesses or individuals are Americans. If they don't pass on the additional costs, their profits will be squeezed, and they will have to find alternative supplies. Otherwise, they will try to make up for the losses, which will slow down demand both domestically and in China.

In effect, Trump may have just signed an executive order locking in price increases and ruling out the possibility of further interest rate cuts, which will undoubtedly pave the way for a showdown with Federal Reserve Chairman Jerome Powell. What goods are we talking about? From consumer goods such as electronics and clothing to heavy industrial products such as machinery and construction materials. There are also semiconductors, medical supplies, agricultural products, and a range of renewable energy components. Australia's largest exports include basic raw materials such as iron ore and energy (in the form of natural gas and coal), as well as agricultural products and services such as education.

This is the worst possible time for China, and by extension, for Australia. China has been under the weight of a self-imposed economic recession for more than five years since Xi Jinping deliberately punctured the massive real estate bubble. The aftermath has led to a plunge in the construction industry and a surge in unemployment, so much so that Beijing no longer publishes youth unemployment data, while the country has been struggling to curb deflation. Interest rates have been repeatedly lowered, and a series of lukewarm stimulus measures have only just begun to take effect.

The US president is vague about the extent to which he wants to punish China. Before the election, he talked about imposing 100% tariffs. Then, as the campaign neared its end, he lowered the tariffs to 60%. Obviously, the higher the tariff, the greater the impact. The Economist Intelligence Unit recently analyzed the impact of various tariffs. It believes that at least a 20% tariff increase will reduce China's GDP by about 0.6% in the next two years. If things get worse and Trump implements a 60% tariff increase, growth could decrease by about 2.5%, which would cause serious pain for Beijing as it tries to get out of its current economic predicament.

As for retaliation, the Economist believes that China "will likely take moderate and targeted retaliation, while mainly relying on non-tariff measures" because Beijing believes tariffs will harm its own economy. His landslide victory in the US election seems to have emboldened Trump, who is not only posturing but also using trade sanctions as his preferred weapon, with China as his primary target. Australia's uneasy relationship between the world's two superpowers, namely its economic partnership with Beijing and its security ties with Washington, is about to be tested. Perhaps in the near future, we will have to make a choice.