The global impact of resurgent trade tensions

The 2018 trade war underscored how damaging the interplay of higher tariffs and business uncertainty can be to global growth.

• Among the various potential shifts in policies, a change in US trade policy is likely to be one of the early decisions of the Trump 2.0 administration.
• While a variety of trade policy changes have been floated during the election campaign, a significant rise in tariffs on China appears most likely.
• But the timing and specifics around other trade policy changes are much less clear.
• As a baseline scenario, we model the global impact of a rise in the average effective US tariff on China to 60% from 20% alongside similar-sized tariffs on transshipment exports from Malaysia and Vietnam.
• The tariffs would likely be differentiated, with lower rates on goods where China is the dominant supplier to the US and higher rates where there are alternative sources.
• The lack of clarity on other trade policy changes is modelled as a rise in trade uncertainty, which is likely to dampen global business sentiment and delay investment, as it did in 2018-19.
• The impact on 2025 US growth and inflation (because of the differentiation) is likely to be modest.
• The impact on China’s growth is an estimated 2%-pts on direct trade, confidence-driven investment, and income declines. Of this half is offset through policy support (fiscal, monetary, FX, and regulatory).
• We estimate the CNY to depreciate by 10-15% (less than the implied tariff adjusted depreciation of 40%) because of financial stability fears.
• Manufacturing exporters in Asia would also get hit (India the least, Malaysia and Vietnam the most) – some could increase their export share in the US, but lose globally as China expands in non-Western markets.
• EM commodity exporters would be modestly impacted as China is likely to double down on strategic stockpiling and friend-shoring, which would support their exports.
• Growth in Western Europe would weaken modestly on confidence-driven slowdown in investment.
• The biggest risks to this scenario are that trade policy changes in the US are not incremental but extreme, involving a larger swath of countries and goods, and that China retaliates disproportionately.

A post-red-sweep roadmap

The US election delivered a decisive victory for President Trump alongside a red sweep in the Congress. This creates the potential for significant changes in US trade, immigration, fiscal, and regulatory policies. Based on public articulations by President Trump and those close to his campaign, the direction of change is broadly clear: more restrictions on trade and immigration; more tax cuts (and thus higher deficits and debt); and increased deregulation.

While the direction of change is clear, the timing and specifics are not. That is likely to be the case for some time, perhaps even well into 2025. The presence of that uncertainty does not mean that, as economic forecasters, we can simply “wait and see” – there is still a need for us to construct a base case for policy around which to build our outlook. This report represents an initial attempt to establish that baseline and establish how it will impact the global economy and a range of related geopolitical issues.

Section II below lays out our thinking on the key policy aspects of Trump 2.0 and most specifically how its shift in US tariff policy may be implemented. As far as the US economy is concerned, many of these changes will have offsetting effects (e.g., deregulation can benefit investment and growth, while increases in tariffs and cuts in immigration can be detrimental). Similarly, lower tax can boost investment and consumption, while the attendant higher inflation and interest rates can dampen both. But these are likely to be a 2026 event. Our US economics team, consequently, has made only modest changes to their growth, inflation, and policy forecast given the elevated uncertainties surrounding the policy changes.

Although the macroeconomic impacts of Trump 2.0 may net out for growth and inflation in the US, that is not the case for elsewhere. Indeed trade policy uncertainty itself can have a large macroeconomic impact. It can dampen global business sentiment, delay investment, and thereby slow capital spending. Section III looks back to draw lessons from Trump’s first administration and the 2018 trade war. In that episode business sentiment plummeted because of trade-related uncertainties, driving capital spending down globally.

With these lessons in mind, section IV is a tour around Trump 2.0 impacts that considers China, EM Asia, Mexico, and Europe in turn. The impact is likely to be differentiated by much more than the size of the change in tariffs on exports to the US each region faces: industrial structure, initial conditions, and the scope for policy response will also play a key role.

II. The Trump 2.0 trade shock

Table 1 summarizes the directional impact of potential Trump 2.0 policies. The trade and immigration changes are seen as negative supply shocks. Deregulation and higher deficits as positive demand and sentiment shocks. And trade uncertainty as a negative demand shock. The impact is differentiated across countries and in several areas it is ambiguous given offsetting effects. There is also uncertainty over mitigating policy responses. For example, if the trade shock damages growth substantially, both fiscal and countervailing tariffs could be used more extensively than envisaged, changing even the direction of the impact. Notwithstanding these caveats, the framework is useful to parse the directional effects of the various policy changes.

Trade is the blade

While many different trade-related measures have been floated during the election campaign, we focus on tariffs on Chinese imports being raised to an effective average rate of 60% from the current level of 20% as this appears to be highly likely. Alongside, we also expect a similar sized tariff on transhipment exports from Malaysia and Vietnam. We also expect these tariffs to be calibrated across categories to minimize the impact on US inflation, i.e. lower tariffs on goods where China is the dominant supplier and higher tariffs where there are alternative sources.

We are not ignoring the possibility of other types of tariffs and trade restrictions being imposed. There is unlikely to be any clarity on these measures for an extended period but none of these options will likely be removed from the table. Thus, following what transpired in 2018-19, we model the impact of these other potential trade measures via a rise in trade-related uncertainty, which, in turn, dampens business sentiment and delays investment.

Separately, even if the exact nature of the policy changes might be unknown, markets already have and will continue to price in the directional changes. The market’s reactions can already be seen in the rise in US equity, bond yields, and USD appreciation. In the coming months, market pricing will be volatile, reacting to any news about the specifics of the policy changes. And even if the Fed focuses only on the US data flow, central banks elsewhere, especially in EM, will need to contend with the changes in US financial conditions. This will affect monetary policy decisions globally and policy is used to buffer against the trade shock.

Detailing the tariff shock

We expect the 60% tariff on China to be relatively easily implemented. Over 2018-20, effective tariffs on Chinese imports were raised from 3% to 20% using mostly Section 301 of the 1974 Trade Act (unfair trade advantage) and, for some items, Section 232 of the 1962 Trade Act (national economic security) . In May 2024, USTR concluded a four-year review of the 2018 Section 301 tariffs. USTR affirmed that China did not commit to a “systematic and sustained response to the issues raised in the section 301 investigation” and, therefore, imposed higher/broader tariffs to “further encourage China to eliminate the acts, policies, and practices at issue.” These new tariffs (e.g., 100% on EVs) did not move the effective rate higher by much as they covered less than 2% of Chinese imports. Raising the tariff rate, in our view, will not require any legislative approval (as it will be under Section 301) nor will it require any investigation, unlike in 2018, because of the 2024 review by USTR . We expect the administration to announce the new tariffs shortly after taking office in late-January 2025 with an implementation date around May-June.

However, the 60% tariff is not expected to be applied uniformly. As in the case of the previous tariffs, they will likely be differentiated. We expect a low (10-20%) rate on items where there are few substitutes for Chinese imports (e.g., pharmaceuticals, rare earths, large-capacity non-EV batteries). On items where there are alternative sources (e.g., textiles and consumer goods), the rate will be much higher (even over 100% in many cases). The differentiation is likely to be calibrated to contain the domestic post-tariff price increase and minimize the impact on US inflation rather than where the assessed “unfair advantage” is higher or lower, which was the rationale last time.

President Trump has also indicated that he might impose a 10% tariff on all US imports. We are not ignoring this. However, it is unclear whether this will be imposed immediately or would be a later action to be used tactically. Invoking the International Emergency Economic Powers Act (IEEPA) would be the most plausible way to impose such tariffs. This act provides the President broad authority to regulate a variety of economic transactions albeit only after declaring a national emergency. The IEEPA is the successor to the Trading with the Enemy Act (TWEA), which was used in 1971 by President Nixon to place a 10% blanket tariff. But these tariffs were imposed in the aftermath of US depegging from the gold standard and were accompanied by a freeze on US wages and prices. The tariffs were removed after four months.

Section 122 could also be used to apply tariffs to countries with trade surpluses with the US (e.g. Euro Area); however, tariffs applied under the statute can be only up to 15% and expire after 150 days. Such actions could challenge several existing free-trade agreements (including USMCA) and spark retaliatory actions by trading partners. The US could invoke Section 301 or 232 to impose tariffs on specific items from targeted countries (e.g., as was done in 2018 on aluminum and steel products from several countries including Canada, the EU, and Mexico). In addition, the USMCA review in 2026 could become confrontational with Mexico. It has been increasingly alleged that the rise in Chinese FDI (direct and re-routed through third countries) in Mexico is for China to gain back-door entry into US markets. Our analysis so far (detailed later) suggest that, so far, Chinese investment has largely targeted Mexico’s domestic market.

Any or a combination of these measures could be imposed by the Trump administration. As we noted, there is a large degree of uncertainty on their specific nature and timing. Rather than complicate the trade shock, we model these possibilities as part of the rise in global trade-related uncertainty that gets transmitted through a decline in sentiment-led postponement of investment and capital projects.

A material but differentiated global impact

As Paul Krugman recently revealed, the “dirty little secret” of international trade is that tariffs do not have large growth effects. The reason being that, in principle, tariffs can be fully offset by exchange rate changes keeping post-tariff prices in foreign currency in the tariff-imposing economy unchanged. Thus, there is no change in volume of trade and growth.

However, this is not true for large changes in tariffs. The offsetting FX changes may need to be large. In the exporting country, the large depreciation can raise inflation, forcing the central bank to tighten policies and slow demand. The depreciation can also endanger financial stability by increasing the local-currency valuation of foreign liabilities and encouraging capital outflows. In the importing country, the currency appreciation can tighten financial conditions, slowing demand unless offset by policy rate cuts. Importantly, in both countries the rise in tariffs can raise trade-related uncertainty, which can dampen business sentiment and delay investment.

Separately, central banks with managed exchange systems can intervene to limit the FX adjustment. This is often done to ward off depreciation-driven inflation or safeguard financial stability, especially when resident’s foreign liabilities are large. If the FX adjustment is incomplete, then the volume of exports and imports changes leading to direct growth shocks.

Our analysis treats the rise in tariffs as a negative supply shock to the global economy. As a result, we expect global growth, on average, to fall and inflation to rise. The impact is differentiated across countries and depends on retaliatory measures and countercyclical measures.

Needless to say, China is the worst affected, in our analysis. We estimate that the direct and indirect effects (trade, confidence, and income) can take off 2%-pts from 2025 growth. Countercyclical measures (fiscal, monetary, FX, and industrial) can offset about 0.8%-pts, leaving a net impact of a 1.2%-pts lower growth (3.2% 4Q/4Q, previously 4.4%). The CNY is likely to depreciate by 10-15%. This is significantly less than the 28-30% implied by the tariff-adjusted fair value of the currency because of financial stability concerns. Reflecting the incomplete FX offset, the volume loss in overall exports is sizeable. China loses market share in the US but partially offsets that elsewhere in EM. Deflationary pressures on both domestic and export prices intensify.

Manufacturing exporters in EM Asia will face the brunt of the spillover effect. Here too the impact is differentiated, with the growth loss in India at the lower end and that in Malaysia and Vietnam much higher. Financial stability and inflation fears limit FX depreciation to less than that in the CNY. Tighter global financial conditions (stronger USD and higher US yields) curtail monetary easing. Fiscal policy turns only modestly supportive as the space is limited.

Growth in EM commodity exporters (e.g., Latam and South Africa) is not materially affected. China is expected to double down on commodity stockpiling and its own friend-shoring (detailed later), benefitting exports. However, the tighter global financial conditions weaken currencies, push up inflation, and limit monetary easing, thereby, dampening demand. We also expect Western Europe to be affected modestly. While the direct impact via trade or appreciation against CNY is small, the impact via a fall in business sentiment is material. With fiscal policy on a consolidation path, ECB rate cuts are front loaded.

Context will matter…

Our simulation results are influenced by the global background against which the policy changes are likely to occur. In the 12 months prior to the imposition of tariffs (Mar-Jun 2018), global growth, IP, and trade were recovering strongly from the 2015-16 slowdown (Figure 1). Labor markets had slack, inflation was lower, as were interest rates. While the GFC, European debt crisis, and the Taper Tantrum had preceded the trade war, the world had by 2018 largely adjusted to these shocks.

Today, while the pandemic supply-chain disruptions have faded, a global recovery has been led by the US with China and Europe lagging. Recently, Japan has begun to shake off the three-decade long stagnation and a flurry of policy stimulus has improved China’s near-term outlook. EM has continued to demonstrate resilience and, although uncertainty still looms, Europe too has shown signs of improvement. That said, global inflation after a strong downshift is turning sticky. But the downshift has allowed central banks (barring a few) to ease policy rates, including in the US. Labor markets in the US, Europe, and in several EMs are tight. Importantly, global trade has revived from the pandemic lows. Consequently, a trade shock now could easily reverberate more strongly disrupting the global recovery, reversing the disinflation gains, and, eventually, pausing the monetary easing.

…as will global politics

Global macroeconomic outcomes will depend not just on the size and breadth of US tariff changes but also on how affected countries respond. China’s response will naturally be critical amid an economic and political landscape that is starkly different from the 2018-19 episode. Back then, while China’s growth was slowing it was seen as part of a controlled design, aiming to transition the economy from being credit-fueled and housing-led to being driven by advanced manufacturing and services. And China’s ambitious “Made in China 2025” plan was still seen to be on track. As such, some political analysts have concluded that China’s economic and geopolitical response then was based on a sense of triumphalism.

The situation today is markedly different. China’s post-pandemic recovery has been anemic. Consumption has floundered and although exports have been strong, that has not been sufficient to absorb the capacity created by policy-supported expansion of industrial production. The rise in excess capacity, in turn, has triggered a deflationary spiral in both domestic and export prices. In addition, the transition from real estate to emergent industries has been significantly slower than expected, with the growth drag from the adjustment in housing not fully offset. The technology sanctions by the Biden administration over the past four years, and increasing restrictions by Europe and the US on China’s new economy exports (such as EVs), are likely to delay the transition even further. Amid slowing growth, deflation, and intensification of technology and export barriers, China’s policymakers today feel they are “under siege” from the West’s hardening policy. This change in perception could potentially alter China’s response this time around. Rather than being limited to currency depreciation and reciprocal tariffs it could swing to more disproportionate and retaliatory measures. In our view it would be unwise to infer that because China’s economic conditions are weak, the response will be measured.

Policy risks amid the geopolitics

Our anticipation of a material but relatively modest growth and inflation impact is based on an incrementalist view of how the policy changes will be implemented. This is also how market pricing appears to be viewing the potential changes. The biggest risk is that the shifts in trade policies could be extreme and more widespread, targeting other countries and goods. If this were to happen, a disruptive market reassessment of Trump 2.0 policies could be on the cards.

It is widely believed that the administration will use the prospect of tariffs as a negotiating tool. For example, US could threaten to raise tariffs (or raise them modestly first) to carve out a Phase 2 deal with China. It is difficult to envisage such a deal as the US goods that China wants to purchase are effectively banned because of technological sanctions that are unlikely to be lifted. Also, given that the Phase 1 deal itself was unsuccessful, going down the same path again is unlikely find much support or be effective.

Raising tariffs (on China or globally) also runs counter to President Trump and his team’s desire for a weaker USD. Some have suggested a Plaza-type accord with China. This seems unlikely as that accord involved commitment of unified FX intervention by major central banks in the yen market. This seems hard to forge in light of Trump administration’s preference for unilateral action in global affairs. There is also widespread fear within China of the “Japanification” of its economy, which it also believes to have been brought on by the forced yen appreciation under the accord.

Others have suggested that “countervailing currency intervention” could achieve both objectives of higher tariffs and a weaker USD, the argument being that if a country’s exchange rate depreciates against the dollar, the US could purchase that currency by selling dollars to offset the depreciation. It is hard to see this strategy working for every currency (in the case of a global tariff) but particularly problematic against the CNY. China maintains capital controls and while the US can intervene in the offshore CNH market, the PBOC, through interventions (e.g., aided by the MOU signed with the HKMA in 2016) and regulatory means, can sustain a wedge between the two markets if it so desires. Such actions will question CNY’s continued inclusion in the IMF’s SDR basket, but price equalization between the CNY and CNH is not inevitable. In addition, the CNH market is just 4% of the CNY monetary base. Consequently, CNH interventions are unlikely to be effective. Instead such actions could increase market uncertainty and even provoke retaliatory measures from the Chinese, e.g., large-scale sale of US treasuries.

China could also react differently this time by “weaponizing” the CNY, deploying aggressive retaliatory measures such as a broad boycott of products of US multinationals, or expansive restrictions on the sale of rare earths and critical pharmaceuticals to the US. China is a dominant supplier of processed critical minerals and certain pharmaceuticals to the US (Tables 3 and 4). While on paper India could be an alternative source of generic drugs, it too depends heavily on China for raw materials. Over time alternative sources can develop but the near term constraints on supply are significant.

Unintended consequences

There are also unintended consequences associated with trade conflict. We saw this playing out in 2018 when global business sentiment soured badly in the face of elevated trade uncertainty which, in turn, slowed IP and investment. This could well be repeated if the trade war intensifies or widens.

There is also the reaction of other EMs to China expanding in their economies to compensate for China’s loss of US market share. We have not assumed any countervailing tariffs imposed by these economies against Chinese exports, but this is a material possibility. If this happens, it will expand the trade war beyond US and China.

One positive outcome could be a material shift in domestic policies in China. Since the pandemic reopening, China’s economic performance has disappointed. Several forces are weighing on growth, the two dominant ones being the continued slowdown in housing and weak consumption. Both are the fallout of policy choices: a housing policy that has dampened price correction and exacerbated the decline in transactions and real-estate investment, and a policy stance that has favored production over consumption. This has, in turn, created excess capacity that has seeped into both domestic and export price deflation . While emergent manufacturing sectors have grown rapidly, it has not been sufficient to offset the drags from housing and consumption. Strong export growth has been the saving grace.

The Chinese government’s recent flurry of policy support will help growth but it is unlikely to allow sufficient time for the economy’s growth driver to transition from real-estate to new manufacturing. With export growth in the line of fire, the resulting growth shock could serve as the wake-up call: shifting the direction of policy support from production to consumption and initiating the needed comprehensive housing and related policy changes.

Geopolitics and climate change: America first and America alone

While we have focused almost exclusively on the economics of tariffs, geopolitics could well play a critical role in shaping the outcome, such as US support for the Ukraine War, its position on Iran and on China-Taiwan tensions. A Trump White House is likely to favor a quick settlement in Ukraine and impose “maximum pressure” on Iran. These differences, if turned into policy choices, will have differential impact on global trade, commodity prices, and likely influence other countries response to US economic policy changes, such as, on tariffs.

Separately, the Biden administration had delineated its external policy into separate areas of competition, cooperation, and confrontation across trade, national security, geopolitics, and technology. This framework is likely to be followed under Trump 2.0, which, as demonstrated before, could approach relationships with other countries to be more transactional. Consequently, there could be be trade-offs between, for example, geopolitics and economics, making it much harder to forecast the direction of both geopolitical stances and economic policies.

Climate change is clearly an area where the Trump administration will likely shift direction. President Trump in his first term withdrew from the Paris Agreement, a move which President Biden reversed. Trump has stated his intention to depart the Paris agreement again. In our view, that will make it difficult for the Conference of the Parties (COP) process to sustain the objective of limiting man-made climate change to 1.5C when it comes to COP30 in Brazil in November 2025. During this Presidential election campaign, Mr Trump has made two things clear. First is his intention to support the production and use of fossil fuels. Second is his intent to reverse a significant portion of the measures contained in the Inflation Reduction Act (IRA) which were motivated by environmental objectives. The Trump 1.0 administration also sought to remove or weaken a range of domestic regulations designed to limit climate change and protect the environment. Such changes can also alter the relocation of supply-chains underway in the US and influence trade policy.

Both geopolitics and climate change are entangled with the new administration’s likely bias towards unilateralism. Trump 1.0 eschewed the former over the latter. The Biden administration made multilateralism a key basis of its foreign engagements in geopolitics and economics. A return to unilateralism will impact not just geopolitics and transnational issues, such as climate change, but also the effectiveness of US trade and technology policies. Much of the effectiveness of the Biden administration’s tech restrictions on China was due to its multilateral implementation with strong cooperation from Western Europe and Japan.

III. Lessons from the 2018 trade war

The US-China tariff war in 2018-19 broke out when President Trump placed a 25% tariff on around US$34 billion of imports from China (including cars, hard disks and aircraft parts). This was followed by a retaliatory 25% tariff by China on the same amount of imported goods from the US. The tariff war escalated in stages, along with several rounds of negotiations and tit-for-tat tariff\ increases, and eventually broadened to cover most tradable goods (Figure 2). By end 2019, the US average tariff on Chinese imports stood at 21% (vs. 3% in early 2018), and China’s average tariff on US imports was at nearly 22% (vs. 8% in early 2018). The two sides reached Phase-one agreement in early 2020, which marked a truce in the trade war, though the average tariffs declined marginally and stayed unchanged until another round of tariffs was imposed by the Biden administration on US$18 billion goods in May 2024.

The expected effects

China’s response was broadly threefold: retaliatory tariffs, currency depreciation, and geographical diversification of exports. Among these, we argue that the more effective responses were the latter two. USD/CNY moved up from 6.3 in April 2018 to 6.85 in August 2018, then exceeded the sensitive 7-threshold in August 2019 and peaked at 7.11 in September 2019: a cumulative 13% depreciation against the USD (Figure 3). During the same period, CNY also depreciated modestly in trade-weighted basket terms.

Supported by a weaker currency, China largely offset the impact on exports by increasing its market share in non-US markets. As was to be expected, China’s share in US imports that were tariffed declined from 22% to 13.5%. Economies such as Canada, Mexico, Vietnam, and to a lesser extent India stepped in to fill the gap. However, China expanded its presence in non-US markets, including Europe, but mostly in other EMs. Indeed, China’s share in global exports rose from 12.6% to 14.7% by end 2019, peaking at 16.6% in 2Q20 when China was a dominant supplier of PPE and WFH-related tech products. At the same time, China reduced its reliance of imports from the G10 and increased that from EM (Figure 4).

The unexpected: China tariffs were borne mostly by US importers …

One surprising element of the trade war was that, contrary to popular belief, Chinese exporters did not lower their prices. Instead, US importers paid the whole tariff (Figure 5). Much of this was passed on to consumers (see here and here). The overall domestic price increase was limited, as countries that were not tariffed increased sales in the US. This was helped by the tariffs being calibrated to avoid goods where US dependency on China was high. We expect the same to happen this time around.

… and global business sentiment plummeted

Another area where the impact was surprising was the global effect on business confidence and capital spending. The trade war and uncertainties around US trade policy adversely affected global business sentiment, including in Europe and the US. Investment spending, industrial production, and growth slowed markedly (Figures 6 and 7). Importantly, even as the share of US in China’s exports fell, its share in global trade did not. China fully offset the loss in the US with increased exports to other countries, including Europe, EM Asia, Latam, and Africa. This, in part, was enabled by the depreciation in the CNY.

These lessons from the 2018 trade war suggest that the impact of higher tariffs, even if limited only to China, can spillover to global growth via sentiment effects and on other EM manufacturing economies as China edges them out in non-US markets. This could, in turn, trigger more rounds of currency depreciation among China’s competitors and countervailing tariffs on Chinese imports, thereby turning the US-China trade war global.

IV. A tour of regional impacts

China will be tested

Trade theory tells us the impact of tariffs should be minimal in a world of freely floating exchange rates. If the US raises tariffs on imported goods from China, the CNY should depreciate against the USD by the same amount. The dollar price of Chinese imports would fall to fully offset the tariff, keeping the post-tariff price of Chinese goods unchanged and, in turn, the volume of imports with China earning the same export revenue in CNY terms. But CNY is a managed floating currency. In the 2018-19 trade war, USD prices of Chinese imports did not change much and imports of tariffed goods fell sharply (Figure 8). However, CNY depreciated to offset ~70% of the rise in tariffs and China broadly preserved export volumes by increasing sales to non-US markets. If China were to allow the USD/CNY to offset 70% of the increased tariffs, as during the last trade war, the USD/CNY fair value would rise nearly 30% to 9.15 (Table 5).

It is unlikely that Chinese authorities would allow such a large CNY depreciation. Barring the last few months, when the CNY has appreciated modestly in the aftermath of the unwinding of the yen carry trade, CNY has been under continued pressure over the last two years reflecting a weak economy and unfavorable yield differential with the US. The PBOC has used both direct and indirect interventions to moderate the depreciation, fearing that it could trigger financial instability and large-scale capital outflows, as happened in 2015-16. Our view is that to preserve financial stability, the PBOC will limit CNY depreciation, likely with USD/CNY at 7.8-8.0 (around 10-12% depreciation).

Can the PBOC withstand the depreciation pressures of keeping the currency overvalued? Probably, but it will be hard. While the PBOC has around $3.3 trillion in reserves, a rapid loss through interventions would only heighten fears of financial instability rather than calm them. So the PBOC (along with other agencies) will complement FX interventions with other measures, including a strong bias in CNY daily fixing, capital controls, forced surrender requirements of export proceeds, and industrial policies, such as added tax refund for exporters as it did during 2018-19.

What about the impact on the real economy? The direct impact is mainly via the hit to China’s exports to the US. Here much will depend on whether Chinese exporters cut prices. In 2018-19, they did not. And it is more difficult today. Since 2Q23, Chinese exporters have cut prices around 16% in CNY terms or 20% in US terms, in the face of continued large excess capacity. Further large cuts in prices would further dent already falling profitability. Alternative compensating measures, such as increased tax refunds for exports, can play a role in creating space for export price cuts, but the room to do seems limited. Thus, as in 2018-19, exports to the US will likely decline. However, in the last trade war, US tariffs were on selected items that were manufactured in other countries that stepped in to fill the gap in the US. However, there are a number of goods where China has a virtual monopoly and it will be difficult for other countries to fully compensate. Thus, in these categories (e.g., rare earths and certain critical pharmaceutical APIs ) the decline in export volume will be less marked.

Much will also depend on the extent to which China is able to expand further into non-US markets. Over the last few years, this has been a successful China strategy. But increasingly China is facing restrictions from other countries on this front (from both DMs and EMs), Examples include the new EU screening framework targeting Chinese FDI that became operational on October 11, the EU’s decision in October to increase tariffs on imported EVs from China, Brazil’s decision in October to impose new tariffs on various imports from China including iron, steel and fibre optic cable to combat dumping, and Indonesia’s decision in July to impose import duties ranging from 100% to 200% on textile goods (primarily from China,) etc. It is likely that such restrictions will intensify as fears grow of a surge in Chinese exports on the back of a significantly depreciated currency.

Then there are indirect effects of the loss of export earnings on consumption and investment via the hit to business sentiment. Lower export profits will reduce investment and employment, dragging consumption. More pernicious could be rising uncertainty on US-China and global trade relations, further damaging investment and hastening the relocation of manufacturing (both multi-national and domestic).

Taken together, we estimate the hit to China’s GDP to be around 2%-pts, most likely spread over 12-18 months. This includes 0.8%pt direct impact via trade, 0.6%pt indirect impact via consumption and investment, and 0.6%pt indirect impact via sentiment (Scenario 1 in Table 6). The indirect impact via sentiment could range from 0.4%pt to 0.8%pt, depending on whether policy uncertainty rises as dramatically as in 2018-19 (Figure 9).

Table 6 also summarizes the impact of various policy responses, including a similar magnitude of retaliatory tariff on US imports and two scenarios of CNY depreciation against the USD: tariff-offsetting CNY depreciation against the USD by 28% (from 7.15 to 9.15), or a partial CNY depreciation by ~10% to 7.75.

Our results suggest that retaliatory tariff has a modest impact on the trade channel (import decline and modestly smaller impact on net exports), but it does not affect the indirect impact via consumption, investment and sentiment, hence the GDP impact is only marginally smaller (1.8%pts, Scenario 2 in Table 6).

A larger CNY depreciation (Scenario 3 in Table 6) would significantly reduce the macro impact (the drag on GDP growth is reduced to 0.9%pt). Currency devaluation would support China’s exports (especially to the rest of the world), reversing the negative trade impact and by extension mitigating the indirect impact via consumption and investment. Nonetheless, it runs the side effect of a larger hit via sentiment and intensified capital outflow pressure, leading to a large fall in FX reserves by US$751bn, on our estimates (nearly a quarter of current FX reserves).

The alternative scenario of modest and orderly CNY depreciation (Scenario 4 in Table 6) might be the preferred policy response, if such a depreciation strategy can help mitigate the sentiment shock. The economic impact via trade, consumption and investment remains negative due to incomplete currency adjustment, but is significantly smaller than under Scenarios 1 and 2. Total impact on GDP growth is 1.1%pt, capital outflow pressure will increase but is at tolerable levels, and FX reserve may decline by US$337bn based on our estimates (slightly above 10% of current FX reserve).

The scenario of tariff war 2.0 will likely lead to broader policy responses. Externally, China may further diversify exports and imports (Figures 10 and 11), especially with global South via RECP, Belt & Road Initiatives and other trade platforms. Domestically, China may step up accommodative macro policies, led by fiscal easing. Scenario 5 in Table 2 assumes additional fiscal easing (fiscal impulse will increased modestly from 0.5% to 1% of GDP) and monetary easing (a total of 30bp policy rate cuts) in 2025. Under this assumption, the total impact on GDP growth can be reduced to 0.7%pt, with the 2025 growth forecast at 3.9%. In addition, the pressure on exports may also increase the chance for Chinese policymakers to take more forceful actions to support domestic consumption and develop a unified domestic market, and adopt a more friendly regulatory policy in service sectors (including faster opening up in the service sector) to broaden the source of innovations and productivity increase, though such a policy re-direction is easy to say than to be delivered.

EM Asia in the cross hairs

A sharp hit to Chinese growth alongside a large CNY depreciation is likely to hit the rest of EM Asia through a multitude of channels:

• First, the region’s exports to China constitute almost a quarter of its total exports, though this has edged down in recent years and varies sharply across the region. But a large China growth hit will have a first-order impact through lower exports.

• Second, and often less appreciated, US tariffs may increasingly induce China to redirect its excess capacity to the rest of Asia, both in low-margin manufactured goods (e.g., textiles, steel) and high-value added products (e.g. electric vehicles), which risks rendering domestic businesses uncompetitive and making the transition to new-economy sectors more challenging for economies in the region. For instance, Thailand has explicitly named China as the source of imported deflation while Indonesia has also announced tariffs against China across a suite of goods.
• Third, if the CNY were to depreciate meaningfully, it’s likely that many regional currencies would have to depreciate but might be unable or unwilling (for financial stability concerns) to depreciate in tandem with the CNY – a phenomenon observed in the 2018-2019 trade war. This would result in a loss of competitiveness of Asian economies vis-à-vis China in third markets. ASEAN economies did not appear to lose market share to China in developed markets outside the US during the 2018-19 trade war, but the latter did increase its market share in Africa and Latin America. Depending on how relative currencies evolve, the competitiveness channel in third markets will need to be closely watched.
• Fourth, to the extent that the region’s currencies will face some depreciation pressures (both because the CNY is depreciating and because, more broadly, the new administration’s policies would argue for a stronger dollar) it will become harder for some of the region’s central banks (e.g. Indonesia, Philippines) to cut interest rates with its attendant effects on growth.
• Fifth, all of the aforementioned channels are likely to significantly dent business confidence and sentiment in the region.

Together, these channels are likely to deliver a non-trivial growth shock to some countries in the region. There are potential growth mitigants. In the last trade war, some Asian economies benefitted from trans-shipment (Chinese goods being re-routed through them) but we expect the US to take a hawkish view on this channel this time around, and therefore presume no transhipments. Second, to the extent that some economies can substitute for China in the US market, they may stand to benefit. But it’s not clear that large capacity exists to ramp up quickly.

In the long run, though, we think a renewed US-China trade war should hasten China+1 and de-risking out of China to the benefit of several Asian economies. We saw how ASEAN has benefitted from FDI flows since the last trade war, and we would expect that process to accelerate. In the medium term, therefore, several Asian economies could gain. But that is a medium-term benefit likely preceded by near-term pain.

Differentiated impacts across the region

As alluded to above, the growth impact is likely to be very differentiated across the region based on the exposure of each economy to the aforementioned transmission channels. Some economies are much more exposed and will see a significant growth shock in 2025, with Vietnam (-1.2%pt.), Singapore (-0.8%pt.) and Malaysia (-0.8%pt.) likely at the top of that list. This presumes the US cracks down on trans-shipment flows from China and potentially implements sanctions against Chinese value added elements in the ASEAN production chains, thereby particularly impacting countries such as Vietnam and Malaysia.

We expect pressures to spread beyond just ASEAN – for example, to Taiwan. In the first 10 months of 2024, for example, more than 30% of Taiwan’s exports were directed to Mainland China/HK SAR, a significant share of which was on account of China’s final exports to the rest of the world, including those to the US. Similarly, of the export orders received by Taiwan manufacturers, almost 40% are still produced out of their production lines in Mainland China. Hence, while a US-China trade war will likely facilitate further supply chain diversification by Taiwan manufacturers in the medium term, it will still impose a meaningful drag on Taiwan’s near-term export activity and the associated uncertainty is likely to impinge on their investment plans.

Conversely, an economy such as India should be affected much less (prima facie) because a very small fraction of India’s exports go to China and, to the extent that lower Chinese growth depresses commodity prices, India – as a large commodity importer – will benefit from the associated positive terms-of-trade impulses. That said, the bigger threat to India is that increased Chinese excess capacity finds its way into Indian markets, which would hurt domestic manufacturing and reduce the incentives for the domestic private sector to invest.

Importantly, these growth estimates assume there is no change to US growth from a US-China trade war because downside risk from the trade war is offset by easier regulatory and fiscal policy in the US. However, if growth suffers, the growth hit to Asia would be even larger.