Kevin Nealer and Tom Gallagher Published in the Nikkei Asian Review

July 12, 2018

Principals Kevin Nealer and Tom Gallagher published an article "The Trade War -- What is Not in the Price" in the Nikkei Asian Review on July 12, 2018. Read the article here or below.

Veteran financial traders often lament that their younger co-workers have never lived through a bear market. But it is fair to say that no one alive has experienced a trade war comparable to what the U.S. under President Donald Trump is starting.

Before the tariffs now being imposed on a range of products from China, it was solar panels, washing machines, steel and aluminum. What's next? We believe it is a foregone conclusion that the "national security" auto case will result in tariffs -- likely against high-end cars from European and Japanese automakers -- before the November midterm elections. Why? Peter Navarro and Robert Lighthizer, Trump's top trade advisers, believe they know what to do based on the U.S. experience in the "car wars" with Japan in the 1980s.

When the U.S. instituted "voluntary" negotiated limits with Tokyo, that agreement capped the total number of vehicles Japan would export to the U.S. The result was that Japanese manufacturers migrated from the production of inexpensive subcompacts to creating premium brands like Lexus and Acura.


The impact was twofold. First, it "trained" Japanese carmakers to directly challenge the (then) "Big Four" U.S. automakers in their most profitable market segment. Second, the Japanese also increased their production in the U.S.

Trump's decision to impose tariffs on high-end cars is shaped by those lessons, but it is now occurring in an auto market that is far more global in terms of supply chains, and which is totally integrated when it comes to North America because of the North American Free Trade Agreement.

We are struck by the inadequacy of the modeling of the impact of the tariffs in most of the studies conducted so far. It is like the old joke about a person looking for their wallet under the streetlight -- not because that's where they lost it but because that's where the light is better.

Economists at think tanks and major investments banks model the tariff effects as if they were simply price increases for imports because that is what they can model. The conclusions offered often need two places to the right of the decimal point to gauge the results as seen in recent findings by the Information Technology & Innovation Foundation and Oxford Economics.

Is that all there is? These studies likely are not wrong for what they do measure. But they appear to us to understate the risks not just to the U.S. and China, but to the Asian investment and supply chain system that is ineluctably bound with Sino-American trade.

The launch of the trade war is based on the premise that trade is a zero-sum game -- the incentives for investing in the U.S. versus the rest of the world would favor companies that want to serve the U.S. market. But the early evidence clearly supports the idea of a negative-sum game -- investment is depressed by the impact of higher tariffs and shifting trade alliance structures as well as the resulting related uncertainty on expectations of U.S. and global growth.

No studies we have seen aggregate the potential disruptions in capital flows, supply chain risks, currency responses, insurance coverage disruptions and the like. Frankly, those effects are hard to model. Obviously, the impact on alliance structures, perceptions of the U.S. investment environment, and the private sector's relationships with suppliers and customers all result in unknowable costs.

In our experience of engaging in emerging market investment for more than 25 years, the most important -- and often most challenging -- factor is the cooperation and trust a foreign investor has built with stakeholders. Trade conflicts prioritize the interests and incentives of governments over those of private actors, reminding them that their relationships are subordinate to policies that can change with little notice.

The disruptive impact of tariffs is not limited to the participants directly engaged in the fight. Looking at the impact of a trade war around Asia, a recent analysis by TD Securities, the Canadian investment bank, estimated the effects that the tariffs on China would have on other Asian actors. It made a strong case that collateral damage to South Korea, Japan and Taiwan would be significant.

We expect the collateral damage to increase further if the full weight of tariffs on China, especially as the threat to impose a tariff of 10% on $200 billion worth of Chinese goods is now being implemented and plans for auto-related tariffs are advancing.

There is another market assumption that we feel it is important to challenge -- that such tariffs are time-limited because they are "just a bargaining chip." To be clear, Trump did not need congressional approval to initiate these tariffs and the only reason they will end is if he relents and removes them or if Congress overrules him through a veto-proof majority. We believe it is unlikely China will back down soon or that the EU and Japan will buckle under auto tariffs.

That means prudent planners in the affected sectors should expect that these tariffs will remain part of the economic landscape through the rest of the Trump administration. It is certainly a bad bet for Asian companies to expect them to end quickly -- the equivalent of military leaders designing a strategy on the premise that it will be a short war.

The price of complacency and best-case planning will be high. Investors, suppliers, exporters and importers would be better off developing coping strategies that diversify supply chains, reconsider sourcing options, and weigh production alternatives to avoid the impact of tariffs.

Neither the history of trade disputes nor the political goals of the U.S. and China suggest that the current contest of wills is likely to end soon.

Kevin Nealer is a principal of The Scowcroft Group and a former U.S. government trade lawyer. Tom Gallagher is a political economist with The Scowcroft Group and a former managing director at a leading U.S. market research firm.