Shipping containers sit stacked at the Port of Oakland in Oakland, California. (Photographer: David Paul Morris/Bloomberg)

Here's How a Trade War Between the U.S. and China Could Get Ugly

(Bloomberg) -- The first shot of the U.S.-China trade war went off without much of a reaction from investors. The calm may be short lived.

For months, financial markets have been bracing for President Donald Trump to follow through with threats of tariffs against China. So it came as little surprise when the U.S. implemented duties on $34 billion in Chinese imports on Friday, as planned, and Beijing retaliated proportionately.

Now comes the hard part for forecasters.

No Spillovers

Economists feel they have a good handle on the direct impact of higher duties. Tariffs raise the price of imported goods, in turn inflating costs for businesses. Those companies can fully absorb the increased cost, or pass some or all of it onto consumers. The bottom line: someone pays, prices rise, demand is hurt.

The Trump administration is currently reviewing another round of tariffs on $16 billion in Chinese goods. If the U.S. stops at duties on $50 billion in imports, and China does likewise, the hit to both countries’ economies will be modest, Bloomberg Economics projects.

Call that the neat-and-tidy trade war: both countries come to their senses, and financial markets bend but don’t break.

Spillovers Galore

However, Trump said last week that he may expand tariffs to more than $500 billion in Chinese goods, to basically cover all imports from the Asian nation into the U.S.

Economists say they can’t fully measure the indirect impact that could occur as the trade war escalates. A decline in U.S. financial markets could be one such element. Factor in a significant slump in equities prices, with the knock-on effect of falling wealth, and the likely hit to U.S. growth widens to 0.4 percentage point, according to Bloomberg Economics.

Chinese stocks and the currency have already taken a beating as concerns about the onset of the trade war gathered. The Shanghai Composite Index is in its longest losing streak in six years, and the yuan posted its worst quarter since 1994 last month. Policy makers have been out in force trying to shore up sentiment.

Here's How a Trade War Between the U.S. and China Could Get Ugly

Business and consumer confidence is another “X factor.” Business contacts in some U.S. districts monitored by the Federal Reserve indicated they’d scaled back or postponed capital spending because of uncertainty over trade, according to minutes of the June meeting of the Fed’s rate-setting committee.

“The risk is you start to see more businesses reacting negatively by constraining their investment,” said Gregory Daco, chief U.S. economist at Oxford Economics. “You’re starting to see some anecdotal evidence of businesses putting their capital expenditure plans on hold.”

In a severe scenario, declining business investment and lower consumer spending would decrease demand, which might prompt other countries to lash out with more trade barriers, creating a vicious cycle of mounting protectionism and slowing growth.

It’s difficult to measure how the “second-order” effects of a trade war would hurt the global economy, said Atsi Sheth, a managing director at Moody’s Investors Service.

“We haven’t had a real trade war at this scale in a long time,” Sheth said. “The last 50 years have been about more integration. So we don’t have very good episodes to choose from in the past that would inform us.”

Breakdown of Relations

Then there’s the unpredictability of the politics.

For now, China has avoided upping the ante. “Our view is that trade war is never a solution,” Premier Li Keqiang told reporters during a visit to Bulgaria on Friday, after the first round of tit-for-tat duties. “It benefits no one.”

“The reaction from Beijing has been restrained,” said Gene Ma, chief China economist at the Institute of International Finance. “Internally, they have a policy to contain this issue. They’ve decided this should be dealt with as a trade issue, not a geopolitical issue.”

That could change, especially if Trump continues to accuse China of trading unfairly and stealing American intellectual property. U.S.-China relations have arguably slumped to their lowest point in years, despite praise by Trump for President Xi Jinping and a prediction that the pair would “make great progress together!”

If Trump doesn’t relent, Beijing may lash out with other measures, such as swamping U.S. firms operating there with red tape, or using a weaker yuan as a weapon.

The longer the spat drags on, the harder it will be to unwind, said Bill Reinsch, senior adviser at the Center for Strategic and International Studies. While the short-term damage of the tariff back-and-forth isn’t too painful, the cumulative impact is significant, he said, adding that he foresees a long-term dispute, not a quick resolution.

Trump “only has one strategy, which is to hit harder,” Reinsch said. “It’s like two 8-year-olds having a staring contest. He’s betting that the Chinese will blink.”

©2018 Bloomberg L.P.