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What are the implications of worsening US-China tensions?


Following US House of Representatives Speaker Nancy Pelosi’s tour of Asia, China has introduced sanctions on trade with Taiwan. In isolation, the sanctions do not amount to much in terms of economic impact. They may, however, signal an acceleration of the decoupling between the US and China.

Chinese markets have tended to underperform during past bouts of trade tensions with the US, while moves to limit China’s access to semiconductors could stifle its economy.

In the longer term, less efficient supply chains are likely to be negative for the global economy, but some emerging markets will benefit if they can grab a share of the manufacturing market. Those that succeed are likely to enjoy a structural improvement in their economies that would ultimately underpin better performance of local assets.

Protectionist policies re-emerge

Pelosi’s tour of Asia, which included a visit to Taiwan, has stirred up regional tensions as well as tensions between China and the US. Beijing has signalled that military drills in the Taiwan Strait are now complete, but that it plans to carry out regular patrols in the region.

So far the disruption to shipping appears to have been short-lived. However, with around half of all the world’s container ships thought to pass through the narrow waterway, there is a clearly a risk that the threat of further military operations in the future will have some impact on supply chains.

Heightened geopolitical tensions have caused protectionist trade policies to re-emerge. In addition to military drills, Beijing also announced a ban on imports of foodstuffs from Taiwan and exports of sand in the other direction. These measures do not amount to much in isolation. Taiwan’s total food exports to China amounted to only about 0.2% of GDP in 2021 while trade in sand is also minimal.

However, a further escalation in trade tensions could have serious consequences, not only for China and Taiwan, but also the global economy.

Global consequences of local tensions

After all, China is by far and away Taiwan’s most important trade partner. China is the destination for over a quarter of all exports and the value-added in China’s final consumption is worth around 10% of its GDP.

China is also very reliant on imports from Taiwan in some areas; in particular, it is the source of around one-third of its total imports of semiconductors. Given China’s importance to global supply chains, there is a risk that local trade tensions could have global consequences by leading to renewed shortages of manufactured goods.

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The uncomfortable symbiosis between China and Taiwan probably means that neither side will escalate trade tensions to levels that would cause such pain, but the decision may be taken out of their hands.

US President Joe Biden last week signed into law the Chips Act. This legislation aims to subsidise the development of onshore semiconductor production and prevent firms that take advantage of the deal from investing in high tech production in China. There are reports that the Biden administration is also planning an export ban to China of high-end semiconductors and manufacturing equipment that use US technology to stifle its bid to become self-sufficient.

Performance headwinds for regional markets

In the short term, heightened trade tensions are headwinds for the performance of financial markets in the region. For example, while US tariffs were largely ineffective (see: Why tariff reversal won’t save the US) in achieving their economic goals, China’s equities and currency performed poorly during the trade war a few years ago.

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In the longer term, the latest spat between the US and China will probably serve to accelerate the decoupling of the two super powers. In addition to US measures regarding semi-conductors, five Chinese SOEs (state-owned enterprises) announced last week that they would delist themselves from the New York Stock Exchange.

Meanwhile, Beijing has temporarily suspended cooperation with Washington over issues such as climate change and companies are likely to reconsider the location of their supply chains. A reversal of current integration (see: What a new world order might mean for the global economy) would be likely to make global supply chains less efficient, therefore subtracting from long term growth and adding upward pressure on prices.

Could some markets enjoy an investment boost?

However, as we discussed back in 2020, other emerging markets (EM) could benefit from the decoupling of the US and China (see: What does US-China decoupling mean for emerging markets?) if they are able to grab a share of global manufacturing output. After all, any EMs that transition towards growth models based on manufactured exports are likely to see a boost to investment and productivity growth.

That would ultimately give rise to structural improvements in their external positions and inflation dynamics. In turn, central banks would be able to sustain lower interest rates and ultimately underpin less volatile returns from local assets.

Vietnam has already been succeeding in grabbing market share in some sectors, but firms are also likely to consider those EMs with large domestic markets and a plentiful supply of relatively cheap labour. India and Indonesia are two such EMs that fit the bill, and recent reform momentum could bolster their case.

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