Threats and counter-threats on US-China trade continue to escalate, with President Trump looking at a 10% tariff on a further $200bn of imports. This appears to be in addition to the 25% tariff on the initial $50bn and the extra $100bn currently under investigation. Limits on Chinese FDI into the US will be announced by the end of the month.

China has already outlined a planned retaliation against the first $50bn (for both sides, $34bn already detailed, with $16bn in progress). However, it cannot retaliate as far as $350bn of US imports for the simple reason that last year it only imported about $130bn of goods from the US. (The US imported $505bn from China.) The next target could be US firms operating in China. Depreciation of RMB is another possibility, in order to maintain competitiveness, and this would be disruptive to the rest of the region.

Recent years have shown that the short-term need for an acceptable growth rate is more important than longer-term plans for deleveraging, so China is likely to loosen monetary policy if barriers to its exports are implemented. Despite its credit bubble, China has policy tools to offset temporary disruption to trade.

It looks like Trump is raising the stakes in order to press China to capitulate and grant concessions without retaliation. This is a dangerous game for both sides, with debt-related stresses in China making it vulnerable to a hit from exports. Meanwhile, retaliation from China is carefully targeted at areas (mainly agriculture) that have been part of Trump’s core support base.

The dispute seems to be about national security as much as trade. Tariffs on imports from China will mainly divert production to other, similar cost producers, rather than the US. Moreover, with the US unemployment rate near to a 50-year low, there is simply not the capacity to shift much production to the US. More realistically, the fiscal stimulus that is currently boosting demand in the US will probably raise imports and lead to a wider overall trade deficit. This means that trade friction – not just with China – will be a recurrent problem.

The focus on intellectual property theft and on products related to China’s 2025 industrialisation plan suggests higher-level US concerns. In this case financial markets might be over-estimating the possibility of compromise, as the US could be ready to accept moderate economic damage in order to undermine a growing military rival.

Calculating the damage from tariffs is difficult. Simply noting that $50bn is only 0.3% of the US economy probably understates the losses, due to the potential disruption to global production networks. Moreover, the proportionate hit to listed firms will be greater than to the economy overall, as it is the large multinationals that dominate global trade.

China owns nearly $1.2trillion of US government debt – more than the annual budget deficit. Talk of a “buyer’s strike” tends to emerge whenever there is an outbreak of trade friction, but it is unrealistic. Firstly, China has not accumulated any additional US bonds in recent years, as its current account surplus has shrunk and its foreign exchange reserves have fallen. Secondly, China could not sell its existing holdings as no other market is large enough to take the funds, while the impact of switching back into RMB would be disastrous for the exchange rate. Of course if President Trump threatens a selective US default on the debt owned by China then this could shock markets, as this is the world’s basic risk-free asset.

We cannot expect any checks and balances on Trump’s action from a compliant Congress. It might be that financial markets offer the best hope of restraint, as Trump has previously viewed the equity market as a gauge of his performance. In that case, things need to get worse before they get better.

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