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As Risks Rise, Gauging the Impact of U.S. Protectionism

A shift in American policy away from free trade, while not the base case, would likely hit Asia hardest, and China in particular, with ripple effects across the global economy.

As the U.S. transitions to a new administration, the risks of trade protectionism are rising, with broad ramifications at home and among its trading partners, especially in Asia, which accounts for 67% of the U.S. goods trade deficit.

While increased protectionism is not the base case, the risk of it occurring is meaningful. Such policies might improve U.S. economic conditions in the near term, but the long-range effects of protectionism—from proposed tax reform to import tariffs and potential renegotiation of free-trade agreements—would be negative, both domestically and globally, with particular impact on countries such as China and sectors such as telecom equipment, computers and passenger cars, according to a recent Morgan Stanley Research report.

A more protectionist U.S. regime would only add to the challenge of a slowing global productivity trend.

Moreover, major U.S. trading partners would likely respond with counter-measures, raising the specter of a global trade war, crimping the free-flow of goods and services, and dragging on productivity, corporate profitability and consumer demand, according to the report, which reflected the perspectives and global expertise of its macroeconomists, market strategists and key sector analysts.

Trade, Taxes and Tariffs

In recent years, global trade has already grown sluggish, compared to previous periods. From 2011 through 2016, the volume of world trade was 25% below what it would have been, had it followed the same growth trajectory observed between 2001 and 2007, notes Chetan Ahya, Morgan Stanley's Co-Head of Global Economics. The slowdown is rooted in several factors, including cyclical conditions, such a stronger dollar and lower commodity prices, as well as changing growth patterns for large countries and the lack of progress on trade deals.

The shifting rhetoric in the U.S. has raised the risk of increasing protectionism, with potential negative repercussions on growth. “A more protectionist U.S. regime would only add to the challenge of a slowing global productivity trend," Ahya says.

In the U.S., trade policy changes could begin with proposed “border adjustability” rules as part of a broader slate of tax reforms. This Republican-backed plan would in essence bar deductions on imports, and eliminate taxes on export revenues. The controversial proposal would benefit net exporters and hinder net importers, leaving retailers and multinational corporations with international supply chains especially exposed, says Michael Zezas, Morgan Stanley’s municipal strategist who has also been leading coverage of policy issues.

Other trade-related policy changes are also on the table. In addition to changing the tax treatment of imports and exports, the U.S. may also establish broad-based tariffs on imported goods. That would mark a break from longstanding policy to lower barriers for general trade. In 2015, as much as 70% of all imported goods entered the U.S. duty-free.

Asia Impact and Response

Not surprisingly, given its role as global trade hub, Asia would bear the brunt of any U.S. shift toward protectionism. Consider that 8 of the 15 countries with which the U.S. has a trade deficit are in Asia, including South Korea, Japan and China, all of whom would feel the sting of the U.S.’s potential protectionist swing.

Still, China would be the most affected. The U.S. is a heavy importer of finished goods from China. Its $348 billion trade deficit with China is far larger than any other trading partner; Japan comes in a distant second at $69 billion. However, China relies on a complex network of regional suppliers to produce these products, everything from cellphones and computers to toys, games and sporting goods, says Robin Xing, chief China economist. “The interconnectedness of the Asian economy would mean that changes in U.S. trade policies would reverberate across the region," he says.

The knock-on effects could be substantial. Slowing imports to the U.S. would hurt any number of Asian sectors, especially manufacturers of telecommunications equipment, computers and data-processing parts, and as well car makers, among others.

That would likely prompt a variety of retaliatory responses from Asian policy makers. To start with, China and other trading partners might launch investigations into specific sectors and restrict U.S. companies from doing business in their countries. If conditions escalate and worsen, China could enact its own tariffs on imports of U.S. goods and restrict engagement with U.S. services, Xing says. The latter is no small matter, as the U.S. enjoys a $33 billion services trade surplus with China.

A GDP Gamble

Could gains at home be worth the potential global fallout? After all, the ultimate purpose of these trade policies is to revive the manufacturing sector, growing jobs in the process.

That may be easier said than done, says Ellen Zentner, Morgan Stanley's chief U.S. economist. “Decades-long shrinkage in U.S. manufacturing has not only reduced the size of the manufacturing sector to 10% of total private sector jobs, but years of sluggish demand for U.S. manufactured goods also led to a mass exodus of workers and loss of skill set," she says. Even if companies begin to create jobs stateside, they may not be able to find the right workers to staff them, at least, in the near term. The policies could boost U.S. GDP growth slightly in the short run, Zentner estimates. However, this would come primarily from a reduction in the trade deficit.

When it comes to the lasting effects of a protectionist trade stance, the outlook is less than optimistic. The Morgan Stanley report modeled the effect of 5%, 20% and 45% tariffs on GDP growth over 50 years. “Beyond a one-year horizon, the longer-term impacts on the U.S. GDP are negative in all scenarios," Zentner says.

For more Morgan Stanley Research on global macroeconomic trends and the outlook for U.S. trade policy, ask your Morgan Stanley representative or Financial Advisor for the full report "Rising Risk of Protectionism: Measuring the Impact” (Jan 5, 2017). Plus, more Ideas.