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Macroeconomic & Geopolitical

The Next-Most Dangerous Trade War

30 August 2019 - 3 min read

Why Investors Should Keep an Eye on Mounting Trade Friction Elsewhere.

As markets gyrate with each new trade signal from Washington and Beijing, investors would be forgiven for thinking that the state of the world’s economy rests entirely on just when new tariffs might hit Christmas toy sales. But the real danger lurks elsewhere.

Of course, the tariffs themselves add a damaging tax on international commerce as recession risks mount. Meanwhile, uncertainty around future trade rules has contributed to a decline in capital investment in the U.S. and China as firms re-think supply chains and addressable markets. These would be manageable if they were restricted to the $660 billion in bilateral goods traded between the U.S. and China.

The unpredictability, however, is spreading fast.

Last week, the world’s next-most threatening trade war between Japan and South Korea escalated to new heights amid renewed tensions intertwined in their complex wartime history. A recent South Korean court ruling awarded compensation to a 94-year-old man conscripted as a teenager to serve essentially as slave labor for a Japanese steel company during the war. Similar rulings have followed, infuriating the Japanese government, which points to compensation it paid in 1965 as part of a treaty that described all claims as settled “completely and finally.”

“The budding feud between Seoul and Tokyo demonstrates once again how populist sentiment can trigger the invocation of “national security” concerns to justify the deployment of trade weapons.”

The exchanges of sharply worded statements escalated rapidly until Tokyo suddenly played a powerful trade card last month, placing restrictions on the sale of key chemicals for Korean computer chips and digital displays. Ostensibly, the Japanese claimed concerns around the secure handling of the products, which also have military applications. But the decisions sent shock waves through Korean firms that depended on crucial Japanese supplies.

Last week, amid a Korean boycott of Japanese goods, Japan upped the ante and removed Korea from its “white list” of countries to which it extends preferred trading status, now making transactions even more cumbersome.  Korea announced it would end an intelligence sharing agreement with Japan, significantly complicating U.S. efforts to negotiate an end to North Korea’s nuclear program and manage China’s regional assertiveness.

The bilateral trading relationship is relatively small for both countries and the United States may yet succeed in managing these tensions between its two key allies. Still, the feud between Seoul and Tokyo demonstrates once again how populist sentiment can trigger the invocation of “national security” concerns to justify the deployment of trade weapons.

EXPORTS BETWEEN JAPAN AND SOUTH KOREA

Source: Factset, IMF, as of May 31, 2019

Historically, economic and military disputes have often overlapped and trade sanctions have substituted for military action. It was, after all, the U.S. oil and gasoline embargo against Japan that proved to be the proximate cause of the Pearl Harbor attack.

Indeed, the World Trade Organization (WTO) allows trade restrictions based on national security grounds, but members have been wary of invoking the principle to avoid opening a loophole large enough to scupper the entire global trading system. It’s a slippery slope to a world in which countries can ignore environmental or labor rules on the grounds that it weakens their economic strength and, therefore, national security.

But the news from Tokyo and Seoul last week suggests we are sliding down that very slope. 

So do developments elsewhere. China has recently inflicted economic punishment on its neighbors around what it deemed national security concerns. Chinese tourism to Korea dropped in half after the deployment of U.S. anti-missile systems in 2017. Chinese economic pressures have led the Philippines to soften its tone around an international tribunal’s ruling against Beijing on a territorial dispute in the South China Seas.

This spring, the WTO ruled that Russia was justified in imposing restrictions on Ukraine’s exports to Central Asia in the wake of the 2014 Russian annexation of Crimea. The ruling rejected Russia’s assertion that the WTO had no jurisdiction in the case, but accepted that the measures conformed to its rules given the context of an armed conflict between the two countries. 

The Trump Administration denounced the ruling as “seriously flawed,” but not because it wanted to back Kiev. Of greater concern was that the logic of the WTO’s ruling that seemed to unlikely to condone recent U.S. tariffs on steel and aluminum that were imposed on national security grounds. The Administration has also invoked similar arguments as it considers tariffs on European automakers.

The lines between security and trade blurred still further this month when President Trump based his recent threat to order U.S. companies to end business with China on the 1977 International Economic Emergency Act. Until now, this has been reserved for the likes of Iran for its nuclear program, or Russia for its foray into Ukraine, and it requires the declaration of a ‘national emergency’ before economic transactions can be blocked. This last threat faded away almost as quickly as it appeared, but if the chances of financial sanctions against China remain low, they are no longer zero and the disruption would be enormous.

In fact, there are fewer and fewer places around the world where the risk of economic sanctions is zero, and investors will just need to live with yet more sources of unpredictability.

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