How a trade war would impact global growth

To estimate the effects of trade tensions on global growth, we created an economic simulation. First, we calculated the direct impact of tariff hikes on GDP. Our simulation assumes that the US will put a 25% tariff on the $505 billion worth of goods imported by China, and that China will retaliate with 50% of the US tariff hike.

We then estimated indirect global impacts of the tariff hikes through iterations of global trade and financial channels. The elasticity is taken from an econometric GDP model (Vector Autoregression) for the US, China and Eurozone, and from two financial condition indexes, to capture shifts in interest rates and broader global financial conditions.

Finally, our simulation assumes that the Fed will have less policy room to absorb a shock in this late-cycle stage. We estimate that a full-blown US-China tariff war could reduce global GDP growth by 0.7 percentage points (pp) to 2.8% in 2019. The impact would be greater on China’s growth (-0.9 pp), due to direct trade effects, and on Europe (-0.8 pp), due to indirect trade effects and financial links (see table). US GDP would decelerate by less (-0.4 pp), due to less direct trade effects and indirect financial links.

Latin America’s growth would slow down significantly in a full-blown trade-war scenario. The impact would occur on two fronts: weaker global growth (and its resulting effect on international trade) and tighter financial conditions. The ultimate impact on each country will depend on how vulnerable the economy is to global financial conditions - specifically, whether or not the economy is facing external or domestic imbalances - and the exposure to trade with each of the core economies.

Argentina has a lot to lose from tighter global financial conditions. Its primary product exports (particularly soy), which account for an important share of the country’s exports (around 60%) could benefit from barriers/tariffs imposed by China on US agricultural products. However, the country’s fiscal deficit is still wide (nominal deficit at around 4.8% of GDP), there are not enough domestic funding sources, and it has the lowest ratios of international reserves in the region.

To make matters worse, markets question whether there will be economic policy continuity after the presidential elections in October 2019, so access to capital markets has been difficult even without a fully-fledged trade war. While the IMF programme ensures financing for the public sector through 2019, it will be crucial for the country to regain market financing thereafter. So, despite the possibility of Argentina’s exporters gaining market share in China with the escalation of trade war, we estimate that the trade conflict could reduce the country’s growth by almost 1.8 pp.

Mexico’s economy should suffer less. We estimate a GDP drag of 0.5 pp, as it competes with Chinese manufacturing exports in the US market, which absorbs 75% of Mexico’s external sales of goods, and as it has already reached an agreement with US and Canadian governments, pending congressional approval, to renegotiate NAFTA (now rebranded as USMCA).

Besides, the country’s fundamentals are solid, with narrow fiscal and current account deficits (2.0% and 1.6% of GDP expected for 2018, respectively), high reserves ($175 billion) and public debt stable at moderate levels (net debt of 46% of GDP). While Mexico’s economy has been facing a lot of uncertainty over the past couple of years, with the renegotiation of NAFTA and erratic signals on domestic economic policies, growth remains near potential - we expect 2.0% for 2018.

In Chile, Colombia and Peru, growth is likely to decelerate. Chile and Peru - where copper represents a large share of exports (49% and 31%, respectively) - are more exposed to China, but their fundamentals are very strong. Net public debt is below 10% of GDP in both countries and public external assets are sizable. This makes room for counter-cyclical policies, although partial dollarization of the Peruvian economy is a constraint.

Colombia is less sensitive to China. Oil represents 40% of total exports and the economy is relatively closed - the sum of exports and imports is 28% of GDP - but the country’s fundamentals are weaker than in Chile and Peru, given the still-wide fiscal and current account deficits (both are around 3.0% of GDP expected for 2018).

The Brazilian economy is relatively closed to international trade, but it would still slow down with the global economy. Exports and imports account for only 24% of GDP, compared to an average of 53% of GDP in other G20 countries. However, Brazil’s economic cycle tends to be highly correlated with the global economy. Besides trade, there are other channels through which the global economy affects Brazilian activity.

First, the country is a large receiver of foreign direct investment (FDI), which could plummet in the event of a trade war. Second, given the country’s fiscal weakness, it is particularly vulnerable to foreign capital flows, which may turn negative in periods of heightened risk aversion. Third, worse financial conditions arising from lower global growth would have a strong impact on the Brazilian economy, given its relatively developed domestic financial markets. Therefore, the impact of a trade war on Brazilian GDP would be around 0.7 pp.