Becker Friedman Institute
for Research in Economics
The University of Chicago

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The Case of the Invisible Trade War

Uncertainty over tariffs might shape trade as much as tariffs themselves.

Here’s a riddle: When does a country extending favorable tariffs effectively pay the costs of a trade war without actually being in a trade war?

When exporters—whether current or prospective, and whether dealing in consumer goods, raw materials, or manufacturing components—can’t be sure how expensive it will be to do business in that country tomorrow.

In other words, a country doesn’t have to act on its protectionist instincts to depress trade and economic activity It merely has to keep its options conspicuously open.

The proof comes from the research of economists Kyle Handley and Nuno Limão, from the Universities of Michigan and Maryland, respectively. The pair, who presented their work at a 2015 Becker Friedman Institute conference on policy uncertainty, developed an economic model of trade policy uncertainty that they could take directly to the data, in this case, data on Chinese exports to the U.S. in the years before and after China’s accession to the World Trade Organization (WTO).

What they found was a direct link between policy uncertainty and market participation. Long-running uncertainty about future tariffs limited Chinese exports to the US in the 1990s  and kept domestic prices roughly half a percent higher than they could have been.

A tale of two Chinas

Trade offers an ideal arena to measure the economic impact of policy uncertainty, argues Handley. First, U.S. Customs tracking creates a detailed picture of real-time economic activity with its record of what was imported, when, from where, and how much. Changes in those measures of economic activity can be checked for correlations with actual and potential changes in U.S. trade policy.

Second, the individual tariffs for products that cross U.S. borders are published. The schedule includes not only the tariffs that are being applied to a country’s exports at any given time but also those that might be applied in future—a quantifiable worst-case scenario should a country fall from political favor and lack the protections afforded by such mechanisms as permanent preferential status, trade pacts, or membership in the World Trade Organization.

Throughout the 1980s and ’90s, the People’s Republic of China and the Republic of China (Taiwan) occupied remarkably similar positions with respect to U.S. trade. While neither country had been admitted to the WTO, both enjoyed normal trade relations—then known as “most favored nation” status, or MFN—with the U.S. For both, that status was subject to periodic review. That is, neither country was permanently protected from the possibility of having to pay dramatically higher tariffs should its political relations with the U.S. stumble.

Had they been triggered, those so-called “column-two” tariffs would have had a significant impact. Exporters’ costs would have jumped from 3 to 5 percent, on average, to as high as 40 or 50 percent, depending on the product.

But if the magnitude of the economic threat was the same for exporters in both countries, the likelihood of that threat being realized was not. Taiwan was a multiparty democracy with a free press and an open economy, characteristics that virtually guaranteed that Congress would extend Taiwan’s favored nation status without debate.

China was a communist country, one whose economic policies were widely regarded as detrimental to U.S. interests. Its record on human rights was seen as problematic. And while the country had begun to show signs of limited economic and democratic reform, there were also dramatic reversals, such as the 1989 crackdown on student protests in Tiananmen Square. Unsurprisingly, U.S. deliberations over extending China’s MFN status were contentious and protracted. From the late 1980s onward, China regularly faced the very real possibility of having its status revoked.

For both nations, the risk of ruinous tariffs was finally removed in the early 2000s. The U.S. granted both countries permanent normal trade relations, ensuring that the favorable tariff rates they had been paying would no longer be subject to annual congressional review. In December 2001, China officially took its seat in the WTO. In January 2002, Taiwan followed. With WTO membership came the added protection of bound tariffs, an agreed upon upper limit to tariff liability that, in the case of U.S. tariffs, matched the applied tariff rates of 3 to 5 percent.

It was what happened next—and what didn’t—that caught the attention of economists Handley and Limão. In Taiwan, where the threat of higher tariffs had been a matter of form, nothing changed. Exports to the U.S. continued at roughly the same levels as before Taiwan’s accession to the WTO . In China, however, when uncertainty was resolved and tariffs were locked in, trade with the U.S. soared: from 2000 to 2005, firms in the People’s Republic increased their exports by 25 percent over the previous five-year period. More than 80 percent of that growth was in products already being traded, that is, in sectors in which China had already established a market position.

Accounting for uncertainty

Had the post–2000 growth been attributable to new demand in the U.S.—a sudden taste for certain kinds of goods, say, or changes in manufacturing—that demand would have affected Taiwanese exporters in more or less the same way. Yet Taiwan’s exports to the U.S. for the period were relatively flat.

One factor that likely did contribute to the increase in trade was political and economic changes within the People’s Republic itself. Rules on foreign investment were being relaxed, state owned enterprises privatized, and policies designed to stimulate exports adopted.

But if these factors were solely responsible for China’s explosive export growth, there should have been a similar effect in all China’s export markets—and there wasn’t. Increases in U.S. trade during the period far outpaced increases in other markets, including that of China’s largest trading partner, the European Union. Coincidentally, the EU had never established policies that routinely threatened to revoke China’s trade status.

Elimination of uncertainty and risk provided a better explanation, Handley and Limão found. They reasoned that if some percentage of China’s export growth had been due to reduced uncertainty, then the greatest increases in trade would be found in those products that had faced the highest risk.

The pair mined the World Bank’s trade database, WITS, which returned a set of more than 3,600 consumer and manufacturing industries in which Chinese firms had participated as exporters. For a first pass analysis, they divided the set into two broad categories: industries for which the gap between the tariffs actually applied and those that could have been triggered was large, and industries for which that gap was relatively small.

As they suspected, post–2000 export growth for the first group was considerably higher than for the second. The bigger the tariff increase a firm would pay on an exported product if   the worst-case scenario materialized, the less inclined that company had been to expand its position or enter the market.

The researchers dug deeper, examining each sector and controlling for variables such as sector-specific tariff reductions, lowered trade or transportation costs, or increased demand in those industries in which Chinese firms had a competitive advantage. None of the effects were large enough to explain the actual trade increase.

The evidence was clear. What mattered to Chinese firms as they weighed the opportunity costs was not just the profits they could earn under the existing conditions, with tariff liabilities at a comfortable 3 to 5 percent, but how much they would stand to lose if, as seemed likely, those tariffs soared to 50 percent. Given a bad enough worst-case scenario and a high-enough probability that it might be realized, exporters had decided to forego profits and delay expansion or entry.

In the final analysis, Handley and Limão found that an impressive 20 to 30 percent of China’s export growth from 2000 to 2005 was directly related to the U.S. decision to eliminate the threat of higher tariffs and so reduce uncertainty for Chinese exporters. And those exporters were not the only winners. The act of granting permanent normal trade relations to China—a change in policy only, that involved no actual change in tariffs or quotas—had increased the variety of goods available in the U.S. and lowered overall prices by roughly half a percent.

To put it another way, if U.S. policymakers today wanted to recreate the effect of that uncertainty on imports and prices, they would have to more than double current applied tariffs.

Can we talk?

Given the current climate, with the average U.S. tariff hovering around 3 percent and rates similarly low across the industrialized nations, it’s logical to wonder about the value of protracted negotiations and free trade agreements generally. What is there to be gained?

One of the most useful insights that Handley and Limão’s work offers to policymakers and negotiators is this: Trade talks that focus solely on lowering applied tariffs may not accomplish all they set out to. If the goal is to realize the economic benefits of trade liberalization, negotiating binding commitments may be just as important.

A second insight may give new impetus to bureaucrats struggling to make headway in the Doha Round. Even if a country decides not to commit to lower tariffs, the talks will have been a success if that country can be persuaded to do nothing more than reduce the gap between what it charges today and what it might charge tomorrow.

When it comes to investing in exports, whether as buyers or sellers, the data show that firms weigh the potential outcomes under multiple scenarios. If an outcome is uncertain enough or bad enough, Handley and Limão’s work demonstrates that even firms that have current market exposure will opt to wait and see.

It’s a course of inaction that has economic consequences across borders. And in a world in which firms seek to break up their supply chains and coordinate production across multiple borders, the magnitude of those consequences can only increase.

—Patricia Nedeau