Liberation Day

The start of a new world order?

Liberation Day came with a bang, with President Trump announcing reciprocal tariffs on the US’ trading partners. Although it is not clear who this policy liberated.

I suppose it can be said that investors in the US stock market were liberated from around US$2.5 trillion as the US stock market crashed by 5%. In the process, making President Trump’s Rose Garden claim that the Liberation Day would herald a new era that would “make America wealthy again” sound somewhat discordant.

Given the size of the tariff shocks, we should not be surprised by the market reaction. It has been clear for some time that a key risk to the economy and financial markets was a tariff policy approximating the one that was launched on Wednesday (see, for example, Vale 2024. Salve the year of the Donald) and the equity market response is consistent with our simulations of a 60% tariff on China and 10% tariff on the rest of the world.

So, what exactly happened? The key Liberation Day announcement was reciprocal tariffs on almost all US trade partners with a baseline tariff of 10%.

Countries were then singled out either to receive a higher tariff rate, with the rate dependent on how unfair their policies were towards US exports, or to receive no reciprocal tariff if their trade was already subject to sanctions. This latter group included Russia.

How did the Trump Administration determine how recalcitrant a country was and, therefore, how high the reciprocal tariff should be? Officially, they announced that they accounted for the tariffs that a country levied on US imports, as well as non-tariff trade barriers (Australia’s embargo on imports of fresh US beef is an example of a non-tariff trade barrier) and the impact of currency manipulation (i.e., targeting their exchange rate against the US dollar so as improve the competitiveness of their exports).

To undertake such a calculation on a country-by-country basis is an extremely ambitious project and would take a team of experts many months of work to accomplish. But the Trump Administration found a way of cutting through the annoyance of painstaking research to find a devilishly cunning short cut – simply take the ratio of the US’ trade deficit with the trade partner (i.e., the value of US imports from the country in excess of the value of US exports to the country) and divide by the value of US’ imports from the country.

Take Vietnam as an example. The US’ trade deficit with Vietnam is US$123.5 billion, the US imports US$136.6 billion from Vietnam, hence, according to this calculation, a tariff of 90.4% would reciprocate for Vietnam’s tariff and non-tariff barriers imposed on US goods imported from Vietnam. But in a gesture of largesse, the Administration cut the “raw” tariff calculation in half, so the final tariff imposed on Vietnam is 45% (also rounded down in, presumably, another gesture of good faith).

Of course, presenting this calculation as having anything to do with a country’s trade barriers is arrant nonsense. Following through with our example, based on Vietnam’s effective tariff on US imports versus the US’ effective tariff on Vietnamese imports, a reciprocal tariff of around 10%, rather than 45%, would equalise the tariff differential between the US and Vietnam (see The tariff dominoes continue to fall).

What is the hit to tariff rates across the globe? The two largest economies among the US’ trading partners, China and the EU, get hit with tariff increases of 34% and 20%, respectively. Countries within our region are hit hard, with the effective tariff rate on US imports from East Asia (ex-China) increasing by around 30%.

Within the region, Cambodia (49%), Vietnam (46%), Myanmar (44%), Indonesia (32%), India (26%), South Korea (25%) and Japan (24%) have among the highest tariffs. Relative to the rest of the region, Australia has come away relatively unscathed, attracting the minimum tariff of 10%.

However, if we were to apply the logic of the “trade deficit calculations” of the Trump Administration, given that the US runs a trade surplus with Australia, the US should impose a negative tariff (i.e., subsidy) of around 50% on all Australian imports into its economy. Fortunately for Australia, the share of our trade with the US is small, at just 5% of total exports.

More important to Australia is the East Asia region that absorbs around 80% of our exports. Australian Prime Minister Albanese has tabled a 5-point plan in response to the US tariffs that has been endorsed by the LNP.

The plan includes providing financial aid to affected industries, subsidising loans to firms seeking new markets, establishing a critical minerals reserve, prioritising government procurement of Australian made goods and strengthening anti-dumping laws. This last item links into the likely change in the direction of global trade arising from the tariffs, which could see countries offloading excess supply created by a fall in demand by the US, at below cost to other countries. In Australia, steel and aluminium industries could be victims of dumping.

More generally, what are the implications for global trade? Outside of the US, the largest players on the world stage are China and the EU. These two economies, both around US$18 trillion in size, each export around US$500 billion to the US per annum.

They also have significant bilateral trade relations, with China exporting around US$500 billion to the EU and the EU exporting around US$250 billion to China. Could China and the EU divert some of the US lost trade to one another?

Trade in electrical machinery, heavy machinery and vehicles, which make up a large share of US imports, could potentially be diverted. However, China and Europe cannot source two key US exports, fuel and food, from one another.

If fuel and food prices were pushed higher in an escalation of the trade war, the higher costs for these two essential commodities could push China and Europe to seek alternative sources of supply – enter Russia into the picture for China and the Middle East for Europe.

Hence, the consequences of tariffs for the direction of trade are significant from a geopolitical perspective. The geopolitical landscape is already complicated and it is possible that the trade implications of tariffs are inconsistent with the US’ geopolitical objectives.

The impact of tariffs could lay bare some of the key geopolitical contradictions lurking beneath the surface. How is that so?

The US views China as its key adversary and is focused on isolating China both economically and politically. As part of its push to isolate China, the US is attempting to break the close ties China enjoys with Russia, by offering Russia the hope of lifted economic sanctions and concessions in Ukraine and a lower US commitment to European security in general.

Europe, however, sees Russia rather than China as its main adversary, and tariffs encourage closer economic ties between Europe and China. This not only compounds Europe’s decoupling from the US over disagreement on how to handle Russia, but also thwarts the US’ attempt to isolate China.

Finally, China is seeking to reassert itself as a major economic and political power on the world stage. It has been attempting to achieve this goal through closer trade relations across the globe.

However, China’s manipulative practices, that have seen rapid growth in its advanced manufacturing, has been met by push back by most developed countries since Covid. Trump’s tariffs threaten to weaken the resolve of developed economies to push back on China.

China’s economic power increases as the US’ trading partners are cut off from US markets due to tariffs. China then remains unchallenged as the main global customer.

The stage is set for a destabilised geopolitical landscape, with the Russian threat rising in Europe as Russia sources military inputs from China in return for supplies of fuel and food. Tariffs push Europe towards greater trade ties with China.

Tariffs also push other US trade partners towards greater reliance on China, particularly in the East Asia region. In this world, the outcome is that the US, rather than China, becomes isolated, that Europe is destabilised by the threat of war with Russia, and China replaces the US as the world’s dominant economic and political power.