Oxford Economics 9 Nov 2018 10:13am

UK relatively well insulated from tariff war

Post-Brexit, the UK economy may not be as susceptible to the negative effects of the tariff war between the US and China as some are suggesting

Amid the focus in the UK on the risk of potential post-Brexit trade barriers with the EU, it is easy to overlook the fact that actual barriers on commerce are steadily being raised between the US and China, the world’s largest and second largest economy respectively.

Late September saw the latest stage in this development, with the US imposing additional tariffs on $200bn of imports from China (starting at 10% and rising to 25% on 1 January 2019), building on the extra 25% duty charged on $50bn of imports in July and August. The result is that about half of all Chinese sales to the US are now subject to higher tariffs.

China has retaliated with extra duties on US imports, varying from 5% to 10%, which came into effect towards the end of September. These apply to a total of $110bn of purchases from the US, covering the majority of goods imported from the US annually ($130bn in 2017). The good news is that there are several reasons to think that the UK is relatively well insulated from any adverse spillovers. The first is that the UK economy has relatively little dependence on manufacturing, a fact which is sometimes cause for disquiet, but which represents a silver lining when it comes to minimising damage resulting from growing barriers on trade in manufactured goods.

Manufacturing accounts for only 10% of UK GDP, a relatively small share among advanced economies. This is particularly true in comparison with Germany, where manufacturing accounts for just over a fifth of economic output. Second is an unusually manufacturing-light export sector.

In 2017, goods accounted for 55% of total UK exports, with services’ share running at 45%. But among other G7 members, ‘physical’ exports made up a much larger proportion of the total, ranging from 65% in the US to 83% in Canada. Third is the make-up of UK exports to China. In terms of the type of third-country products vulnerable to increased protectionism in US–China trade, exports of capital goods such a machinery and tools are obvious candidates.

If Chinese manufacturers produce less because of US tariffs, Chinese demand for machinery used in that production will also decline. But the UK’s exposure is limited. In 2017, China bought just over 5% of UK goods exports, making it the sixth largest destination for sales, just behind Ireland. Of those exports, sales of machinery and mechanical equipment amounted to £1.5bn, representing 9% of total goods exports to China and a mere 0.4% of total UK goods exports globally.

UK exports to China in the machinery and mechanical equipment category ranked third in importance, behind vehicles (£4.5bn or 27% of the total) and fuel and oil (£3bn/18%). Beyond the indirect effect of weaker demand for UK exports, trade diversion could add an extra channel of impact if US tariffs encourage Chinese producers to try to divert sales away from the US to other markets.

This would deliver lower prices for consumers, but at the expense of the market share and profitability of producers, including those from the UK, competing with Chinese firms. But a look at the detail of UK-China trade suggests that the balance of costs and benefits to the UK from such diversion could favour the latter.

For example, in 2017, the UK imported £9.6bn of machinery and mechanical equipment (a prominent target of US action) from China, more than six times the value of UK sales to China. Taking electrical machinery and equipment (another focus of extra tariffs), imports and exports amounted to £11.2bn and £0.9bn respectively.

These imbalances are suggestive of sectors where import penetration into the UK is already very high, leaving all but the more specialised and competitive of domestic players, and where the volume of purchases from China offers plenty of scope for UK consumers to gain from lower prices. The UK could derive a net gain from trade diversion, with the benefit of lower prices to consumers exceeding the cost to producers.

There is sometimes a tendency by commentators to over-egg the economic cost of trade barriers on the parties affected, let alone third countries, relative to what both theory and empirical evidence suggest. If we add to this the (favourable in current circumstances) structure of the UK economy and the make-up of its exports, the modest economic cost to the UK of even a full-blown trade war between the US and China should not come as too much of a surprise.

Martin Beck is lead UK economist at Oxford Economics