The Trade War Is Transforming Oil Markets

The increase of US tariffs on goods imported from China in May and the Chinese response - higher tariffs on a further $60 billion of US exports to China - threaten a slowdown in the global economy. The IMF had already warned in April that trade growth would fall from 3.0% in 2018 to 2.6% this year. Leading economic indicators, which have been weak since mid-2018, point to increasing economic fragility and a heightened risk of recession amid rising signs of stress in emerging markets.

Fundamental divisions

The failure of US-China trade talks has exposed deep divisions, stemming from differences in the two countries' economic models. While there is no real ideological conflict along the lines of the Cold War, there are clear economic incompatibilities between US market capitalism and China's state-sponsored model when it comes to international trade.

China's extensive use of subsidies to support traditional industries and develop new ones, its insistence on technology transfer for market access and its poor record on intellectual property rights all represent, in US eyes, unfair, anti-competitive practices.

China has been drawn into a rules-based trading system in part because the costs of doing so were relatively low, as a result of weak enforcement, and the benefits of increased trade relatively high. Western nations, including the US until now, assumed or hoped that China's adoption of rules-based international trading would lead to the development within China of a more free-market economy, in which the state's role would gradually be reduced. The country's integration into the world trading system was to be an adaptive process as a formerly insular China opened itself to the world.

The reality is proving somewhat different. China has pursued a highly successful strategy of rapid industrialization, which is now heavily focused on new technologies, such as electric vehicles, telecommunications, IT and artificial intelligence. Yet there has been little sign of any weakening of the Chinese state, which remains heavily involved in all sectors of the economy.

A parallel could be drawn between this and the US's own military-industrial complex, but state support in China is much more extensive and its granting of reciprocal market access more restrictive than in most western economies. There has also been little development of civil and human rights, reinforcing the concern that economic progress is not 'normalising' China along the lines of the western democratic ideal.

It is highly unlikely that China will change its direction of travel as weakening the role of the state in the economy weakens the ruling Communist Party. These ultimately are the "extravagant expectations" that Beijing says are unrealistic. Any agreement must to some extent turn a blind eye to anti-competitive practices in return for a combination of promised reforms, commodity sales and improved market access, but this would now look like a climbdown for the Trump administration.

The exercise of power

US President Donald Trump has abandoned traditional means of trade dispute resolution, such as the World Trade Organisation, making the trade war an acutely bilateral test of economic strength and political will. He has abandoned the adaptive process of China's economic integration into the world economy by demanding more radical change.

The US wants to enforce its own terms by its own means, exercising power through the imposition of tariffs, sanctions - for example against Iran, Venezuela and Russia - and now the exclusion of companies like Huawei. From the US perspective, the narrowing of its technological lead is alarming because this is a key counterbalance to the high level of state support afforded to industry in China.

For China and many other countries, Washington's wielding of extraterritorial and financial strength is seen as an abuse of power, which the US can only achieve because of its hegemony over the financial system and the key role of the dollar in international trade and finance.

The implications of the US's exercise of power via the financial system will not be lost on China. On the one hand, it is a heavy reminder that the rules of international trade were developed by the western powers after the Second World War based on their own economic models of development. On the other hand, it demonstrates US willingness not to play by those rules. While Beijing appears impotent in the face of this weapon today, it will be looking for ways to counter it tomorrow.

Changed outlook

The broad economic outlook has changed substantively from the beginning of the year. Early in 2019 there was the expectation that fear of the economic consequences for both the US and China of the trade war would result in a deal that saw the removal of trade tariffs. Now, there is the growing expectation that the consequences, both economic and political, of the trade war must be suffered first before an accommodation can be reached.

There is also a third more pessimistic possibility, which is that the trade war persists, dealing a more long-lasting blow to the world economy. By abandoning the adaptive process of integrating China into the world economy, the US has instead drawn clear red lines, which threaten to retard that process, potentially dividing the world into two antagonistic economic spheres.

In the short term, the possibility of a slowing world economy complicates OPEC and Russia's calculations as they contemplate the possible extension of their production cuts into the second half of the year. While US sanctions have taken millions of barrels off the market and increased Middle Eastern tensions, supporting the oil price, the prospect of recession means OPEC and Russia may be in no hurry to replace those barrels with their own surplus capacity.