The risk of a trade war between the USA and China has grabbed markets’ attention recently, fuelled by headlines; Twitter quotes from Donald Trump and also because of the threat of retaliatory action from China. Equity markets are under pressure, credit spreads are wider, and bond yields lower as a result.

No one wins in a trade war – The argument for free trade is based on the theory of comparative advantage, according to 19th century economist David Ricardo. Comparative advantage is the ability of a country to carry out a particular economic activity more efficiently than another country. The theory states that if countries specialise in producing goods where they have the lower opportunity cost, there will be an increase in economic welfare and both countries will gain by trading with each other.

The trading relationship between the US and China has moved from near zero to a deficit of $US375 billion over the past 20 years. President Trump wants to reduce this deficit and has planned to implement tariffs against certain Chinese imports.

The US argues that Chinese companies sell their products at lower prices in foreign markets than they do at home — a practice known as “dumping.” In addition, the US claims that China is stealing intellectual property despite the practice having been tolerated since China entered the World Trade Organization (WTO).

A trade deficit happens when a country imports more than it exports. What these numbers do not show is that if US goods are sent to China for assembly and then returned to the US, these so-called “intermediate goods” are considered Chinese imports, even if the parts are made in the US. Oxford Economics and the US-China Business Council suggest that if the data were adjusted for intermediate goods, the deficit would be cut in half.

Experience shows that President Trump does not always follow through on everything he says or tweets. Currently, the consensus is that the US and China are in the midst of a noisy negotiation process that (surely) will end at the negotiation table with a sensible solution.