Since early 2018, the imposition of tariffs and other trade restrictions by the US against its major trade partners has often been met with retaliatory tariffs and measures. Especially worrying is the ongoing trade dispute between the US and the People’s Republic of China (PRC), the world’s two largest economies.

The PRC has been a key target of US actions due to its large and growing trade surplus vis-à-vis the US. Between 2000 and 2017, the surplus jumped from $83 billion to $396 billion. Figure 1 shows the evolution of the trade conflict between the PRC and US.

There have been intermittent and unsuccessful negotiations to resolve the dispute, which shows no sign of abating at this point in time. This represents a major downside risk for the global and regional economic outlook, especially if it escalates substantially.

The PRC plays a central role in the tightly integrated regional production network that is vital to global manufacturing supply chains. The country imports a wide range of intermediate goods from East and Southeast Asia, and assembles them into final products for export to the world, including the US.

[tweet="ADB economists: US-PRC trade dispute to disrupt global manufacturing supply chains" text="US-PRC trade dispute to disrupt global manufacturing supply chains"]

The ongoing US-PRC trade dispute will adversely affect the PRC’s exports to the US, and thus disrupt the regional production network and global manufacturing supply chain.

Therefore, the primary and immediate impact of the trade dispute will be on trade and growth. Yet there may be important secondary effects. More specifically, the tensions may harm business and consumer confidence in both countries, which in turn may adversely affect global financial markets.

For example, the trade dispute is likely to have contributed to the recent weak performance of the PRC’s equity market, which has declined by 17.6% between the start of the year and 25 September.

Nevertheless, overall global financial markets have responded calmly so far. This is evident in the relatively stable trend of the Chicago Board Options Exchange Volatility Index and other indicators of market volatility.

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New ADB analysis in the September issue of the Asia Bond Monitor takes a closer, more rigorous look at the effect of the PRC-US trade dispute on financial markets. It examines how the dynamics of daily returns in Asian equity markets responded to the events related to the dispute, outlined in Figure 1.

The analysis separately considers two types of events announcement day and implementation day. On announcement days, trade measures or plans are either to be activated in the future or under consideration or discussion, while on implementation days the trade measures are actually activated.

Financial markets typically react on the announcement days to incorporate the new information into asset prices. However, uncertainty about implementation means that actual implementation may also produce a market reaction.

Using daily stock returns on major emerging Asia stock markets from 18 July 2017 to 17 July 2018, the analysis deploys the GARCH-in-mean (1,1) methodology to capture the price reactions around the announcement and implementation of trade conflict events. The estimated results reported in Table 1 show negative reactions of most Asian stock markets to trade dispute-related news.

[tweet="ADB economists: US-PRC trade dispute impact on Asia as limited as scope of #tariffs" text="US-PRC trade dispute impact on Asia as limited as scope of tariffs"]

Overall, the estimated results indicate that the negative effect of trade dispute-related news on Asian stock market news is statistically significant. In particular, in response to the implementation of trade restrictions, the stock index of the PRC dropped by -0.37% (i.e. 37 basis points) while those of Japan, the Republic of Korea, Malaysia, and Singapore lost 32 to 46 basis points.

On announcement days, the stock indexes of Hong Kong, China, Malaysia, Singapore, Viet Nam, and the Philippines slipped 34 to 118 basis points. The time lag between announcement and implementation gives some time to financial markets to adjust for tariff hikes, which helps prevent large swings.

Current evidence indicates a market perception that the trade dispute may have limited impacts on developing Asia’s economic prospects. This is largely consistent with the limited—albeit expanding—scope of the tariffs and other restrictions so far.

At the moment, with a great deal of uncertainty surrounding the eventual evolution of the PRC-US trade dispute, the financial markets seem to be rationally taking a wait-and-see stance. Nevertheless, if the dispute escalates significantly, the damage to trade and growth is likely to be tangibly larger. And the damage to financial markets will grow correspondingly.