Traders' dilemma: Developing countries' response to trade wars

Abstract

AbstractAs the United States engages in a trade war with its major trading partners, policymakers in developing countries face the ‘traders’ dilemma’: should they join the trade war, stay out or do something different, including continuing to pursue regional trading arrangements? Using a global, general equilibrium model, we paper simulate an increase in U.S. tariffs to non‐MFN rates and retaliation in kind by its major trading partners—the European Union, China, Mexico, Canada and Japan. We consider four possible responses by developing countries to this trade war: (a) join the trade war; (b) do nothing; (c) form regional trading arrangements with all regions outside the United States; and (d) unilaterally liberalise tariffs on imports from the United States. We find that joining the trade war is the worst option for developing countries (twice as bad as doing nothing); and forming RTAs with non‐U.S. regions and liberalising tariffs on U.S. imports (“turning the other cheek”) is the best. The reason is that a trade war between the United States and its major partners creates opportunities for developing countries to increase their exports to these markets. Liberalising tariffs increases developing countries’ price competitiveness, enabling them to further capitalise on these opportunities.