Trade War 2.0: Scenarios for China’s Response and Impacts on Gulf Economies

Key Takeaways 

• In the short-term, China is expected to adopt a “calculated response” as part of its balancing policy to manage the transitional phase of the trade war. However, this strategy may shift toward an “escalating confrontation” in the medium to long term if the calculated measures prove inefficient in changing the Trump administration’s approach. 
• The Gulf countries could emerge as alternative hubs for supply chains disrupted by American tariffs in Southeast Asia. To mitigate risks, a balanced strategy combining trade openness with some precautionary measures is crucial to shield Gulf markets from the potential fallout of the potential trade war. 

On the campaign trail, American president-elect Donald Trump floated the idea of universal tariffs of up to 20%, on all trade partners, and of at least 60% on Chinese goods. In November 2024, Trump also pledged to impose 25% tariffs on Canada and Mexico if they failed to address drug trafficking and migration across the border. Moreover, Trump threatened a 100% tariff on the exports of BRICS member countries  if they undercut the US dollar in global trade.

This paper examines Trump’s motivations for adopting this protectionist policy toward China, Beijing’s potential responses and the likely implications for Gulf countries.

Return of the Trade War

If implemented, American consumers would bear the brunt of this protectionist policy. According to some assessments, the average US household could face an additional tax burden of nearly $3,000 in 2025. However, Trump will not have a free hand and some precautions should be taken into consideration. This paper estimates that while legal mechanisms, such as executive orders, allow the US president to impose tariffs, the process could extend into late 2025 or early 2026 despite Trump’s urgency to act early in his term.

It is also highly likely that these threats are part of Trump’s broader negotiating strategy, suggesting delays in imposing tariffs on targeted countries.

Taking these two factors into consideration and the likely endeavor by the Trump administration to limit inflationary fallouts on American households, the assessment of this paper aligns with others predicting that Trump will impose:

A 30% across-the-board tariff on Chinese imports to the US.

A 25% tariff on selected goods from Europe, including steel, aluminum and automobiles.

A 10% tariff on selected imports from Canada, Mexico, Japan, South Korea and Vietnam.

These measures would raise the effective US tariff rate on imported goods from 2% to around  6%.

China’s Tools for Response: Scenarios

The level of sanctions imposed by the Trump administration is likely to shape Beijing’s response. However, factors determining China’s relative power in the context of competition between the two countries have changed compared to Trump’s first term. Contrary to expectations by most Western experts, this variable may influence the Chinese leadership’s decisions more significantly than the tariff levels. This adds considerable uncertainty, making it challenging to establish clear standards for predicting Beijing’s actions or accurately measuring its potential response.

This paper focuses on two broad scenarios fundamentally based on Beijing’s assessments of its interests in the context of its bilateral ties with Washington and its evolving perception of its role in the global order, which has shifted significantly in the four years that followed Trump’s first term.

Scenario 1: A Calculated Response

Regardless of the size of tariffs imposed, China may conclude that avoiding direct confrontation with the US is in its best interest. In this scenario, Beijing would pursue de-escalation, adopt measures to mitigate the impact of tariffs and prioritize diplomacy to stabilize bilateral ties and preserve gains achieved during the Biden era.

A critical tool in this approach would be engaging with the new US administration on “Phase Two” of the trade negotiations, following the Phase One agreement reached after two years of talks. Trump’s associates accuse China of failing to meet the terms of this agreement, particularly its commitment to increase imports of American goods by $200 billion. In response, China’s commerce ministry has signaled its willingness to collaborate with the Trump administration’s economic and trade teams.

China’s strategy under this scenario might also involve prolonging negotiations, recognizing that Trump might seek a political victory before the 2026 midterm elections. This tactic could turn these negotiations into a pressure tool.

This scenario hinges on the Chinese leaders’ assessment of their country’s vulnerabilities, including the sharp decline in China’s economic performance, delays in advancing its high-tech sector compared to Western countries and military challenges in the South China Sea and the Taiwan Strait.

Therefore, China’s response might be limited to several non-confrontational measures, notably:

Expand Economic Stimulus: Increase the $1.4 trillion economic stimulus package announced in November 2024 by expanding the debt package. The Politburo of the Chinese Communist Party signaled this shift in its November 9, 2024 statement, marking a shift in China’s monetary policy from “prudent” to “moderately loose,” a term not used since the 2008 global financial crisis.

Devalue the Yuan: Compensate for tariff-related costs by devaluing the yuan for exported goods. This tactic was effectively employed during Trump’s first term to mitigate trade pressures.

Promote Domestic Production: Increase dependence on local products to meet the needs of the government and official institutions. This will have an impact on major American corporations and Western exporters.

Accelerate Economic Decoupling: Speed up the decoupling from the US to immunize China’s economy. This trajectory has actually existed since the start of Trump’s first era, encompassing goods not included in tariffs. For instance, since the implementation of the first tranche of tariffs in 2018, China’s share of US imports fell from around 18% to around 14% last year. In particular, China’s share of exports of goods under tariffs declined to 17% from 25%, while goods not under tariffs saw their share fall to 35% from 40%. This trajectory is likely to continue in the medium and long terms regardless of the level of imposed tariffs.

Enhance Security Cooperation: Strengthen measures to curb the export and trafficking of fentanyl used in making narcotics from China to the US, a condition Trump has cited for reconsidering some tariffs.

Address Excess Capacity: Implement reforms to address China’s “excess capacity” problem to convince other nations not to join US-led tariffs. In addition, accelerate efforts to localize Chinese industries in other countries and redirect exports to Western markets through countries not targeted by Trump’s tariffs.

The fundamental objective behind China’s adoption of these measures is to compel Trump to return to the negotiating table – a goal that aligns with Trump’s own strategy. However, a key challenge to this approach would arise if the Trump administration quickly imposes tariffs upon taking office in January 2025, a move likely intended to appease his domestic base.

Scenario 2: Escalation of Confrontation

While the first scenario focuses on de-escalation and non-confrontational policies, the second scenario assumes that the Chinese leadership might opt for escalatory measures in response to US tariffs. Beijing may calculate that China is now much stronger than during Trump’s first term, based on both internal and external factors.

Internal Strengths: President Xi Jinping enjoys consolidated authority, with his closest allies dominating the Communist Party. This unity contrasts with the factionalism prevalent during Trump’s first term, providing Xi greater flexibility to respond to external pressures – whether through cooperative engagement with the Trump administration without expecting an internal reaction or through adopting vengeful measures without facing significant domestic opposition.

External Strengths: China’s position as a global power has solidified, with Beijing aspiring to lead the Global South through multilateral platforms such as BRICS and the Shanghai Cooperation Organization (SCO). Additionally, China continues to champion a more open global economy under World Trade Organization (WTO) rules. Moreover, China is seen as a potential mediator in international conflicts.

Beijing might also estimate that it has acquired strategic tools to pressure the Trump administration to make recalculations and de-escalate. This could lead to a fierce trade war between the two sides with significant implications for the global economy. Key measures could include:

Imposing Retaliatory Tariffs: Introduce tariffs on US goods sold within its market.

Restricting Critical Exports: Limiting the export of critical and rare minerals, particularly those crucial to high-tech industries where China holds a dominant global market share.

Targeting US Companies: Enforcing bans on US firms under China’s “Unreliable Entity List” or the ” Anti- Foreign Sanctions Law,” mirroring Washington’s “Foreign Direct Product Rules.” This approach could target major US companies wherever Chinese components are integral – like Apple and Nvidia – potentially disrupting the global flow of US products.

Reducing US Treasury Bond Holdings: Escalating the sell-off of US Treasury bonds, currently valued at $780 billion. Having already reduced its holdings by 30% since 2017, such a move could destabilize US financial markets.

The primary obstacle to the realization of this scenario lies in China’s main objective in “Scenario 1:” bringing both sides to the negotiating table. Such negotiations could either extend the period of escalation or result in a mutual agreement.

Implications of the Trade War for the Gulf

Predicting the Chinese leadership’s exact calculations remains challenging, especially during these early stages. However, in the near term, China is likely to adopt the measures outlined in “Scenario 1” as part of a balancing strategy to navigate this transitional trade war. Over the medium to long term, however, Beijing may pivot to the actions described in “Scenario 2” if the tools in “Scenario 1” fail to influence the Trump administration’s approach.

This shift will largely depend on the progress of negotiations and the challenges encountered in reaching agreements on US-China trade relations. A critical factor will be the potential renewal of the US-China Agreement on Cooperation in Science and Technology, which expired last August. Beijing views the extension of this agreement as a potential safeguard against further escalation in the technology war by the Trump administration.

In essence, China will likely explore every possible avenue to avoid a full-scale trade war – or, at the very least, to avoid initiating one.

This trajectory of US-China relations will have significant implications for Gulf countries, largely shaped by the scale of the trade escalation. A key opportunity lies in the potential relocation of Chinese industries, particularly those associated with the energy transition, such as solar panels, electric vehicles and batteries. Gulf nations could position themselves as alternative hubs for disrupted Chinese supply chains, especially in Southeast Asia.

The Trump administration’s imposition of tariffs on Chinese companies operating in Southeast Asia has already reshaped trade patterns. By 2023, less than 1% of total US solar panel imports originated directly from China, according to official data. Instead, over 80% came from four countries: Cambodia, Malaysia, Thailand and Vietnam. This prompted some Chinese companies to relocate production lines to other countries in the region, including Indonesia and Laos.

US imports of solar panels from Indonesia doubled in 2023, reaching $246 million. By the first nine months of 2024, Vietnam reported a $83 billion trade surplus with the US, while Thailand recorded $39 billion, Indonesia $11 billion and Malaysia $15 billion.

In contrast, the ASEAN bloc recorded a trade deficit of $88 billion with China during the same period, underscoring the shifting trade dynamics in the region.

This suggests that Gulf countries could capitalize on the ongoing restructuring of global supply chains – a process that Chinese companies initiated early. For instance, Saudi Arabia and the UAE together account for approximately 53% of total solar production in the Gulf region. In 2022, Middle Eastern countries imported nearly 11.4 gigawatts of solar components from China, marking a 78% increase compared to the previous year. On the export side, China’s policy revisions aimed at addressing “overcapacity” in its industrial sector may foster greater balance in bilateral trade with several countries in the region. However, the Gulf bloc, as a whole, does not generally experience a trade deficit with China.

Additionally, Beijing is expected to strengthen ties with key US allies, including the European Union, Japan, South Korea, Australia and Britain, aiming to position itself as a leader among nations pursuing strategic independence. This strategy is intended to deter these countries from aligning with the US in the trade war. China’s efforts to deepen these relationships are already evident through key diplomatic engagements: President Xi’s visit to the EU in May, Premier Li Keqiang’s visit to Australia in June, Li’s meeting with his Japanese counterpart in October, Xi’s subsequent meeting with the Japanese prime minister in November and improved relations with Britain.

The desire of these countries to counterbalance the Trump administration by strengthening trade relations with China presents opportunities for the Gulf region. This is reflected in the openness of both sides to diversifying relations and partnerships to mitigate the impact of Trump’s protectionist policies. However, the challenges faced by Gulf countries due to the escalating trade war between Washington and Beijing outweigh the potential opportunities, even under the assumption of the Scenario 1, until an agreement is reached, as any resolution is likely to require considerable time. Among the most significant challenges are:

First, if the US imposes tariffs – whether as a bargaining tool or otherwise – a global economic slowdown is anticipated. This would likely lead to a decline in oil prices, reminiscent of the scenario during Trump’s first term. A slowdown in global demand, particularly from China and the broader Asian market, would be the key driver of this trend. Policies aimed at curbing industrial production in China while boosting domestic consumption would further contribute to this scenario. As a result, the oil-exporting Gulf states could experience a decline in both GDP and exports, while Iranian exports are also expected to drop as the “maximum pressure” policy is reinstated. Additionally, the anticipated slowdown in the energy transition, driven by Trump’s right-wing stance, could hinder global efforts to combat climate change. This would likely lead to a further deceleration of clean energy growth in the Gulf region.

Second, the Trump administration may extend tariffs to Chinese manufacturers operating in the Gulf countries, potentially stifling the region’s industrial growth. Ongoing discussions in Washington suggest that the Gulf states could be included among countries targeted by these tariffs, similar to those in Southeast Asia. This move would seek to prevent China from turning the Gulf region into an alternative export hub for its companies, regardless of existing Gulf trade agreements with the United States. In 2018, Trump extended tariffs of 25% on steel imports and 10% on aluminum imports to the European Union, Canada and Mexico, primarily to counter the re-export of Chinese products from these countries to the US.

Third, China may attempt to redirect its exports from US, European, Canadian and Mexican markets to the Gulf, leveraging the region’s high demand and purchasing power to mitigate the impact of tariffs. This redirection could result in a surge of low-cost Chinese goods entering Gulf Cooperation Council (GCC) markets. This would likely undermine local companies that may struggle to compete with cheaper imports and lead to a slowdown in the region’s industrial transformation and localization efforts, particularly as local markets become saturated.

Fourth, the Gulf region’s exports could also be indirectly affected by US tariffs on third-party countries, such as the European Union and ASEAN nations. While Gulf countries do not directly compete with China in these markets – due to their focus on oil exports – these tariffs could result in a trade deficit with some of these countries. This would be due to an expected increase in exports to the Gulf as Asian markets become saturated with inexpensive Chinese products. Furthermore, the imposition of new tariffs could drive up the cost of goods imported to the Gulf.

Conclusions

The Gulf economies face significant challenges in 2025 due to the global trade turbulence expected under the Trump administration. Even without the immediate imposition of tariffs, the persistent threat of such measures will likely influence market expectations. This could lead to higher prices for goods and services and a decline in the performance of Gulf financial markets. However, in the medium to longer term (over the next four years), the Gulf region could emerge as a new hub for Chinese investors and exporters seeking bypass US tariffs. This could position the Gulf as a key gateway for Chinese goods destined for Western markets.

In light of these developments, it is essential to adopt a balanced approach that combines trade openness with precautionary measures to safeguard the Gulf markets against the direct repercussions of a potential trade war. This could include exploring the imposition of tariffs on the re-export of certain Chinese goods destined for the US. At the same time, efforts should be made to enhance the competitiveness and diversification of Gulf-manufactured goods, as well as sources of foreign investment. Additionally, deepening cooperation with East and Southeast Asian markets, which are looking to counterbalance US sanctions, should be a priority. Expanding trade relations with the European Union and opening new markets in Latin America will also be key to fostering resilience and long-term growth in the Gulf region.