Tariff wars: How will the US reciprocal tariff impact Sri Lanka?

The proposed additional tariffs on the US imports from Canada, China, and Mexico went into effect early Tuesday morning (4 March), paving the way for a trade war between the US and major trade partners. In addition, the Presidential Memorandum on Reciprocal Trade and Tariff of the United States (US) has called for studies on the “unfair trade practices” of US trade partners to determine reciprocal tariff rates as a counter measure. This means that, if the EU has a 10% automobile tariff, the US reciprocal tariff would also be 10%, matching its trade partner’s tariff. 

With the US having roughly about 13,000 tariff lines, 200 trading partners, and about 2.6 million individual tariff rates, if the proposed reciprocal tariffs are fully implemented, this complex tariff system may have unprecedented effects on the global economy. This could then potentially lead to retaliation from trade partners.

The threat of reciprocal tariffs could also potentially cause a trade war between the European Union (EU) and the US with the EU likely to decrease imports from countries like Sri Lanka, making sustainable export growth in a more protectionist global economy more difficult for countries like Sri Lanka.

Tariff threats are also being used as a bargaining tool and the US may revise high tariffs in exchange for concessions from major trade partners.  

The possible disintegration of the current global free trade system, which may be inevitable if the US implements broad-based tariff hikes, is a great and immediate concern for Sri Lanka, as it is a small economy with limited domestic demand and a high dependency on external value chains.

Given that the US accounts for a quarter of exports from Sri Lanka, if the US government goes ahead with reciprocal tariffs, how would said reciprocal tariffs impact Sri Lanka’s exports? 

Reciprocal tariff rates: How will the US determine these rates?

The Office of the US Trade Representative (USTR) lists various policies as “unfair trade practices,” providing flexibility for the US authorities to determine the reciprocal tariff rate. These include high tariffs, value-added taxes, non-tariff barriers, subsidies, burdensome regulatory requirements, exchange rate interventions, and any other practice deemed by the USTR. The US plans to complete all the studies on “unfair trade practices” by 1 April 2025. 

The flexible definition of what constitutes unfair practices and the inclusion of domestically applied taxes like value-added tax (VAT) have injected substantial uncertainty into the global trade system. Over 170 economies worldwide have VAT, which is a significant revenue source for their governments. VAT is imposed non-discriminately, regardless of the product’s origin. If VAT is included in the US reciprocal tariff, the tariff hike will be larger for any economy. 

Reciprocity of tariffs: How will they affect Sri Lanka? 

Ignoring VAT, subsidies, and exchange rate interventions, reciprocity can be simplified to import tariffs and para-tariffs. Sri Lanka has general custom duties, an Export Development Board CESS, Excise Duty, Port and Airport Development (PAL), and Social Security Contribution Levy (SSCL). Once the product level tariff rates are calculated on ad-valorem basis, Sri Lanka has a higher tariff rate than the US for almost all sectors (Figure 1). 

This implies that, if the US raises tariffs reciprocally, Sri Lanka will be affected directly by increased price levels in the US market (Figure 1). As the magnitude of the negative export effect coming from a reciprocal tariff depends on the tariff differential – i.e. percentage points of tariffs Sri Lanka charges more than the US – industries such as wearing apparel, rubber and plastic products, and food products, will be more vulnerable to reciprocal tariffs.  

The export effect of tariff hikes can be estimated once reciprocal tariff rates are announced, as the magnitude of the effect on Sri Lanka’s exports depends on the relative price change compared to the competitors in the US market. Moreover, a uniform coverage across all products may not happen given the inflationary outcome of a tariff. In the first trade war, although the US announced tariffs on apparel and footwear in August, 2019 it was not implemented. 

Reciprocal tariffs, among other policies announced by the US in 2025, should be evaluated under different policy scenarios (Table 1). For instance, if Sri Lanka’s key export competitors face a higher relative tariff hike, Sri Lanka may benefit. Under the assumption that Sri Lanka will not face a tariff hike, and the US will focus on large trade partners, the likely effect on Sri Lanka due to trade diversion might be positive. For example, apparel exporters to the US, such as China and Mexico, are directly targeted for higher tariffs. Before the tariff hikes enforced on 4 March, Mexico enjoys zero apparel sector tariffs under the United States-Mexico-Canada (USMCA) trade agreement (Figure 2).

However, enforced new tariffs on Canada, China, and Mexico are estimated to cost a typical US household $ 1,200 annually. Higher prices, alongside recessionary impacts from retaliation and supply chain disruption, will negatively impact most US households, reducing import demand. This may dampen positive gains from any anticipated trade diversion. Similarly, an EU-US trade war will affect the EU economy too, dampening import demand, including from countries like Sri Lanka. 

US reciprocal tariffs, retaliations, and dysfunctional multilateral organisations will break the post-GATT/WTO liberal trade system. Maintaining sustainable export growth in a more protectionist global economy will be increasingly difficult for a country like Sri Lanka.  

Sri Lanka’s options: Phasing out para-tariffs and tightening trade relations

A closer look at Sri Lanka’s tariff data shows a heavy reliance on para-tariffs and special commodity levies (SCL). There are plans to phase out para-tariffs and replace the SCL with VAT. Under the Singapore-Sri Lanka Free Trade Agreement too, Sri Lanka has currently phased out a portion of CESS and PAL. 

Under the Sri Lanka-Thailand Free Trade Agreement also, para-tariffs are planned to be phased out. Proceeding with such measures and broadening to all trade partners will reduce the differential tariffs between Sri Lanka and the US. Overall, eliminating para-tariffs in the long run can reduce the anti-export bias in the economy, incentivising production for exports. 

A more immediate and greater worry for Sri Lanka is the possible disintegration of the current global free trade system, which may be inevitable if the US implements broad-based tariff hikes. As a small economy with limited domestic demand and dependency on external value chains, Sri Lanka's future growth will be drastically affected in a world where countries plunge into protectionism and beggar-thy-neighbour tariff practices. 

Anticipating such global circumstances, Sri Lanka needs to tighten trade relations with regional partners, particularly with the growing middle-income countries in East Asia. Continuation of negotiations for FTAs with East Asian economies and for a more effective Indo-Sri Lanka FTA are sound strategies Sri Lanka may take. Removing the existing hurdles like quotas for apparel sector in the Indian market will yield benefits from the growing middle-class demand in India.