Gunfight that no one wins
When the world’s two largest economies go to war with one another, the entire world suffers
Not quite Gunfight at OK Corral, Trumpji
China has let loose a salvo in response to President Trump’s tariff assault announced on April 34% import duty on all goods imported from the US, the exact same rate of reciprocal tariffs that Trump had imposed on imports from China. The world’s two largest economies, which are also the two largest trading nations, are now officially at trade war.
Unlike with shootout at OK corral, the casualties do not stay confined to the direct combatants. Other countries take the hit as well. The European Union, Japan and South Korea, too, are likely to join the fray. When elephants rumble, you know what happens to the grass. Smaller trading nations, even those who have not been at the receiving end of Trump’s Maga ministrations, are likely to feel the searing heat.
The World Trade Organisation has forecast that world trade would shrink, as a result of the trade war initiated by the US, instead of growing some 3% as is normal. The IMF says world growth would turn sluggish. Oil prices have fallen, in anticipation of lower growth, as well as because OPEC Plus have decided to commence winding down their production cuts.
The impact of tariffs announced in the course of a bilateral confrontation between two major trading nations spills over to third countries in multiple ways. Take an example close to home. Bangladesh has been slapped with a 37% duty. This is 11 percentage points higher than the duty imposed on Indian exports. Suddenly, Indian garment exports become suddenly more competitive in the US market vis-à-vis Bangla garment exports than they were prior to the Trump tariffs.
Consider another possibility. China, the EU and the US make and export a variety of sophisticated machine goods. A portion of the machine goods that used to go from the EU and China to the US, and the machine goods that the US used to export to China now need to find fresh markets, as their traditional destinations see tariff-induced reduction in demand. This is the right opportunity for a country with a low level of sophistication in its domestic production capacity to acquire cutting edge machinery and acquire new competitiveness in export markets.
These exports could come to India or go to India’s traditional export markets. In other words, Indian exports would be squeezed not just in the US that has levied tariffs on India, but also in two kinds of traditional Indian export destinations. One, markets that now face a flood of discount-price imports from China or other economies targeted by Trump tariffs and now are in search of alternative markets for their produce. Two, markets targeted by newly competitive export producers, who have snapped up the machine goods and other equipment being dumped wherever they can be sold, thanks to the trade war.
When economic growth slows down, demand will fall. That would shrink the export market for all, including for India, and for economies that are far removed from the trade confrontation between the US and its major trading partners.
Then, there is the likely impact on currencies and interest rates, arising from the negative impact of the trade war on the US economy.
A one-time imposition of an import duty on a good raises its price once. Unless the duty is raised again the next year, there would be no change in inflation on account of that good the next year. However, a trade war and the loose cannons it sets off make for a series of price changes spread out over time. That is what is called inflation. In addition, the uncertainty about tariff changes on imports and in the markets for exports would turn wild animal spirits into languid torpor of the kind we associate with snails. Investment and entrepreneurship would falter, economic growth would slump.
Depending on whether the US central bank, the Federal Reserve, sees inflation or unemployment as the bigger danger, it would raise or lower policy rates. Given that Trump’s messianic zeal is not limited to trade, and is active in the sphere of clearing out illegal immigrants from the US, inflation rather than unemployment is the more likely outcome.
Quite a few lines of American economic activity depend on cheap immigrant labour – agriculture, construction, hospitality, healthcare, facilities management. If hundreds of thousands of immigrants are deported, or choose to stay put at home, fearing being grabbled by immigration officials and deported, the labour force would shrink. Uemployment would, therefore, be repressed. Wage rise would contribute to inflationary pressures unleashed by tariffs and policy uncertainty.
The Fed would be forced to raise policy rates. This would induce a movement of capital to the US, leaving emerging markets like India. Higher rates normally tend to strengthen the dollar. Changes in the US interest and currency rates would impact emerging market monetary policy.
If there is a flight of capital from India, the demand for dollars would go up in the forex market, pushing up its price, that is, weakening the rupee. Too sharp or too sudden a fall of the rupee would be undesirable for holding the priceline or keeping debt service costs predictable. The RBI would intervene to smoothen out wild fluctuations in the exchange rate, selling dollars, and sucking out rupees. The resultant shrinking of liquidity would tend to push up yields, even without direct repo rate rises by the RBI.
Apart from shrinking exports, forced hikes in interest rates would crimp investment, housebuilding and financed purchases of consumer durables. Together, the effect would be contractionary.
What started off as a trade war would end up depressing growth around the world. In other words, Trump is right now presiding over America’s Demonetisation moment.