The trade war seems to be getting fierce with the US announcing tariffs on $50 billion in Chinese imports. China, not to be left behind, has already announced its intention of retaliating against these new US import duties. The stage for this escalation in trade war was set at the recently-concluded G7 summit that turned out to be one of the most acrimonious where the US was completely isolated and its relationship with its allies reached historic lows. The confrontation was prompted by the issue of US tariffs on steel and aluminium, and the summit concluded with a threat of a war between allies. But can the US really continue to engage in a trade war for long? Remember that in recent period there have been historic shifts in monetary and fiscal policies of the US.
First, as the US economy gathered momentum with falling unemployment rate and increasing growth, the Fed has shifted its stance from its long pursued accommodative policy to a tighter one to keep inflation in check. In its latest monetary policy statement released on June 13, the Fed hiked its benchmark interest rate by 25 basis points. Since November, the Fed has raised its key interest rate from 0.5% to 2.0%. The expectation is that the Fed will raise the interest rate two more times in 2018. The Fed has also announced its plan of reversing its policy of quantitative easing to normalise its balance sheet. In June 2017, the Fed stated that it would slowly begin to shrink the balance sheet from October, starting at a rate of $6 billion per month and working up to a maximum of $30 billion per month. It is believed that it would shrink its balance-sheet from about $4.5 trillion to a range of $2.5 trillion to $3 trillion. The emerging markets are already starting to bear the brunt of the tighter dollar liquidity condition because of tighter monetary policy and normalisation of the balance sheet by the Fed. Emerging markets witnessed heavy capital outflow in May 2018. As per Bloomberg, foreign investors pulled out $12.3 billion, which is the biggest since November 2016. Currencies of such nations have been hammered in a spreading sell-off. It has prompted central banks in India, Indonesia and Turkey to raise interest rates.
Second, the fiscal policy of the US has become expansionary as the government decided to cut its corporate tax from 34% to 21%. Consequently, it will have to raise more debt from the market to fund its expenses if expenditure is not cut elsewhere. Remember that this expansionary fiscal policy of the US at the same time as the Fed is tightening its monetary policy and shrinking its balance-sheet may create conditions that further accelerate capital outflow from the emerging nations to the US. This capital outflow, as RBI Governor Urjit Patel highlighted in his recent Financial Times article, will intensify dollar liquidity shortage in the market. As capital starts to flow back to the US, its capital account will get a boost and the dollar will appreciate. Consequently, the current account of the US will have to deteriorate to adjust the overall balance of payment. This adjustment may happen in following two ways.
First, in absence of higher tariffs, exports would decline, and imports go up in response to appreciation of dollar. This increase in US imports would have provided much-needed dollar to rest of the world and would have restored equilibrium again. Second, if imports are not allowed to go up by imposing higher tariffs, there would be a sharp decline in US’ exports to rest of the world and overall global trade will decline. This second outcome will be highly undesirable for the US as it would lead to decline in the GDP growth, bringing a premature halt to the recovery of the economy. Of course, rest of the world will also suffer as global trade would decline leading to decline in overall global growth rate. The US must understand that it may not escape the clutches of impossible trinity—tighter monetary policy, expansionary fiscal policy and inward-looking trade policy—for long. Either the Fed will have to go slow on tightening the liquidity or the government will have to cut down on its expenditure if Trump is serious about raising tariffs.
Navneeraj Sharma & Abhishek Anand
Sharma is consultant, ministry of finance, and Anand is from the Indian Economic Service 2014 batch. Views are personal