US-China Trade Dispute - Far From Over

On 1 August 2019, US President Donald Trump announced that his administration would impose 10 per cent tariffs on a further $300 billion of Chinese goods in early September, in a move that would jeopardise recently resumed trade talks between the countries. This caught the Chinese officials and global investors off-guard, triggering a major sell-off in global equities. At the time, China had pledged to retaliate if the US introduces fresh tariffs, and it seems China has retaliated against the proposed tariff, though in a different form. On 5 August, the Chinese administration allowed the weakening of the Chinese currency past Rmb7 per dollar, signalling that it is prepared to use the currency as a weapon and a near-term settlement with the US looks unlikely.

The devaluation past the critical level of Rmb7 per dollar was a psychological setback for the investors and marked the lowest such exchange rate in over a decade. This was seen as a move to cushion the worsening effects of the trade war with the US and is a carefully calculated gamble by the Chinese government, as it looks to stand up to the aggressive actions of the US administration. Though the Chinese central bank sets a range for movement in yuan against a 24-currency basket, it’s noticeable weakening against the dollar made experts particularly nervous. The increase in trade tensions is expected to take a toll on the global economy and stock markets across the world slipped lower, while emerging market currencies also weakened in tandem.

Soon, the US Treasury announced its decision to label China as a currency manipulator, in response to the decision by the Chinese government to devalue its currency. It came after Trump accused China of devaluing its currency to create an unfair trade advantage and marked a dramatic escalation in the ongoing trade war between the two economic superpowers. Many analysts reckon that it would serve as a political justification to raise tariffs and was primarily seen as a symbolic move only. However, the trade war has escalated into an all-out and open economic warfare up to a point where backing down would be politically difficult for both the country heads.

The Treasury Department said that China had taken concrete steps to devalue its currency and has had a long history of undervaluing its currency. Experts said that the Chinese economy is under a lot of strain lately, mainly due to the trade war. Its economy has slowed, and the exports have fallen as well. Depreciation of the currency was a logical step had the currency freely floated in the market. However, by preventing a fall in the currency, the country was doing Trump a favour, but it seems the administration has now decided against it. Market commentators said the move marks the first manipulator designation since 1994 when China was declared a manipulator, and technically triggered a process in which the US could ask the International Monetary Fund to evaluate the currency policies of China.

Many experts said that other than fanning trade and currency wars, the designation would not change the situation much as the remedies are very weak and ineffective. The International Monetary Fund has already said what it thinks about the yuan, noting the softer economic fundamentals of the country, although it noted that the dollar was overvalued by around 6 per cent to 12 per cent.

Earlier in July, there were talks in the White House to intervene in the market to weaken the dollar in response to what Mr Trump said was currency manipulation by competitors. He had criticised China and Europe for allegedly manipulating their currencies to try to gain some temporary trade advantages. However, the officials had later ruled out any intervention as the administration would have faced big challenges. But erratic decision making by Trump administration can make this possible. US President in his 2016 election campaign had promised that on his very first day in office China will be branded a currency manipulator.

Chinese officials reassured foreign companies that the currency would not weaken significantly, and the authorities are expected to step in if the speed of depreciation accelerates enough to risk capital outflows. The latest moves by both the countries have made investors worry whether a resolution to the trade war would be possible in the near future or not. The dispute has taken a toll on the growth in the global economy and investors have sought refuge in the surety of sovereign bonds, driving yields to record lows. A consensus is forming in the market that the belligerent countries are in no mood to concede to each other’s demands, making the possibility of a solution before the 2020 presidential elections a distant dream.

Since the trade war started in 2018, the impact on the world economy has been benign and considerably less than what was predicted by economists and the market. The rest of the world has dragged along with the US, which has grown at an impressive rate. But it can be argued that the growth in the country was driven by tax cuts announced by the Trump administration, and as the effect of the same starts to fade, the impact on the economy can now be seen.

Growth in the US has now started to catch up with the realities and uncertainties of the macro and political environments. While the labour market is still strong, mixed economic data has now been reported by the officials. Slowing from an enviable annualised rate of 3.1 per cent in the first quarter, the gross domestic output grew by only 2.1 per cent in second quarter, though it was still high from the perspective of other developed countries. In the July-September quarter, the growth rate is expected to fall below 2 per cent, far less than the 3 per cent rate promised by Donald Trump in his election campaign. The Federal Reserve Bank also seemed to be cognizant of the risks to the economy from a prolonged trade war and therefore decided to cut the policy rate by 0.25 per cent, with a cut of more than 0.50 per cent already priced in by the market.

While Trump has repetitively said that China would pay the full price of the increased tariffs, he seems to have realised that the US consumer would not be left untouched and thus announced his decision to delay imposing a tariff on a host of goods until mid-November. His latest decision was a tacit admission of its impact on American consumers, and with the election looming, the US president is in no position to roil his support base which has been left untouched. The tariffs have impacted producers, who have not passed on the increased cost yet to consumers., Economists at the Federal Reserve Bank of San Francisco have estimated that the first round of tariffs on China would increase the inflation rate by 0.1 percentage points, even though inflation remains below the 2 per cent target rate set by the central bank, a fact Mr Trump sometimes cites as proof that the tariffs have not impacted prices. The economists also predicted that an additional 0.3 percentage points would be added to inflation if the Trump administration levies a 25 per cent tariff on all Chinese imports.

The latest tariff caused jitters in the market as well, leading to investors seeking safe-haven assets like gold and sovereign bonds. Demand for government bonds has led to a dangerous rally, leading to record low yields. The chances of recession have also risen considerably, and European bigwigs like the UK and Germany reported a contraction in their economies. A slowdown in the economy of Germany can be attributed to the trade war to some extent, which has reduced demand for cars and other manufacturing goods. Growth in China has also touched multi-decades low, and if the trade dispute continues, experts reckon growth will fall further.

Markets have braced for the eventual downturn, as was indicated by the inverted bond yield curve on 14 August 2019 – the yields on 10-year bonds, which should ideally demand a higher return, fell below the yields on 2-year bonds. This is seen as a very strong indicator of an impending recession, which sent the market deep into the red during the day. It must be noted that the equity market was still in its expansionary phase even as Chinese market declined during the whole period. But now optimism of a deal has started to wane amongst the American investors, which the American President might start to factor in from now on.

Donald Trump is looking to achieve the impossible trinity – a thriving economy, high barriers to trade and a weak dollar. But he will soon need to realise that sometimes even achieving two might seem like a herculean task. The dollar being the global business currency, the US cannot directly intervene in the market to regulate it and governments might push the economy for a short-term, but sustained growth requires fundamental changes.

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