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Mainstream, VOL LVI No 40 New Delhi September 22, 2018

The Global Economy and the Trade War

Tuesday 25 September 2018

by Monaem Sarkar

The trade war between the United States and its trading partners has created a number of downside risks for the global economy. So how is the global economy faring? How will the retaliatory tariffs imposed by the United States and China, among others, affect the global economy? These are questions that have been raised in recent policy discussions around the globe.

The US economy is on course to post another strong showing in 2018. The US real Gross Domestic Product (GDP) grew at a 4.1 per cent pace during the second quarter. The underlying details were even stronger than the headline number, with real final sales surging as inventories being drawn down sharply. While there is doubt that there will be another four per cent GDP number in coming quarters, the economy clearly has strong momentum going into the second half of the year. Part of the second quarter’s strength came from efforts to produce and ship products ahead of retaliatory tariffs. The inventory drawdown pulled production forward and left inventories excep-tionally lean throughout the supply chain. Despite a fading boost from fiscal stimulus and rising short-term interest rates, rebuilding inventories should keep output growing at around a three per cent pace in the second half of 2018. Stronger economic growth will keep the Federal Reserve Bank on its current course of gradually raising the interest rate. We expect quarter-point hikes in federal funds rate in September and December, respectively. The US economy appears well positioned to absorb further increases in interest rates.

As the US economy hums along quite well, other economies are not faring so well. Real GDP growth in the Eurozone slowed modestly in the second quarter at 2.1 per cent. The eurozone entered 2018 on a high, having racked up its most rapid expansion in a decade during 2017. But growth slowed sharply in the first three months of this year, a setback that can be partially attributed to unusually cold weather and labour strikes in Germany and France. The failure of the economy to rebound in the second quarter shows other forces may be at work. We expect to see this divergence in economic growth between the US and others continuing for the rest of 2018.

Inflation in the Eurozone is still largely benign. Although headline inflation has picked up to reach the European Central Bank’s (ECB) two per cent target in recent months, core inflation still remains steady around one per cent and has restrained the more rapid removal of policy accommodation on the part of the ECB. That said, the ECB plans to end its quantitative easing programme at the end of this year. Assuming economic growth and inflation continue to pick up, we then look for the ECB to begin raising interest rates in mid-2019.

Trade tensions in the Eurozone heated up in the second quarter of 2018 as the Trump Administration threatened a 25 per cent tariff on auto imports from the European Union (EU). A recent Washington D.C. summit has since calmed the nerves of trade watchers as the EU and US agreed to work toward removing trade barriers. However, the situation could deteriorate again if negotiations were to reach an impasse.

A full-blown trade war, should one come to pass, probably would not completely derail the Eurozone economy. Exports to the United States totalled just 2.5 per cent of the Eurozone GDP in 2017, meaning that the effect from tariffs could be painful, but not large enough to meaningfully drag on the overall economy. Although trade tensions present a downside risk, we look for the economic expansion to remain in place, and forecast that real GDP will grow roughly two per cent in 2018.

The US dollar’s continued rise is injecting further risk into emerging markets, particularly those which have been borrowing heavily in the US currency and benefiting from foreign investment, such as, Turkey, Hungary, Argentina, Poland, and Chile. Countries with large US currency debts and big foreign capital flows are at risk as the US dollar climbs.

Countries with large chunks of equities and bonds held by foreign investors also become increasingly vulnerable as markets turn more rocky. A rising dollar also pressures prices for commodities, which are denominated in the US currency and become less affordable to foreign buyers when the dollar appreciates. That’s bad news for commodity exporters like Brazil, Chile and Russia. Meanwhile, commodity importers whose currencies have been battered, like Turkey, India and China, now have to pay up for oil and other raw materials.

There is reason to believe the rest of the year will be calmer for the dollar, meaning less risky for emerging markets and other volatile assets. Against major currencies like the euro, the dollar has stopped climbing. A good deal of divergence between growth and monetary policy in Europe and the US already looks priced in. Where the dollar’s strength has exposed weak links in emerging markets, such as Turkey, it may continue to cause problems.  The bigger picture will be influenced a good deal by the trade dispute between the US and China and whether the Chinese yuan continues to fall, raising depreciation pressures on other currencies.

The US and Mexico have agreed on the key sticking points between the two countries that had held up renegotiating of the NAFTA for over a year. The deal still needs approval by the U.S. and Mexican legislatures and negotiators still hope that Canada will join as well.

The Trump Administration has heralded economic strength as a source of leverage in its quest to force rivals to make concessions to the US on trade. Those talks are entering a new phase, with an understanding with Mexico on the NAFTA, and an agreement to hold off on tariffs against Europe after a Washington visit by the European Commission President.

The US and China, meanwhile, are making little progress in behind-the-scenes efforts to restart formal trade talks. A trade war with the United States, should one come to pass, would weigh on Chinese economic growth, but it probably would not bring that economy completely to its knees.

Chinese real gross domestic product (GDP) rose by 6.7 per cent (year-on-year) in the second quarter of 2018. The Chinese authorities have already reacted to mitigate the negative impact of $ 265 billion in US tariffs by easing monetary policy and allowing the renminbi to depreciate more than six per cent against the US dollar. Given China’s limited capacity to retaliate in kind to the proposed tariffs, Chinese authorities are likely to undertake non-tariff actions to impede US business interests in the region, such as imposing more stringent customs controls targeting US goods, and seeking out allies to help generate a global response to US protec-tionism. Overall, we anticipate that protectionist actions by the US Administration will put about 0.5 ppts of Chinese growth at risk over the next six quarters, and may place downward pressure on the economic growth of its supply-chain partners. Emerging markets could become collateral damage in an escalating trade conflict where the US is squaring off against China and Europe. Export-dependent Asian economies may be especially vulnerable, and major stock markets in the region have tumbled in recent months. A significant portion of US-bound exports from countries like Malaysia, South Korea and Thailand pass through China, given its central role in the global supply chain. The trade conflict is also slowing a revival in global growth, stoking worries over demand for raw materials and hurting the economies of commodity exporters.

The first round of US tariffs has begun to reverberate globally, and the economic effects are likely to become more apparent if they remain in place—and as other countries retaliate. But for many US trading partners, the tariffs may be just one of many challenges they face.

In recent weeks, there has been lot of discussion with the Turkish economy spiralling into a volatile situation. Turkey is too small in the scope of the global economy to trigger a broader global crisis. Contagion risk via trade linkages is low, although Europe is most exposed. Similarly, the financial contagion is limited, with Spanish, Italian, and French banks at risk to lose a tiny proportion of foreign loans.

Although concerns eased in recent days, Turkey is not out of the woods yet. It remains in the early stages of a balance of payments crisis. A sudden stop to capital inflows has occurred, and the next step for Turkey involves spending cuts and an emphasis on boosting exports to help generate foreign currency required to pay for its large external obligations. The medicine will be bitter, but the sooner Turkish authorities follow through with interest rate increases, capital controls, and fiscal spending cuts, the more likely they can mitigate the economic fallout.

That said, contagion to other economies can still occur through confidence and sentiment channels. That was evident recently with the turmoil in global financial markets that drove a selloff in risk assets and emerging market currencies, and a bid for developed market bonds. Further bouts of volatility are likely as emerging market economies with large imbalances are targeted one-by-one by increasingly discerning investors.

Looking forward, we expect that the global economic expansion will remain intact through at least the end of 2019. Although many central banks have started the process of slowly raising interest rates, monetary policy remains accommodative in most economies, which should continue to support the global economic expansion.

The tariffs and counter-tariffs imposed by the US and their trading partners, respectively, remain a downside risk to the global economic growth outlook. Although the direct threat to the global economy from the tariffs enacted so far is relatively low, trade data are already showing signs that tariffs are affecting activity. In addition, the second-order effects, such as a potential decline in the stock market and corresponding fall in household net worth/consumer confidence, are another threat that could compound any direct effect on growth from a full-blown trade war.

We remain hopeful that such a scenario never materialises, and that ongoing discussions between the US and its major trading partners prove fruitful.

The author, a politician and columnist, is presently the Director General, Bangladesh Foundation for Development Research, Dhaka.

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