<b>Abheek Barua & Bidisha Ganguly:</b> Trade war between US and China

Protectionism is not a zero-sum game; it will end up hurting both the players

What gives Donald Trump the gumption to take China on, question the long established “One China” policy and threaten to impose punitive tariffs on imports? The simple (or perhaps simplistic) answer to this question lies in the balance of trade between the two economies. China sells much more in dollar terms to the US than it buys from it. In 2015, US exports to China were only $116.2 billion while imports from China hit a new record of $483.9 million. The upshot is that if there is indeed a trade war, the bigger seller China would stand to lose. 

Does the massive stock of reserves ($3 trillion at last count) that China holds give it some leverage with the US? Yes and no. Why “no”? With its currency under constant pressure since its equity market crisis of 2015, China has been buying dollars steadily to prevent a large slip in the yuan’s exchange rate.  If it threatens the US by dumping US government bonds (selling dollars in effect), the dollar will lose and the yuan gain. This will erode China’s competitiveness further and damage exports.

Thus, prima facie, Trump seems to have the upper hand in this game. Despite this apparent advantage, a war with China is bound to leave some deep cuts and bruises. A switch in production from external to domestic markets is unlikely to be easy: It might take years to build a supply base in the US that can substitute offshore production. China, for instance, supplies a large fraction of electronics, mobile handsets, electrical machinery and clothing just to pick a few of the list of its top exports to the US. In short, US consumers and firms might be forced to buy Chinese products but at prices inflated by the tariff. Even if some substitution is possible, higher wages in the US would have the same effect as the tariff by raising the cost of production. Estimates show that average wages in the US are roughly six to seven times higher than that of China. The net result could be high inflation and high interest rates that might end up crowding out private investments.

Besides, protectionism is not just a zero-sum game. It ends up hurting both the players. If indeed the US and the rest of the world engage in a trade war, global growth, investments and trade are all likely to suffer. An International Monetary Fund estimate shows that if import prices were to go up by 10 per cent due to both trade and non-trade barriers, global growth would slow down by two percentage points and investments by five per cent. Thus, while Trump might show some quick and somewhat superficial gains in manufacturing, the US cannot be protected from the downside of a shrinking global economy. A combination of a fiscal stimulus and aggressive protection could buy America a couple of years of growth in the ballpark of three per cent but as the twin pressures of high interest rates and protection kick in, it might see itself slipping well below its potential rate. The consensus among economists is that its steady state or potential output (determined by demographics and productivity growth) is just 2.5 per cent.

However, the nuclear weapon in China’s arsenal in its economic and political war with the US is the threat to actually stop “manipulating the currency”, as it is accused of, and let the yuan float. This would be perfectly compatible with the agenda of internationalising the currency that China has been pushing so hard. Traders estimate this will lead to a depreciation of the currency by 10 to 20 per cent and make China hugely competitive against the US and other trading partners. Of course, there are key deterrents to its use. Chinese companies are sitting on about $1.6 trillion of external debt. With sharp depreciation, servicing this might become difficult and lead to large defaults. However, let’s not forget the fact that it still has about $3 trillion of reserves. It need not hold so much if it lets its currency float and the government could use some of its reserve trove to help stressed borrowers. What happens then to economies and markets across the world remains an open and perhaps alarming question.

Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is chief economist, CII