Trade war will hit global growth

Apart from direct bets against the rupee, look out for higher export growth

The market has been responding to fears about a trade war where China and the US start placing punitive customs tariffs on each others’ goods. Europe could also get dragged into this situation. India has already placed high customs duties on multiple categories of imports, including steel solar panels and mobile phones. These “anti-dumping” duties are supposed to protect domestic industries from cheap imports.

There’s plenty of economic theory that demonstrates why this sort of policy is bad for the country or countries implementing it. 

The concept of Comparative Advantage states that it is better for every nation to specialise at producing the goods and services where it has a comparative advantage than to try and produce everything.  
 

Country A produces bread more efficiently, B produces better cheese, A does better at plumbing and B produces better electrical equipment. It makes sense for A to import the cheese and electrical equipment and export the bread and the plumbing gear, while B should do the reverse.  

Both nations will deploy resources more efficiently, and overall, the production of all goods will be higher. It even makes sense for this sort of trade to take place when A may actually be able to produce both bread and cheese more efficiently than B. Say A can produce the equivalent of 5 kg of bread for every kg of cheese, while B can produce 3 kg of bread for every kg cheese. If A and B  produce both bread and cheese, there will be 2kg of cheese and 8 kg of bread. If B produces only cheese and A produces only bread, there would be 2kg of cheese and 10 kg of bread.

This has been understood since the late 18th century. The comparative advantage may be based on the distribution of natural resources.  One nation may have been blessed with more minerals or more arable land. The comparative edge may also be based on wage differences. That can get contentious.

If nation A has higher wages, it is very likely that A also has a more efficient economy and B is exploiting the wage differential. The emotional-nationalist argument may be that B is running a sweatshop to push cheap goods into A. But in such a case, it remains logical for A's highly paid labour to focus on more valuable goods, and it is also likely that wages in B would be even lower if B were not exporting. This is a win-win.

A further complication arises if B decides to subsidise exports in some fashion to earn forex. For example, it is a common tactic to offer tax-breaks to exporters or cheap land or discounted electricity rates. It is also common for export-oriented nations to try and keep their currency under-valued and hence, make exports cheaper.
 

Then the emotional-nationalistic arguments get more strident: B is depriving A’s citizens of doing productive work.  It is “manipulating” the currency. This is usually the situation when non-tariff barriers or anti-dumping duties are imposed. That can lead to tit-for-tat scenarios where trade partners retaliate.

Entrepreneurs in every nation will use these arguments to try and set up import barriers. That way, the entrepreneur can receive protection from cheap imports and indeed, jobs may be created locally. However, the efficiency of production falls, and consumers suffer because they end up paying more. If the goods are intermediate, such as steel or some sort of components, that can cause further inflation down the line because user industries try to pass on costs.

If the world is headed into a trade war, it will lead to a slowdown in global growth. It will also lead to higher inflation. This would be unfortunate because the global economy was expected to grow at around four per cent this year prior to the trade faceoffs. Expectations centred on normalisation of central bank policy. The Fed had already started raising, and the European Central Bank and Bank of Japan were expected to tighten their respective quantitative easing programmes and hike rates.

Higher inflation could trigger drastic central bank policy action instead of gradual hikes and tapering of quantitative easing. Given other inflationary pressures such as higher crude prices, this may bring serious pressure to bear on an already weakening rupee. Apart from direct bets against the rupee, investors should also look out for higher export growth.