US Protectionism: More talk than action?

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1 US Protectionism: More talk than action? The US trade deficit has widened In Focus: US Tariffs Treasury Research Group For private circulation only The US has recently proposed imposition of tariffs against its major trading partner China thereby kicking off widespread fears of a trade war Despite recent rhetoric, we do not expect a full-blown trade war and see a more watered down and a compromise solution as our base-case scenario. This is especially the case as a full-blown trade war will mean weaker growth outcomes for both the US and China in the longer-term. Global growth could also get knocked down by an adverse outcome However, there could be a period of uncertainty until such a deal is reached that could weigh on market sentiment and possibly investment intentions of firms. A lot will depend on the rhetoric from both Washington and Beijing While a mild technical rebound in the near-term cannot be ruled out especially as short-term money market rates have moved higher and risk aversion could return with a vengeance depending on the final outcome, we remain convinced that the USD will likely weaken in the longer-term Source: Bloomberg, CEIC & ICICI Bank Research March 29, 2018 Shivom Chakravarti shivom.chakravarti@icicibank.com Tel no: Ramakrishna Reddy Bogathi ramakrishna.bogathi@icicibank.com Tel no: (Ext: 6943) Pradeep Kumar pradee.kmr@icicibank.com Tel No: (Ext No: 6272) Please see important disclaimer at the end of this report Trying to tackle the crux of the problem: The US President has started to back his hawkish rhetoric on protectionism with actions by imposing tariffs. If the US President is serious about reducing the trade deficit that has widened sharply over the last decade, targeting China does have a logical precedence given that it comprises close to half of the US s trade deficit and close to 22% of the US economy s import bill. Strong rhetoric has not been backed by strong actions as yet: A key take-away from the tariffs announced by the US government and the retaliation measures taken by China so far is that there are likely to have a limited direct first-round impact on the economy. The upshot is that we view recent actions/statements more as political posturing not meant to derail growth prospects in either region or start a full-blow trade war but as steps taken to open up rounds of negotiations. Our base-case is for a more moderated toned down version of what was announced after several rounds of negotiation. There could be some compromises made on both fronts. What are the downside risks to the global economy?: For the US economy, trade tariffs are likely to act as a headwind. The most prominent effect could be to raise the inflation profile higher as import prices are likely to rise. Rising inflation will work as an additional headwind. It could act as a hindrance to China s efforts to re-balance its economy. The main vulnerability of the rest of the world from US protectionism policies targeted at China lies from the possible disruption in trade flows and global supply-chains. The USD: Our long-term bearish call remains in place: Uncertainty as US-China enter a negotiation period could result in interim volatility and periodic bouts of weakness in risky assets. The possible unwinding of USD carry trades if risk sentiment deteriorates and the possibility of a continued uptrend in the TED spread and the libor-ois spread could create some temporary USD buying. Whether our base-case scenario pans out or an adverse case scenario of a disruptive trade war, we remain convinced that the USD is due for a correction over the longer-term driven by the twin deficit problem and as inflation pressures locally could intensify.

2 Trying to tackle the crux of the problem: The US President has started to back his hawkish rhetoric on protectionism with actions by imposing tariffs. While the response to the initial round of tariffs on steel and aluminum was somewhat mild, risk aversion intensified as the US government imposed tariffs of USD 50 billion worth of Chinese imports citing section 301 of the trade act of The initial actions and statements seem to suggest that a trade war was in the offing and that there could be substantial tit-for-tat responses between the two global superpowers. Chart 1: Market responded more adversely to the China tariffs than the tariffs on steel & aluminium Note: Figures are day-over-day percentage changes Source: Bloomberg & ICICI Bank Research If the US President is serious about reducing the trade deficit that has widened sharply over the last decade, targeting China does have a logical precedence given that it comprises close to half of the US s trade deficit and close to 22% of the US economy s import bill. However, we remain of the view that a more watered-down version of the tariff measures that have been announced on China is likely and that China for its part might make some concessions. After all, the tariffs on China will take another days to come into effect implying that there will be a series of negotiations before a final decision will be made. During this period, the United States Trade Representative (USTR) will publish a list of products, which are imported from China, that will be targeted. Chart 2: The US has a substantial trade deficit with China The US-China trade relation: A short- review Source: Bloomberg, CEIC & ICICI Bank Research Trade deficit with China amounted to USD 375 bn in US exports have not risen in line with the growth in imports from China. Hence, the trade deficit that was less than USD 100 bn in 2001 has increased by more than thrice that amount. China s exports to the US have undergone a substantial transformation over the years. Initially the products were labour intensive such as toys, footwear, clothing etc. but now it exports goods such as telecommunication equipment. This shows the transformation of industry and exports from China as they have slowly moved away from export of labour intensive products to relatively more capital intensive products. The US administration has been accusing China of intellectual property (IP) theft as they increased manufacturing of capital intensive products (i.e. products that require more technology) such as electronic goods. The next round of proposed sanction threats could 2

3 come from the US looking to take action against the IP theft front. Media reports seem to indicate that aerospace, information communication technology and machinery are the goods that are going to be targeted for tariffs. Chart 3: Rising imports from China has been the crux of the problem Source: Bloomberg, CEIC & ICICI Bank Research Chart 4: The top ten commodities that US imports from China Source: CEIC & ICICI Bank Research The Chinese government did respond to tariffs imposed by saying that it would be willing to slap a USD 3 billion worth of tariffs on US imports. The ministry announced a list of 128 products in 7 categories for additional tariffs. It includes two groups: the first group of 120 products (fruits, nuts, wine, ginseng, seamless steel pipes etc.) that had an import value of USD 977 million in 2017 will face 15% additional tariffs. The second group, includes 8 products including pork & pork products and recycled aluminum, that had total import value of around USD 2 billion in 2017, will face a 25% tariff. 3

4 Chart 5: The top ten commodities that US exports to China Commodity Amount (USD bn) % of total Aircraft & equipment Oilseeds & Oleaginous fruits Motor cars Thermonic, cold cathode Oil from bituminous minerals Instruments Machinery & Equipment Non-ferrous base metal waste Accessories for motor vehicles Chemical products Total Source: CEIC & ICICI Bank Research Strong rhetoric has not been backed by strong actions as yet: A key take-away from the tariffs announced by the US government and the retaliation measures taken by China so far is that there are likely to have a limited direct first-round impact on the economy. The US tariffs on China would cover less than 0.5% of total US goods imports and would only affect around 10% of China s exports to the US that works out to being less than 0.3% of US GDP and less than 0.5% of China s GDP. Even the retaliation measures announced by China are likely to be only 0.2% of its imports basket and around 5% of the US economy s export basket. Furthermore, China has avoided placing a tariff on the main (top ten) goods that it imports from the US (see chart: 5 above). The upshot is that the we view recent actions/statements more as political posturing not meant to derail growth prospects in either region or start a full-blow trade war but as steps taken to open up rounds of negotiations. After all protectionist policies were one of the main electoral promises of President Trump in his campaign and he would want to appease his base given that the US mid-term elections are due towards the end of the year. India: Caught in the cross-fire as well The US government s drive to tackle trade deficits has meant that it has not spared India either. The US launched a case against India at WTO to challenge India s export subsidy programs. This has also highlighted that on an annual basis Indian government is providing USD 7 bn benefits to Indian companies and USTR has alleged that these programs created uneven playing field for the US and Indian companies and workers. India has a trade surplus of around USD 20 billion. The Indian government for its part has responded by saying that it will resolve the US government s concerns via bilateral discussions. While a full-blown India-US trade war is unlikely as the US is focused more on China, there could be some signs of back and forth that may from time to time weigh on Indian markets. US has listed the following programs of Government of India: The Merchandise Exports from India Scheme; Export Oriented Units Scheme and sector specific schemes, including Electronics Hardware Technology Parks Scheme; Special Economic Zones; Export Promotion Capital Goods Scheme; and Duty free imports for exporters program 4

5 Chart 6: India s trade surplus with the US has increased dramatically over the last four years What could happen? Source: Ministry of Commerce, India & ICICI Bank Research Chart 7: The top ten commodities that India exports to the US (Amount in USD bn) (Apr-Jan) Our base-case: A compromise solution: Our base-case is for a more toned down version of what was announced after several rounds of negotiation. There could be some compromises made on both fronts. For instance, there could be an agreement to reduce the trade deficit by USD 100 billion over a five-to-ten-year period that would entail the US going back on its tariffs announcements. An agreement could also be made to bring about some parity by taxing Chinese imports on the difference between the tariff structures/tax structures between the two countries. Another possible solution could be for China to accept tariffs of a lesser amount on a few select items than is being currently proposed. Such outcomes might help President Donald Trump in claiming some form of victory on the protectionist front. Besides, it would be in sync with the recent developments of the President making a very strong headline announcement but scaling back some of those actions as was visible in the exemptions that were provided to a number of countries after the announcement of the steel and aluminum tariffs. A similar dynamic is possible. Alternate-case: A full-blown trade war: While we see a compromised solution as the most likely outcome, a full-blown trade war with retaliations and counter retaliations between US and China cannot be totally ruled out. Such a scenario would pose substantial downside risks to global growth and is the main reason for us not anticipating the worst-case scenario. What China can use in the negotiation table? Natural or cultured pearls Textile articles and apparel Pharmaceutical products Nuclear reactors and machinery Fish and crustaceans Organic chemicals Mineral fuels and mineral oils Vehicles other than railway electrical machinery and equipment Articles of iron and steel For one, China is one of the largest holders of US debt. It holds close to 11% of the total foreign holdings of US debt securities. Just the mere threat of it lowering its holdings will likely result in a very quick upward move across the curve of the US treasury market raising borrowing costs within the US economy. Second, tariffs from the Chinese government could be imposed on those goods that the US is very reliant on Chinese demand and where other alternatives might be difficult to access. Close to 25% of US agricultural exports go to China that includes 60% of soybean exports, around 10% of oilseeds and oleaginous fruits, China is the largest purchaser of US cereals and aircraft and associated equipment exports go to China. The US still needs China s help in de-escalating the tensions with North Korea. Hence, China could commit to a more active role in future talks between the US and North Korea. Lastly, Chinese officials could also threaten US officials by allowing some competitive devaluation of the CNY that would in tail mean upside risks for the USD that would go against the US policymakers desires of reinig in the trade deficit. What are the downside risks to the global economy? A key reason for us not to expect a full-scale global trade war is the harmful effects that could have on the global growth outlook for the US, China and the rest of the world in the following ways: For the US economy, trade tariffs are likely to act as a headwind. The most prominent effect could be to raise the inflation profile higher as import prices are likely to rise. Rising inflation will work as an additional headwind knocking down real incomes and consumption in the process. Given capacity constraints, it is unclear as to 5

6 Feb-00 Feb-01 Feb-02 Feb-03 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 Feb-10 Feb-11 Feb-12 Feb-13 Feb-14 Feb-15 Feb-16 Feb-17 Feb-18 whether supply will be able to be ramped in the short-term quickly enough to meet demand. It is most likely that manufacturers/companies import goods from other alternative destinations than ramp up domestic supply in the near-term. Theoretically, the Fed should see through cost-push related one-off increase in inflation driven by changes in taxes. However, given that the Fed is in the midst of its tightening cycle further inflation increases might prompt an even more aggressive response. Hence, much tighter monetary policy could act as another headwind to growth. Besides, given the savings-investment identity, it is unclear whether the US government can meet a dual objective of running expansionary fiscal policy along with trying to rein in the trade deficit at the same time. Additionally, whatever benefit that the US might hope to achieve from a possible fall in imports that might take place over the longer-term resulting in an improvement in the net exports position will likely get counterbalanced by weaker domestic demand resulting in lower growth in the medium to longer-term. Chart 8: Rising capacity utilization could stoke inflation Capacity Utilization (%) Iron and Steel products Total Industry (RHS) (%) Source: Bloomberg & ICICI Bank Research China: Risks to rebalancing strategy: The Chinese government is in the middle of re-balancing the economy from an investment led economy to consumer driven economy. Excess supply is a chronic problem at least until domestic demand matches supply. To engineer this process, China needs strong global demand to eat into the excess capacity that it has. Hence, the current tariffs do impose additional downside risks to growth outlook especially if the US increases the scale/size of the commodities that it plans to impose tariffs on. This perhaps explains why the immediate size of retaliation from China was limited and that why China would be open to negotiate a viable outcome. Chart 9: China is looking to re-balance its economy from investments to consumption Source: Bloomberg & ICICI Bank research 6

7 Rest of the world: A negative disruption: The main vulnerability of the rest of the world from US protectionism policies targeted at China lies from the possible disruption in trade flows and global supply-chains. This is particularly the case for the ASEAN region that has a substantial integrated trade network with China and are very trade-dependent economies. Europe could also feel the pinch if uncertainty about trade persists or if the US takes further action not only against China but also a more broad-based attack on other nations. The other areas that we remain very concerned about is on business investment and consumer confidence. Prolonged uncertainty about the state of global trade environment could in particular act as a headwind for investment spending/investment intentions. This was visible in the release of the German IFO/ZEW survey that should that investment confidence had deteriorated in February. We will watch the results of the business surveys very closely to see if there is any softening in the global growth outlook. Furthermore, the Conference Board measure of US consumer confidence moderated in March-2018 highlighting that sentiment is deteriorating in response to recent developments. Chart 10: Global confidence has started to show signs of deteriorating Source: Bloomberg & ICICI Bank research Currency markets: A review post the tariff announcements There were broadly two important dynamics that unfolded in the currency market: (a) The current account effect: Currencies of those economies hit by tariffs should face depreciation pressures because the first-round effects are likely to be a deterioration in the trade position and subsequently the current account position. This was exactly what happened when the steel and aluminium tariffs were announced the CAD came under strong selling pressure given that Canada was one of the main exporting partners of the two commodities to the US. However, that trend reversed once the exemptions were announced. (b) The capital account effect: Any shock to the global economy such as the tariffs should force investors to price in a weaker global growth outcome resulting in risk aversion providing strong support to safe-haven assets. The JPY, CHF and bullion prices rallied. High beta currencies such as the EM currencies, commodity currencies, crude prices, prices of industrial metals and equity markets came under strong selling pressure. While the JPY and CHF witnessed some support, the USD that is the primary safe-haven currency saw a very little upward revision in demand. Even considering that the USD should in theory benefit from tariffs as they should in time result in an improvement in the trade position, it appears that investors started to price in a bearish long-term outcome in response to protectionist policies. Hence, the USD came under pressure. The USD: Our long-term bearish call remains in place We have examined USD performance during periods in which the US government has imposed tariffs and have not found any consistent patterns. However, out of 8 occasions in which tariffs were initiated the USD has weakened on 5 of those occasions. This suggests to us that tariffs are viewed negatively by investors and that other global factors play a more prominent role in driving the currency markets. For instance, the sharp USD uptrend in 2012 post the tariff announcements also coincided with investor concerns about the EU sovereign crisis that forced investors to turn to the safety of US treasury securities. 7

8 Dec-90 Jun-92 Dec-93 Jun-95 Dec-96 Jun-98 Dec-99 Jun-01 Dec-02 Jun-04 Dec-05 Jun-07 Dec-08 Jun-10 Dec-11 Jun-13 Dec-14 Jun-16 Dec-17 Chart 11: The USD & trade tariffs no clear relationship Tariffs in the US Change in DXY (%) (3 months after tariffs) Tariffs On Steel From 19 Countries (Jan 1993) 3.68 Tariffs imposed on Japan (May 1995) Tariffs on Japanese, Brazilian steel imports (Feb 1999) Steel tariffs (March 2002) 3.80 Tariffs imposed on Chinse tires (September 2009) Tariffs on Chinese solar panels (May 2012) Tariffs on Chinese Solar Panels (December 2014) Tariffs on imported washing machines and solar panels (Jan 2018) Source: Bloomberg & ICICI Bank Research Uncertainty as US-China enter a negotiation period over the next month should result in interim volatility and periodic bouts of weakness in risky assets. The possible unwinding of USD carry trades if risk sentiment deteriorates and the possibility of a continued uptrend (please refer our publication titled FOMC preview: Rate hike certain; focus will be on the dot plot, March 20, 2018) in the TED spread and the Libor-OIS spread could create some temporary USD buying. We see two possible scenarios going forward: In our base-case scenario in which a compromise is reached, the extent of USD upside will likely remain limited as investors will continue to focus on the deterioration of the long-term fundamentals of the US economy. Global growth would not get derailed and there is likely to be a continued pricing in of strong growth outside the US. Hence, the USD is likely to weaken. In the adverse case scenario in which there is a downgrade of global growth prospects that could create a brief period of USD strength as USD carry trades get unwound aggressively and there is a re-allocation back into US treasuries and other safe-haven assets. Whether the base-case scenario pans out or the adverse case scenario, we remain convinced that the USD is due for a correction over the longer-term driven by the twin deficit problem and as inflation pressures locally could intensify. The twin deficit problem in particular could come under increasing focus in 2019 when the effect of the fiscal stimulus measures start to become more prominent and a new wave of higher Treasury issuances start to hit the market. Chart 12: The USD is vulnerable to the twin deficit problem and debt outflows (USD bn) Net inflows into the US markets Debt Equity Source: Bloomberg and ICICI Bank Research 8

9 Appendix: The US President does have the legal power: The US President wants to reduce the nation s trade deficit by imposing import tariffs on its main trading partners as his main strategy. In this regard, the US President does have powers to regulate trade via several statutes that have been inducted within the US constitution (Trade Expansion Act of 1962 and Trade Expansion Act 1974) if such measures can be justified for economic or national security reasons. For that matter a US President imposing a tariff is not a new development. President Regan initiated protective measures against Japanese automakers in the early 1980s, President Bush imposed steel tariffs in March-2002, President Obama instituted tariffs in 2009 on Chinese tires and again in 2012 on Chinese Solar imports. However, the difference this time around is the hawkish rhetoric on protectionism coming from both the President and his newly reshaped administration. Chart 13: The President s tariff issuing powers summarized Parts of the US constitution that give the President power to impose tariffs US law Section 201 of trade act of 1974 Section 301 of trade act of 1974 Section 232 of trade act of 1974 Section 232 of the trade expansion act Rational for action If the US International Trade Commission finds that an increase in imports is casusing injury to the import-competing US industry, trade tariffs can be imposed US Trade Representative conducts investigation and makes preliminary recommendations if a foreign country denies the US free trade agreements or conducts activities that are unjustifiable,unreasonable or discriminatory Tariffs of up to 15% or other quantitative restrictions or both can be imposed for upto 150 days against one or more countries with large balance of payment surpluses Tariffs can be imposed on national security grounds Source: Media sources The story in 2018 so far: While the first year of the new administration passed without any substantial action being taken against the main trading partners, the story so far in 2018 has been very different. The following set of measures has been taken by the US government in 2018: January-2018: Section 201 was used to impose a 30% tariff on solar cells and modules and a 20% tariff on washing machine imports. March-2018: Section 201 was used to impose a 25% tariff on steel imports, 10% tariff on aluminium imports and Section 301 was used to impose a 25% tariff on Chinese imports worth USD billion. Key highlights of the Section 301 investigation report: On August 14, 2017, the US President authorized the US Trade Representative Council (UTRC) to review China s law, policies, or actions that may be adversely impacting US intellectual property rights, innovation or technology development. This was the report that the US President used as a justification to invoke tariffs on China. The main findings of the report are summarized below: Chinese government uses a wide range of tools to force US companies to transfer technologies and intellectual properties to Chinese companies. The Chinese government s acts, policies and practices deny U.S. companies the ability to set market-based terms in licensing and other technology related negotiations with Chinese companies and that undermine US companies control over their technology. Government directed systematic investment of Chinese companies in US companies and assets and transfer technology to industries deemed important by Chinese government industrial plans. Source: United States Trade Representative 9

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