Trade wars or currency wars?

Tom Traill - 05 July 2018

To all US Dollar bulls out there, beware the thinly-veiled intentions of the US president to sabotage the currency.  While the Renminbi has weakened quite suddenly, prompting concerns of a deliberate Chinese devaluation strategy, the Renminbi remains in an uptrend (figure 1). Trump’s disruptive pronouncements on tariffs and trade are designed to have a much more profound impact on the US Dollar.  They may well succeed.

Thus far, it has been possible to dismiss the impact of tariff announcements as quantitatively small. There are the initial levies on washing machines and solar panels and subsequent tariffs on steel and aluminum.  However, a further US$34 billion of tariffs levied against China goods are due to come into effect on Friday 6th July, bringing the total to around US$100bn. On a worst-case scenario, US$1trn of global trade could be infected by this dispute, equivalent to about 6 per cent of the global goods trade.

Many of the tariffs are predominately aimed at China, but any unilateral tariff is likely to have wider ranging impacts. For example, China indirectly exports many products to the US via Japan and Korea, it is likely that these conduit countries could be caught in the crossfire. The ongoing discussions with NAFTA are also an important element to consider, despite the rhetoric being, for now, less inflammatory, there is a lot more trade within North America that between the US and China. It could be that Canada and Mexico suffer the largest detriments to trade.

This week there have been reports of a leaked draft bill called the “Fair and Reciprocal Trade Act” that seeks to give Trump and his administration the ability to implement new tariffs based only on their subjective opinion of whether principles of “fair trade” have been violated. Currently, the job of raising tariffs is the responsibility of Congress not the president. The Steel and Aluminum tariffs circumvented this process by claiming to be a national security issue. There are reports that the new bill is incompatible with the World Trade Organization’s Most Favoured Nation ruling. The bill is likely to confront strong opposition to its passing, but it reflects the current thinking in the White House.

Despite the rhetoric of the Trump administration, some painful consequences of retaliatory actions of the Europeans will become apparent quite soon. It is conceivable that the president will soften his stance and withdraw the threats of punitive measures later in the year. Yet the damage to US credentials as the leader of the free world will not easily be undone. The substantial consequences of these ill-tempered exchanges will be measured by the transactions that are abandoned and the direct and portfolio capital flows that are reversed. If tariff impacts are large enough to boost goods price inflation, then the attractiveness of all US financial assets could suffer further impairment. Figure 2 is a reminder of an uncanny inverse correlation between the return on US deposits to a non-resident and the headline inflation rate.   

Figure 1

Data source: Thomson Reuters Datastream

Figure 2

Data source: FRED and Thomson Reuters Datastream

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