What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
In the pages of financial newspapers and magazines as well as in blogs posted by well-known economists, there has lately been increasing discussion about the possibility of de-dollarization of the global economy. That is, there is increasing speculation that the dominant role of the dollar in global commerce could be undermined by a variety of factors currently taking place.
The most notable factor is that the US government has lately imposed an unusually high number of sanctions on the governments and nationals of Iran, North Korea, Russia, and even China and the European Union (EU).1 These have been undertaken in order to punish countries like Iran and prevent them from benefitting from selling their exports in dollars. For example, the United States will sanction European companies that purchase Iranian oil in dollars. The goal appears to be to prevent Iran from being able to generate any export revenue. However, China and European countries are keen on importing Iranian oil and are now taking steps meant to provide an ability to use their currencies to purchase Iranian oil. Unlike past sanctions on Iran, these have been done unilaterally by the United States following its exit from the nuclear weapons deal, and without the support of US allies. The dollar dominance of oil trade is related to an agreement between the United States and Saudi Arabia in the 1970s. There is nothing sacrosanct about this arrangement. If China and/or Europe are successful in creating a new nondollar payments system, it could mean that the dollar becomes less important in global commerce.
Another factor that could undermine the dominance of the US dollar is the fact that China is moving in the direction of running external deficits.2 For many years, China ran large surpluses, generating lots of excess dollars that it reinvested in the global economy. Yet demographic changes are pushing China toward an end to surpluses. If China runs deficits in the coming years, it will mean that it must borrow from the rest of the world—just as the United States has done for years. Yet the United States has benefited from the ability to borrow in its own currency due to the dominance of the dollar. This has enabled it to maintain low borrowing costs and avoid currency risk. China would likely prefer to have a similar privilege. Thus, China is likely to seek ways to fund its external deficit in renminbi, especially by encouraging other countries to trade in renminbi and hold reserves in renminbi. Moreover, China is the world’s largest importer of oil, mostly paid for in dollars. It would also like to be able to fund oil purchases in its own currency. Thus, China has a strong incentive to internationalize the renminbi.
The problem for China is that, in recent years, it has moved away from internationalizing the renminbi, mainly by imposing capital controls meant to avoid a sharp drop in the value of the renminbi. Regardless, it has taken steps meant to boost trade in renminbi.3 Also, other countries have shifted their foreign currency reserves in the direction of the renminbi, especially Russia. Many countries are evidently betting that the renminbi will likely grow in importance. In the process of making that bet, they could be making it happen.
Europe, too, is concerned about its vulnerability to US government policy decisions.4 The European Central Bank (ECB) and the EU are looking at ways to promote the international use of the euro, especially in order to protect European companies from US government sanctions. Benoit Coeure, a member of the ECB’s Executive Board, said that there is already currency diversification of trade taking place and that “we are the most natural candidate for diversification of the dollar as we are the second largest global reserve currency.” Indeed when the euro was created in 1999, there were hopes that it would supplant the dollar as a major global currency. This did not happen to the degree expected. However, the current European aversion to US sanctions could be the main driver of a push to further internationalize the euro.
For now, it is not clear whether the dominant role of the dollar will be undermined. It might happen or it might not happen any time soon. But, clearly, there are reasons why it is not a trivial risk. If, however, de-dollarization was to take place, it could have significant implications for the global economy. First, it is likely that the value of the US dollar would fall while that of the renminbi and/or the euro would rise. For the United States, this would mean more expensive imports and suppression of consumer spending growth. For China, it would mean cheaper imports and a boost to domestic demand. It could help to shift China’s growth away from exports and toward consumer spending. In addition, without the ability to borrow externally in dollars, the United States would likely face higher borrowing costs. This would mean that the ability of the US government to run large budget deficits with impunity might go away. For years, many observers have wondered when the United States would pay a price for running large deficits. De-dollarization might be the event that imposes a price.
US equity prices hit a record high following comments from Federal Reserve Chairman Powell indicating amenability to cutting interest rates. Powell is in a difficult position. President Trump has been urging him to cut rates and criticizing him for not cutting rates.5 It is important for Powell to maintain the independence of the Fed, including the appearance of independence. Thus, if the Fed cuts rates soon, Powell faces the risk that it will appear that he buckled under pressure from the administration. However, if he does not cut rates, he risks allowing the economy to further decelerate. Powell’s comments were evidently meant to make the case and set the stage for an interest rate reduction. He had noted that “uncertainties about the outlook have increased in recent months.”6 In addition, he said, “Economic momentum appears to have slowed in some major foreign economies, and that weakness could affect the US economy. Moreover, a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling, and Brexit. And there is a risk that weak inflation will be even more persistent that we currently anticipate.” Powell specifically noted the trade wars as a potential source of trouble. He said, “It appears that uncertainties around trade tensions and concerns about the strength of the global economy continue to weigh on the US economic outlook.”7 He is likely not confident that the current round of talks between the United States and China will result in a reduction in trade restrictions any time soon.
Powell also addressed the conundrum concerning the failure of a tight labor market to generate significant wage gains. This is one of the explanations as to why inflation has remained muted. Noting that many analysts have commented on the “hot” US labor market, Powell said, “To call something hot, you need to see some heat. While we hear lots of reports of companies having a hard time finding qualified labor, nonetheless we don't see wages really responding, so I don't really see that as a current issue.”8 This is similar to the sentiment expressed by Minneapolis Fed President Neel Kashkari, who said to businesses that “if you’re not raising wages, then it just sounds like whining.”9 Powell also said that the strong jobs report for June released last week did not change his view of the labor market or the economic outlook.
Although Powell provided no guidance as to when or by how much the Fed intends to cut rates, investors reacted swiftly, with the benchmark S&P 500 equity index topping the 3,000 mark for the first time ever. The yield on the two-year government bond fell sharply while that on the 10-year bond fell modestly. The value of the dollar fell as well. It appears that investors are now betting that the Fed will cut rates when it meets later this month and will likely cut rates further later this year. The rise in equity prices reflects an investor recalculation of the discounted present value of future earnings, based on a lower expected discount rate. It also reflects a belief that an easing of monetary policy will stimulate faster economic growth than would otherwise be the case. Yet the strong equity prices are not a reflection of the current state of the economy, which remains somewhat weak. As such, monetary policy appears to be driving asset prices. The same appears to be true in Europe where equity prices are frothy and monetary policy is easy and expected to become even easier. Finally, although an easing of monetary policy might be warranted, the persistence of very low borrowing costs could discourage businesses from disinvesting in less profitable enterprises. It has been argued that low borrowing costs have reduced the amount of creative destruction on which a market economy relies to generate new productive investment.10 This raises the question as to when the world will return to historically normal borrowing costs, if ever.
China’s trade flows weakened in the first half of 2019, especially in June.11 June was the first month in which the higher US tariffs took effect. As such, in June, Chinese exports were down 1.3 percent from a year earlier when measured in US dollars. For the first half of 2019, exports were up 0.1 percent (compared to a 12.8 percent increase in the previous year). Exports to the United States, however, were down 7.8 percent in June and 8.1 percent in the first half of the year, largely a result of trade restrictions. Meanwhile, Chinese imports were down 7.3 percent in June versus a year earlier. For the first half of 2019, imports were down 4.3 percent, while imports from the United States were down 29.9 percent. The weakness of overall imports partly reflects weak domestic demand in China, but also reflects weak export demand. The latter means that China requires fewer imported components. The overall weakness of trade is having a negative impact on Chinese economic growth as well as a negative spillover effect on other Asian countries that are integrated into China-led supply chains. Meanwhile, a low reading of the manufacturing Purchasing Managers Index for China as well as weak orders for shipping commodities by sea and air suggest that trade flows are likely to remain weak in the months ahead.
Meanwhile, the US-China trade war is having divergent effects on the economies of Southeast Asia.12 Consider this: in the second quarter of 2019, real GDP in Singapore was up only 0.1 percent from a year earlier, the slowest rate of growth in 10 years. Moreover, Singapore’s GDP fell at an annualized rate of 3.4 percent from the first to the second quarter,13 the worst quarterly performance since 2012. In the same quarter, real GDP in Vietnam was up a strong 6.7 percent from a year earlier. Although other Southeast Asian countries have not yet released their second-quarter GDP results, most analysts expect that growth will be in the range of 4 to 6 percent. The Philippines and Indonesia are expected to be strong, while Thailand and Malaysia are expected to be somewhat weaker.
In the case of Singapore, the very slow economic growth most likely reflects the impact of the trade war. The output of Singapore’s manufacturing sector fell 3.8 percent in the second quarter versus a year earlier. Manufacturing accounts for about 20 percent of economic output. The trade war has led to a decline in Pacific trade flows, with China reporting weakened exports and imports. With Chinese exports down, Chinese companies are importing fewer components from other countries in Asia. This has especially hurt Singapore that makes high-value components that are used in electronics products. Moreover, the global electronics industry is going through a slowdown as well. Meanwhile Singapore’s services sector grew 1.2 percent, while construction grew 2.2 percent.
It has been reported that many producers are shifting production of electronics, apparel, textiles, and footwear from China to Vietnam in order to produce final products that will not be subject to US tariffs. Thus, Vietnam’s economy appears to be benefitting from the side effects of the trade war. Nonetheless, there have been reports that some manufacturers are having trouble making the transition from China to Vietnam, with some planning to return production to China.14 This likely reflects rising labor costs in Vietnam as well as potential difficulties in training new workers.
Many countries in the EU are frustrated by US-based technology companies that book their profits in low-tax countries. France, for example, would like to be able to tax the profits of such companies, but faces obstacles. Consequently, France is enacting legislation that will tax the France-based revenues of technology companies.15 Specifically, this digital services tax will entail imposing a 3.0 percent levy on revenue generated within France through advertising and/or digital marketplaces. Other European countries, including the United Kingdom, are considering doing the same, and the US government is not happy about this. Consequently, the US administration opened a Section 301 investigation to determine whether France’s action harms US companies. If so, then the US administration could impose punitive tariffs on French imports. This is the same process by which the United States imposed significant tariffs on imports from China. The United States had threatened to start this process before France acted, but ignoring US warnings, the French Senate has passed the legislation. US trade negotiator Robert Lighthizer said, “The United States is very concerned that the digital services tax … unfairly targets American companies.
The president has directed that we investigate the effects of this legislation and determine whether it is discriminatory or unreasonable and burdens or restricts United States commerce.” In response, France’s Finance Minister Bruno Le Maire commented, “France is a sovereign state. It makes sovereign decisions on tax matters and will continue to make sovereign decisions on tax matters. Between allies, we can and we must resolve our disputes without resorting to threats.”16 Interestingly, US technology companies, which have been highly critical of the US administration’s trade policy toward China, have welcomed the US action with respect to France. Meanwhile, the dispute between the United States and France over the digital services tax is but one part of a larger fraying of economic relations between the United States and Europe. The United States has already imposed tariffs on imports of EU steel and aluminum, and threatened to impose tariffs on automotive imports as well as on a variety of goods in retaliation for EU aerospace subsidies. The United States and the EU are set to begin talks on an overall free trade agreement, but have not yet agreed on the scope of talks.17
Although the United States and China are set to begin another round of trade talks, it appears that there are substantial obstacles to making progress.18 First, after the Trump-Xi meeting at the G20 Summit in Osaka, President Trump said that China had committed to purchasing a “tremendous” quantity of agricultural products from the United States. Yet it is reported that China’s government does not accept that such a commitment was made. Moreover, US government data indicates that Chinese purchases of US farm products actually declined after the Trump-Xi summit.19 Second, the two sides remain far apart on the process by which tariffs will ultimately come down. The US side wants to wait to cut tariffs until it is evident that China adheres to any future agreement. China, in contrast, wants tariffs to be cut as soon as a deal is signed. A Chinese official said that “all tariffs that have been imposed must be removed if China and the US come to an agreement.”20 Third, although the United States has temporarily eased restrictions on the sale of products to Chinese technology companies, the US administration faces resistance from Congress and the US intelligence community.
Moreover, the United States has threatened to withhold intelligence from the British government if it purchases certain Chinese technology products. If the United States eases restrictions on these products, allied governments might become less willing to support US technology policy.
The US job market surprised many investors last week. The government released its monthly employment report for June and the numbers were better than expected. The US government releases two jobs reports: one based on a survey of establishments and the other based on a survey of households. Here is what these reports showed.
The establishment survey results reveal that 224,000 new jobs were created in June, up significantly from the 72,000 created in May.21 The number of new jobs was far more than investors expected, especially since a private sector estimate from ADP, which was released on Wednesday, suggested weak job growth.22 By industry, there was robust growth in both construction and manufacturing, but the automotive industry experienced a decline in employment. Within services, there was strong growth in transportation and warehousing, professional and business services, and health care. At the same time, the decline in employment in the retail industry continued due to the rise of online shopping. The leisure and hospitality industry, which had seen strong job growth in the past year, had only modest growth in June. The wholesale trade, finance, and information industries experienced almost no employment growth. The survey also found that wages continued to rise at a robust pace, with average hourly earnings up 3.1 percent from a year earlier, the same rate of increase as in May.
The separate survey of households found that labor force participation increased in June.23 Employment grew a bit slower than the size of the labor force. The result was that the unemployment rate rose from 3.6 percent in May to 3.7 percent in June. Still, it remains historically low.
The latest jobs report led many investors to revise their expectations regarding a Federal Reserve interest rate reduction. The report, which indicated that the job market remains relatively strong, suggests that the Fed need not cut rates quickly. That is because one can infer from the report that the economy continues to grow at a faster-than-expected pace, thereby generating potentially more inflationary pressure than previously estimated. The result following release of the report was that bond yields rose and equity prices fell,24 and the value of the US dollar was up against most major currencies. The yield on the 10-year bond went above the 2.0 percent mark for the first time in several weeks. The market’s implied probability of a 50-basis point rate cut this year fell sharply, while the implied probability of a 25-basis point cut increased.25 Meanwhile, despite the rise in bond yields, the yield curve remains inverted, which is often a good predictor of an upcoming recession.
For the Federal Reserve, the jobs report creates a bit of a conundrum. If the data suggested a robust economy and accelerating inflation, the Fed would not even be thinking about cutting interest rates. Conversely, if the data indicated a very weak and disinflationary economy, a Fed decision to cut rates would be a no brainer. The problem for the Fed is that the data is somewhere in between. Thus, it is at a time like this when a good central banker earns his/her pay. Of course, the Fed leadership is cognizant of the fact that the US recovery is now the longest on record. Enabling that recovery to continue means carefully evaluating the countervailing influences on the economy. On the one hand, the robust job market still has the potential to boost inflation. On the other hand, credit market stress and trade conflicts have the potential to derail the recovery. The inversion of the yield curve is signaling that investors perceive greater downside risk.
In a surprise move, the Member States of the Eurozone agreed that the International Monetary Fund’s (IMF) Managing Director Christine Lagarde should be appointed to lead the European Central Bank (ECB), replacing outgoing President Mario Draghi.26 In addition, the members of the European Union (EU) agreed that Ursula Von Der Leyen, the German defense minister and a close ally of Chancellor Merkel, should become the next president of the European Commission. She would replace Jean Claude Juncker.
The choice of Lagarde to head the ECB took investors by surprise, but the decision is likely to be ratified. Still, she was not on the list of candidates that had widely been seen as likely successors to Draghi. Moreover, unlike Draghi, she is not an economist by training. Rather, she was an attorney prior to becoming French finance minister and later managing director of the IMF. This is similar to the situation regarding US Federal Reserve Chairman Jay Powell, who is also an attorney, and not an economist by training. Previously leaders of both the ECB and the Fed were academic economists. When Mario Draghi and Ben Bernanke ran the ECB and Fed, respectively, they actually had much in common, both having obtained their doctorates at the Massachusetts Institute of Technology and having worked under the same academic advisor. This is not a trivial issue. Central bankers must make policy choices that, in large part, are driven by competing academic theories about how monetary policy influences the economy. They must make choices about which of the various policy tools are most appropriate for a given situation. Essentially, central bankers are technocrats who either have technocratic skills or rely on the advice of technocratic staff. Familiarity with the academic debates is no doubt helpful in making informed decisions, although not necessarily essential.
The news that Christine Lagarde will be the next President of the ECB was greeted with euphoria on the part of investors.27 Global bond prices soared (yields fell) as investors evidently expect Lagarde to continue the relatively easy monetary policies of Mario Draghi. Draghi has kept interest rates historically low and, lately, due to the evident slowdown in the Eurozone economy and persistent low inflation, he has expressed amenability to reviving the policy of quantitative easing (asset purchases). It is known that Lagarde had been supportive of these policies in the past. She and Draghi had worked closely on resolving the Eurozone debt crisis several years ago when Greece appeared to be on the verge of default. Although some observers expressed concern that Lagarde does not have an economics background, investors appear to be confident that she will be a source of continuity in monetary policy. There had been other candidates who were not seen as likely to maintain continuity, which was a source of concern to some investors. The choice of Lagarde was seen as a victory for French President Macron who is reported to have pushed hard for her appointment.
Italian bond yields fell last week on investor expectations that the ongoing fiscal dispute between the Italian government and the EU will abate.28 This expectation stems from the fact that the Italian government reached an agreement to cut the budget in order to abide by EU rules. The yield on the 10-year bond fell below 2.0 percent for the first time since May 2018, and the yield on the 2-year bond fell below 0.0 percent, also for the first time since May 2018. What makes May 2018 significant is that it was when the current government came to power and when bond yields began to soar. Since the government came to power, bond yields have been on a roller coaster, rising and falling on changing expectations about the degree to which the government and the EU were likely to hit a brick wall. The cost of insuring Italian government debt against default rose during the past year on concerns that Italy might choose to, or be forced to, exit the Eurozone.
The recent decline in yields suggests that investors are now more optimistic that the Italian government will not do anything to cause EU fines or worse. At the same time, a recent survey found that the share of investors who believe that Italy will ultimately exit the Eurozone has increased somewhat in recent months, although it remains quite low.29 Meanwhile, the yields on most European government bonds have fallen lately due to pessimism about inflation and growth as well as expectations that the ECB will possibly reengage in asset purchases. Yields for Spain and Portugal have also fallen. What makes the drop in Italian yields notable is that the spread between Italian and German bond yields has declined. This means that investors likely perceive Italy as being less at risk than previously was the case.
The global manufacturing industry continues to deteriorate, according to the latest purchasing managers’ indices (PMIs) published by IHS Markit. The PMI is a forward-looking indicator meant to signal the direction of activity in the crucial manufacturing sector. It is based on sub-indices such as output, new orders, export orders, employment, pricing, inventories, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth—and vice versa. The latest data for June indicates declining manufacturing activity in the Eurozone, United Kingdom, China, Japan, and members of ASEAN (or the Association of Southeast Asian Nations, an intergovernmental organization comprising 10 countries in Southeast Asia). It also indicates only modest growth in the United States. Here are some details.
In the United States, the PMI rose slightly from May to June, hitting a level of 50.6, which reflects very slow growth in activity.30 Yet both monthly readings were the lowest in 10 years. The weakness was due to weak output, new orders, and employment, in part driven by an excessive accumulation of inventories. A statement from Markit notes “Tariffs … continued to push up prices, but weak demand often limited the ability of firms to pass higher prices onto customers.” This meant weak output price inflation and tightening margins for manufacturers. Going forward, the trade war truce could have a modest positive impact on trade.
In the 19-member Eurozone, the PMI fell slightly in June, hitting 47.6, a 6-year low and a level consistent with a sharp decline in activity.31 This was the sixth consecutive month in which activity declined. The weakness was due to declining output, new orders, export orders, and employment. While consumer-oriented industries improved, performance in intermediate and investment goods industries was especially weak, boding poorly for further business investment. In addition, weakness was evident across geographies, with the notable exception of France. The PMI for France improved and was in positive territory at 51.9, unlike the other major economies of the region. Still, France’s manufacturing growth was modest at best. Germany’s PMI was especially low at 45.0, and Spain’s PMI hit a 6-year low of 47.9.
In the United Kingdom, the PMI fell to a 6-year low, hitting 48.0, a level indicating a significant decline in activity.32 The weakness was due to a sharp decline in output, new orders, and employment. Export orders continued to decline, a trend that Markit attributed to the weakness in the global economy as well as uncertainty about Brexit.
The PMI for China fell back into negative territory in June, hitting 49.4. This indicates a modest decline in activity.33 There was a decline in output, export orders, domestic orders, sales revenue, and employment. Markit reported that export orders were probably front-loaded owing to fears of a potential increase in US tariffs. This means that export orders were likely better than would otherwise have been the case, and it bodes poorly for growth of export orders in the coming months.
The weakness in China’s manufacturing sector spilled over into the manufacturing sectors of other East Asian economies.34 The PMIs for ASEAN (49.7), South Korea (47.5), and Taiwan (45.5) were all in negative territory in June, with Taiwan’s PMI hitting an 8-year low. The latter was driven in large part by the slump in the global electronics industry and the disruption of electronics industry supply chains stemming from the trade wars. Within ASEAN, Myanmar and the Philippines performed well, with PMIs in positive territory. The PMIs for Malaysia and Singapore were in negative territory, with Singapore’s PMI hitting a record low of 42.9. Singapore’s electronics industry has been hard hit by the trade war between the United States and China.
Finally, Japan’s PMI fell to 49.3 in June, a level indicating continued declining activity.35 There was weakness in output, new orders, export orders, and employment. This stemmed from weak overseas demand, especially from China, as well as overall weakness in the global automotive sector.
Vietnam and the EU have signed a free trade agreement.36 This is likely to create an incentive for export-oriented companies to locate production in Vietnam in order to obtain tariff-free access to Europe. It is expected that some companies currently producing in China will shift production to Vietnam. This could include Chinese companies that engage in contract manufacturing for global fashion and technology companies. The EU, which just a few weeks ago penciled a trade agreement with the Mercosur nations of South America, said that the agreement with Vietnam is “the most ambitious free trade deal ever concluded with a developing country.” The deal will lead to the elimination of 99 percent of customs duties currently imposed on one another. The deal took seven years to negotiate. Even before this agreement, there was a shift of final assembly from China to Vietnam under way. This was due to rising labor costs in China and, more recently, fears of tariffs imposed by the United States. The deal with the EU will likely speed up this process and contribute to faster economic growth in Vietnam. Meanwhile, the deal is yet another indication that the EU is keen on liberalizing trade with many countries, in part to offset future restrictions on trade with the United States. This could further isolate the United States as well as the United Kingdom should it exit the EU without a deal.
While the United States and China have engineered a temporary truce in their continuing trade war, the United States has now targeted the EU for trade restrictions related to the EU’s alleged subsidies for Airbus.37 Specifically, the US government says that it is considering imposing tariffs on US$4 billion in imports from the EU pending completion of a dispute at the World Trade Organization (WTO) about aerospace subsidies. The tariffs would be applied to a range of products including cheese, pasta, and Scottish and Irish whiskey. The latter might be welcomed by producers of Kentucky bourbon. The threat of tariffs pending completion of a WTO case is unusual. Normally, both sides wait for resolution of a WTO case before deciding on retaliatory action. Meanwhile, the US continues to refuse to approve of the appointment of new members of the WTO’s dispute resolution panel, which is responsible for adjudicating trade disputes, including the current one related to aerospace subsidies.38 By the end of this year, if the United States fails to allow the appointment of new members, the panel will have only one member and, consequently, will cease to have authority. In that case, countries will theoretically be free to take whatever actions they deem necessary to resolve their grievances. The WTO’s dispute settlement process is a key part of the global rules-based trading system. The EU has offered to make changes to some WTO rules in order to assuage US concerns. However, the United States has not accepted the proposed changes and the dispute over appointing new judges continues.
In his inaugural address in January 2017, US President Trump said that “protection will lead to great prosperity and strength.”39 Thus he began his administration with a protectionist viewpoint, and he has stuck to it, especially in the past year. The result has been one of the biggest disruptions of the global trading system since the end of World War II. Meanwhile, Trump and the leaders of the other G20 countries assembled last week in Osaka, Japan to discuss global economic issues and attempt to resolve conflicts. Many of the conflicts revolve around US trade initiatives or threats. Such conflicts are exacerbated by the fact that, in many democratic countries, voters have tilted in a populist direction, rejecting parties that espouse traditional policies of open trade and economic integration.
Before discussing the recent meeting, it is worth recalling the origins of the G20. This organization of the world’s 19 largest national economies and the European Union (EU) began in 1999 as a venue for finance ministers and central bankers to discuss global economic issues. In the wake of the global crisis in 2008, it was extended to become an annual get together of heads of government. The meetings in 2008 and 2009 were crucial in that they resulted in a joint commitment to avoid protectionist policies in the face of rising unemployment and populist sentiment. Finally, the meeting in 2009 entailed a joint commitment to use fiscal and monetary policies to stabilize the global economy. As such, the G20 process was considered modestly successful at that time. At the least, it probably helped to avoid a disintegration of the global system. In the decade since then, much time was spent looking for ways to further integrate the global economy. This included working on a free trade agreement for the Asia-Pacific region (the Trans-Pacific Partnership or TPP), a free trade agreement between the United States and the EU (the Transatlantic Trade and Investment Partnership or T-TIP), an agreement to liberalize cross-border investment between the United States and China, and efforts to save the Eurozone during the Greek debt crisis. The only trade agreement to be completed was the TPP, and the United States withdrew from it when the new administration came into office. Thus, by 2017, the globalist promise of the G20 had not been met.
Last week, the G20 leaders met at a critical time, when the global economy appears to be in the midst of a synchronized deceleration in economic activity. Monetary policies are mostly easy, with historically low interest rates that could mitigate against the capacity to respond to a new crisis. Fiscal policy in the United States is historically expansionary, which also mitigates against a further easing of fiscal policy if a downturn should come. Fiscal policy in the EU remains hamstrung by rules designed to avoid profligacy. The corporate world is laden with debts accumulated at a time of historically low borrowing costs. And many emerging economies are fragile, the result of excessive debt and reliance on commodity exports. Thus, there are questions as to how readily the world can respond to a downturn. Add to this mixture the existence of a set of trade disputes, characterized by increasing restrictions on trade and uncertainty about the future of trading relations, and you have a recipe for potential trouble.
So, what came of the G20 Summit? At the end of the summit, there was a statement endorsed by all of the leaders. Yet it was relatively vague and uncontroversial, offering support for free trade and innovation as drivers of economic growth, but failing to condemn protectionism for the first time since the G20 leaders started meeting in 2008.40 It appears to have been a heroic effort to paper over significant differences between the United States and the others. Still, the summit did have consequences. Here is what we know so far:
The United States and China agreed to a temporary truce in their ongoing trade war;41 that is, the United States will postpone imposition of another round of tariffs on Chinese imports, China will purchase more US agricultural products, and the two sides will continue to talk. Although the United States has already imposed a 25 percent tariff on roughly half of imports from China, it had threatened to impose a 25 percent tariff on all remaining imports from China in the absence of a trade deal. This additional tariff will now be postponed. In addition, there were hints that the technology dispute between the two countries might ease, although no details were provided. Regardless, global businesses will likely be pleased not to face ruinous tariffs and immediate massive disruption to supply chains. That being said, mere postponement of tariffs simply prolongs the uncertainty that is currently gripping the world of international trade. This will likely continue to have a chilling effect on investment in global supply chains. Two questions remain. First, will the two sides ultimately find common ground that could form the basis of a new trade agreement, or will they simply continue to kick the can down the road? Second, will the two sides step back from the growing dispute about technology? The latter is critically important as it could be hugely disruptive to the further development of breakthrough technologies. Indeed, this dispute could result in a bifurcated world of technology. That, in turn, would not only influence the technology industry, but all other industries that use technology to run their businesses.
All of this raises the question as to how this gets resolved. For now, the trade dispute between the United States and China increasingly resembles the film “Groundhog Day” in which Bill Murray awakens each day to the start of the same day. In the trade dispute, postponements of tariffs while talks take place have happened before, most recently in December when US President Trump and Chinese President Xi agreed to talk rather than impose tariffs. The current agreement also came about because of a meeting between the two presidents on the side lines of the G20 Summit in Osaka. The cycle will only be broken if one of two things happens. Either China accedes to US demands regarding structural economic issues (which seems unlikely), or the United States accepts a superficial deal and declares victory. The latter could happen if the United States were to worry that further trade tensions might undermine the economic recovery. Otherwise, we may be condemned to a repetition of events that suppresses investment and undermines economic expansion.
Another big issue at the G20 Summit was US relations with its traditional European and Japanese allies. The United States has imposed and/or threatened to impose significant tariffs on these countries. It has questioned the military and geopolitical alliances with these countries and has demanded greater reciprocity in terms of trade rules and military spending. European and Japanese efforts to appease the United States have been modestly successful at best.
Regarding Japan, Prime Minister Abe has worked very hard to solidify a relationship with US President Trump, even being the first foreign leader to visit Trump before he was inaugurated. So far this strategy has paid dividends in that the United States has not specifically targeted Japan for trade restrictions. However, the US president recently challenged Japan’s geopolitical role. Specifically, in anticipation of the G20 Summit in Osaka, Trump raised questions about the usefulness of the military pact between the United States and Japan, which was signed in 1950 during the Cold War and meant to protect Japan from attack by either the Soviet Union or China. The pact calls for the United States to defend Japan from attack. In exchange, the United States gets to station troops and equipment in Japan. Trump suggested that the pact is biased and does not require that Japan defend the United States. He said, “If Japan is attacked, we will fight World War III. We will go in and protect them with our lives and with our treasure. We will fight at all costs. But if we are attacked, Japan doesn’t have to help us at all. They can watch on a Sony television.”42 In addition, it is reported that, privately, Trump has mused about the possibility of having the United States withdraw from the military pact. The US reticence about its relationship with Japan has alarmed leaders in both Japan and South Korea. The latter, too, relies on a military alliance with the United States.
If the United States were to withdraw from its obligations with respect to Japan, it is likely that there would be increased support within Japan to develop its own nuclear weapon as a safeguard against attack by China and, especially, North Korea. South Korea might see such a situation as warranting its own nuclear weapon. Thus, the US presence in the region has likely helped to avoid increased nuclearization of the region. Moreover, the US relationship with Japan has allowed the United States to project military power in the region in a manner that would otherwise be more difficult. From China’s perspective, the US nuclear umbrella over Japan has been beneficial in that it has discouraged Japan from remilitarizing.
While the world continues to wait for a possible trade agreement between the United States and China, many global companies are not waiting and have chosen to begin making changes to their supply chains.45 They are likely concerned that the world has changed in ways that increase the risk of disruption, even if a temporary accord is reached this year between the US and China. For example, it is reported that some leading US-based electronics companies are considering shifting some of their final assembly outside of China.46 Yet this would likely entail a prolonged and costly process. Meanwhile, if the United States ultimately imposes a 25 percent tariff on all remaining Chinese imports (which would include mobile telephones), the likely result will be an increase of US$100-150 in the retail price of a mobile phone sold in the United States, provided that the producer fully passes the tariffs onto consumers.
Although many electronics companies are looking at their options, most of them are lobbying strenuously to persuade the US government not to impose new restrictions on imports from China. They argue that most of the value added to their products does not actually take place in China. Rather, relatively inexpensive assembly takes place in China, taking advantage of low-cost labor. Meanwhile, much of the value added for leading-edge electronics products takes place in the United States, Japan, Taiwan, and South Korea. Despite the very large amount of Chinese labor devoted to assembling electronics products, China’s contribution to the value added is considered modest.
The number of foreign investment projects in the United Kingdom has fallen sharply over the past year according to the British government.47 Specifically, the number of foreign-funded investment projects fell 14 percent in the fiscal year ending in March 2019 versus a year earlier. This was the second consecutive annual decline. This was also the lowest level of foreign investment in six years. It is notable that there was an increase in foreign investment in the rest of Europe during this period. Also, the British government reports that the number of jobs created by foreign investment projects has fallen as well, with sharp declines in such industries as financial services, automotive, software, and advanced engineering. Some commentators have attributed the decline in inbound foreign investment to the uncertainty unleashed by the Brexit referendum. Many global companies have looked to the United Kingdom as a gateway to the rest of Europe. The risk that the United Kingdom might exit the EU without an agreement means that, at least in the immediate aftermath of such a no-deal exit, the United Kingdom would be less attractive as a place from which to do business in Europe.
With uncertainty about the possible path of Brexit remaining, Bank of England Governor Mark Carney suggested that, in the event of a no-deal Brexit, it might be necessary for the central bank to ease monetary policy.48 Specifically, he said that in the event of a no-deal Brexit, “It is more likely that we would provide some stimulus in that event.” He said that a no-deal Brexit would be a significant shock to the British economy and would not necessarily resolve the uncertainty that is currently hurting economic activity. Notably, a no-deal Brexit would likely be inflationary, at least initially. It would likely lead to a sharp drop in the value of the pound, thereby boosting import prices. It would also likely entail the imposition of new tariff barriers, which would boost import prices as well. Yet the inflationary impact would probably be more than offset by a weakening of the British economy, thereby warranting an easing of monetary policy.
Amidst the trade wars, the global trend of merger and acquisition (M&A) activity has shifted significantly. Cross-border M&A has fallen sharply as companies shy away from commitments that could be disrupted by changing trade rules. Specifically, according to data from Dealogic, as of mid-point in 2019, the number of cross-border M&A deals has fallen to the lowest level since 2005 and the dollar value of deals is the lowest since 2010.49 Meanwhile, deal making within Europe and Japan has slowed as well. Deals between European companies are down 57 percent while deals between Japanese companies are down 23 percent. The sharp slowdown in Europe might, in part, reflect aggressive action by competition authorities. The only major exception is the volume of deal making between companies based in the United States. Specifically, the volume of deals within the United States has increased 20 percent as of mid-2019 compared to a year earlier, according to data from Refinitiv.50 The rise in deal making within the United States may reflect concerns about protectionism and a desire to secure market share within the country. It may also reflect the fact that borrowing costs remain low and asset values high. Thus, companies might be attempting to secure favorable deals before the ultimate downturn takes place. The future direction of the M&A industry will depend, in part, on how the current turmoil in trade unfolds.