What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
The trade war between the United States and China deepened last week when China announced retaliatory tariffs. Investors were shaken as evidenced by a very sharp drop in global equity prices, especially prices in the United States. Here is what happened:
China announced it will boost tariffs on US$60 billion of imports from the United States. The roughly 5,000 products targeted are currently taxed at between 0 and 10 percent.1 Under the new regime, they will face tariffs of 5 to 25 percent. Specifically, 2,493 products will be taxed at 25 percent, 1,078 products at 20 percent, 974 products at 10 percent, and 595 products at 5 percent. The tariffs will take effect at the start of June. The tariffs previously announced by the United States will apply only to merchandise that left China after the announcement. As such, they will actually take effect only when those products reach the United States, likely in early June. It thus appears that both sides attempted to ease the transition and allow some time to possibly reach an accommodation. The Chinese tariffs apply to a wide range of products including agricultural goods, liquid natural gas, apparel, home appliances, and even condoms. However, China avoided tariffs on aircraft and crude oil given the growing domestic demand for air travel. Some analysts pointed out that a number of the products targeted by the Chinese are largely produced in states that are politically important to President Trump. Moreover, it is widely expected that China will engage in non-tariff means of restricting trade with the United States. In addition, China recently introduced new processes for reviewing inbound foreign direct investment, which could be used to restrict inbound investment by US companies. The magnitude of the restrictive actions taken by both sides is unprecedented in modern times. The last time that large economies undertook major protectionist measures was during the Great Depression in the early 1930s.
Interestingly, prior to last year’s initiation of the trade war, the average effective tariff rate for the United States was among the lowest in the world. Not any longer. With the tariffs imposed in 2018, the US tariff rate became higher than that of most developed countries, such as Japan and the European Union (EU).2 With the actions taken last week, the average tariff is now higher than Russia’s and Turkey’s. And, if the United States follows through on its threat to boost tariffs on all imports from China, which is likely, the average tariff rate will be higher than China’s and India’s, and only slightly lower than Brazil’s. For the US tariff rate to be similar to those of big emerging markets is unprecedented in the post-war era. If sustained over a long period of time, it is likely to be game changer for the global economy.
Investors reacted to the action by China.3 On the day of the announcement, the Shanghai market fell 1.2 percent while the technology-heavy Shenzhen market fell 1.4 percent. In the United States, the Dow Jones Average and the S&P 500 Index were both down sharply, and the technology-heavy NASDAQ was down even more. There were especially sharp drops in the prices of US companies that sell capital goods in China as well as major US-based technology companies. Also, shares of United States and European automotive companies were hit hard given the increasing dependence of US car companies, as well as European car factories in the United States, on the Chinese market. In addition, equity prices fell in Europe, crude oil prices fell, and bond yields fell in the United States.
The trade spat between the United States and China is not the only source of potential trouble in the global economy. Almost three months ago, the US Commerce Department reported to the White House that automotive imports are a threat to US national security. The President had until last Thursday to decide whether to impose punitive tariffs on auto imports.4 If he had done so, it would mainly have involved targeting cars from Europe and Japan given that cars from Mexico, Canada, and South Korea are already covered by other trading arrangements. However, the president has chosen to delay boosting tariffs on automotive imports for up to six months.5 Perhaps the administration decided that one trade war at a time is enough. Perhaps it also decided that, if it is to take on China, it needs support from its traditional allies. Launching a new trade war that would largely have targeted Europe and Japan would have rendered the United States alone in its fight with China. Still, the fact that automotive tariffs remain on the table will mean that automotive companies and their suppliers will continue to face uncertainty about future trading relations. That, in turn, will likely stifle investment.
Meanwhile, the United States announced late last week that it will eliminate tariffs on imports of steel and aluminum from Canada and Mexico.6 Despite US demands, there will be no quotas replacing the tariffs. This action helps to eliminate a major sticking point between the countries of North America, and likely improves the chances that the US Congress will approve the new trade agreement meant to succeed the North American Free Trade Agreement (commonly known as NAFTA). Notably, this action includes an agreement to limit metals produced outside North America from being traded within North America. This was likely meant to be directed against China. Thus, by taking steps to ease trade tensions with allies, the United States is setting the stage for a more coordinated action with respect to China.
For the ninth time in the last 12 months, industrial production in the 19-member eurozone declined from the preceding month.7 The EU reports that, in April, industrial production fell 0.3 percent from March. It was down 0.6 percent from a year earlier, the sixth consecutive month in which industrial production failed to grow from a year earlier. The weakness in production in the past year has been part of a larger trend of weakening economic activity in the eurozone. Among the possible reasons for the slowdown have been weaker demand from China, the trade conflict with the United States, uncertainty regarding Brexit, and some factors specific to major countries within the eurozone. For example, Germany has been hit hard by the transition away from diesel engines; France has been hit by a protest movement; and Italy has been hit by much higher bond yields that result from a sharp change in fiscal policy. On the positive side, there has been a modest increase in production of capital goods, boding well for increased business investment. In addition, the policy environment is favorable for continued, if only modest, economic growth. The European Central Bank (ECB) is maintaining a historically easy monetary policy. Meanwhile, several countries have moved toward an easing of fiscal policy. These include Germany, France, and Italy. Thus, the Eurozone does not appear to be at near term risk of a recession. By country, industrial production fell 2.5 percent from a year earlier in Germany, fell 1.0 percent in France, fell 1.4 percent in Italy, fell 3.4 percent in Spain, and fell 1.9 percent in the Netherlands.
Consumer price inflation in the 19-member Eurozone accelerated in April.8 Prices were up 1.7 percent in April versus a year earlier, the highest rate of inflation since November. When volatile food and energy prices are excluded, core prices were up 1.3 percent, matching the highest underlying rate of inflation since late 2015. Overall inflation was 2.1 percent in Germany, 1.5 percent in France, 1.1 percent in Italy, and 1.6 percent in Spain. The highest inflation in the eurozone was in the Netherlands at 3.0 percent. The lowest was in Portugal at 0.9 percent. That disparity demonstrates the challenge facing the ECB, which is keen to boost the overall rate of inflation toward the 2.0 percent target. Yet with Germany and the Netherlands showing inflation above the target, the ECB must be careful not to produce excessive inflation in those countries.
Economic activity in China appears to have slowed in April, even before the United States and China imposed new tariffs on one another. This follows a relatively favorable performance of the economy in the first quarter that, for now, appears not likely to be replicated. Existing trade tensions between the United States and China likely explained the weak performance, especially as there was a sharp slowdown in manufacturing output. However, retail sales also weakened considerably, suggesting that domestic demand in China is decelerating. Here are the details:
In April, retail sales grew only 7.2 percent from a year earlier, the slowest growth since 20039 and far slower than the 8.7 percent increase seen in March. There was a sharp slowdown in the growth of spending on home appliances (up 3.2 percent), furniture (up 4.2 percent), and telecom equipment (up 2.1 percent). In addition, spending on apparel was down 1.1 percent and on automobiles 2.1 percent. Retail sales data in China is not entirely reliable given that it includes some government spending. However, the evident deceleration suggests that the consumer sector is becoming weaker at a time when the external sector is especially challenged.
Industrial production in China grew modestly in April, up 5.4 percent from a year earlier.10 This was far slower than in March, but consistent with the experience of the prior four months. Before that, growth had been faster. The weakening of the performance of the industrial sector coincided with the implementation of the trade war between the United States and China.
One bright spot for Chinese economic data concerns fixed asset investment.11 It rebounded modestly in the past year, although it decelerated slightly in the January through April period when investment was up 6.1 percent from a year earlier. Still, growth during the past year was much slower than at any time in nearly two decades. Private sector investment was up 5.5 percent while public sector investment was up 7.8 percent. Manufacturing investment rose only 2.5 percent.
Although China’s economy has shown signs of deceleration, house prices have lately rebounded due to the stimulus provided by the government for housing market activity.12 Specifically, the easing of monetary policy has meant lower mortgage interest rates. In addition, the government has eased restrictions on housing market transactions. The result is that, in April, prices were up in 67 of 70 cities analyzed by the government. This is up from 57 cities in February. In addition, the volume of activity in the housing market, in terms of both floor space and the value of activity, accelerated. Housing starts and new investment in housing both accelerated as well.
So, what can be said about the overall outlook for the Chinese economy? The trade war between the United States and China could cut China’s annual GDP growth by one percentage point this year, according to a senior Chinese government official.13 The economy has lately been growing at a rate of 6.5 percent. Thus, a one percentage point drop would put growth at about 5.5 percent. The official, who is a member of the Politburo’s Standing Committee, said that, although growth will slow, it will not result in any change in the economy’s structure. The forecast is an unusually candid assessment and is consistent with private sector estimates. At the same time, some people in the government endorse taking steps to assist the growth of small- and medium-sized enterprises in the private sector. Such measures could help to offset the decline in growth. It is reported that there is debate within the government about the appropriate level of stimulus.14 A spokesman for the government said that it will “fully study the impact of the implementation of the tariff increases, and promptly introduce countermeasures as needed to ensure that the economy operates within a reasonable range.” The government already took steps last year to stimulate the economy. The question now is whether the new tariffs warrant further stimulus.
The value of China’s currency is partly determined by the government, which sets a daily band within which the currency can trade. The band is adjusted in a way that allows the currency to move in the direction desired by the government or prevents the currency from moving in a direction not desired by the government. In the past year, the renminbi fell about 10 percent against the value of the US dollar, thus largely offsetting the impact of the 10 percent tariff the United States imposed on a large volume of Chinese imports. Now, with the United States boosting that tariff to 25 percent, and threatening to apply a 25 percent tariff to all imports from China, the future movement in the value of the renminbi will play a critical role in determining the degree to which China’s exports remain competitive. Thus, it is no small matter that the renminbi has been falling recently.15 This week the value of the renminbi hit the lowest level since December.
It is likely that the currency is falling due to market conditions and that the government is simply letting it happen. It is probably not taking steps to cause a depreciation. After all, the tariff war has likely dampened investor sentiment about the renminbi. Either way, the declining value will help to offset the impact of tariffs, and could inflame relations with the United States. Meanwhile, a cheaper renminbi will hurt the competitiveness of other countries’ exports, whether they are selling directly to China or to other countries. A cheaper renminbi will also cause increases in prices in China and could exacerbate inflation which is currently quite low.
Meanwhile, China’s central bank has been selling US Treasury bonds at the fastest pace in two years. The result is that holdings of Treasuries have fallen to the lowest level in two years. This raises the question as to whether China’s government intends to use its US$1.12 trillion in Treasuries as a weapon in the trade war. There has been speculation that it might sell bonds at a rapid pace, thereby possibly leading to a sharp rise in bond yields, which would hurt the US economy. China remains the single-largest foreign holder of US Treasuries, followed by Japan.
Retail sales in the United States declined 0.2 percent from March to April, and were up 3.1 percent from a year earlier.16 This weak performance was not an aberration. Retail sales only grew from month to month in three of the last nine months. The aberration, however, was the strong growth in March which evidently excited investors. On a month-to-month basis, retail sales in April declined sharply for automotive dealers, electronics retailers, and home improvement retailers. Thus, it appears that consumers are sharply cutting back on big-ticket, durable expenditures. Even non-store retail spending declined. So, it is rather surprising that sales at department stores actually increased at a strong pace. This is a category that has been perennially weak. The other category where spending increased strongly was gasoline stations, mainly driven by higher gasoline prices.
Industrial production in the United States fell in April, dropping 0.5 percent from March to April and rising only 0.9 percent from a year earlier.17 The monthly decline was actually the fourth consecutive drop. In April, production was down for most categories, especially production of capital goods which fell 2.1 percent from March to April. That bodes poorly for business investment. The weakness of both retail sales and industrial production both suggest a significant slowing of the US economy. Thus, it is not surprising that the Federal Reserve has chosen to stop tightening monetary policy.
Among the many Asian countries that stand to suffer from the US-China trade war, Taiwan is especially vulnerable. About 90 percent of components used by US computer companies to assemble laptops in China are made in Taiwan.18 In addition, some Taiwanese companies actually assemble US-branded laptops in China. With tariffs likely to go up on US imports of laptops from China, Taiwanese technology companies are set to experience a sharp drop in demand. That is because laptop prices are likely to rise sharply, thereby hurting demand in the United States. For US computer makers, there are few alternatives to assembling in China, at least in the short run. Thus, the tariffs, if fully implemented, could significantly cut the growth of Taiwan’s economy this year, and especially next year. Meanwhile, some Taiwanese companies have already started to move some assembly from China back to Taiwan or to other East Asian countries, especially Vietnam.
Last weekend, President Trump threatened to raise tariffs on China by the end of last week, and the tariffs did indeed go up by then. The US administration said that China had backtracked on promises made during negotiations.19 Consequently, the United States increased existing tariffs on Friday because a deal had not been reached. Specifically, the 10 percent tariff on US$200 billion in imports from China went up to 25 percent. The US trade negotiator Robert Lighthizer said, “Over the course of the last week or so we have seen an erosion in commitments by China. Really, I would use the word reneging on prior commitments.” Lighthizer was asked why he thought the Chinese had backtracked. He noted, “My own view is that these were serious, real commitments that were enforceable and that some people in China found that difficult and objected to it. For whatever reason, it is where it is.” In addition, US Treasury Secretary Steve Mnuchin said, “It did become particularly clear over the weekend, with some new information, that they were trying to go back on language that had been previously negotiated, very clear language that had the potential of changing the deal dramatically. It’s unfortunate if we can’t conclude an agreement because I think this agreement would have opened up China.” Thus, the two US officials appeared to suggest that hardliners in the Chinese regime resisted some of the commitments made by China’s negotiators.
Because the threatened higher tariffs were previously scheduled to take effect earlier this year, and were then postponed, the normal review process has already taken place. Thus, it was feasible to increase the tariffs quickly. At the same time, the president’s additional threat to impose new tariffs on all remaining US$325 billion in imports from China cannot happen quickly and must go through a review period.20 The US administration indicated that it will move to boost tariffs on all remaining Chinese imports if an agreement is not reached within 30 days. If this happens, all Chinese goods sent to the United States will be subject to a 25 percent tariff. That would directly cost the American economy roughly 0.5 percent of GDP. Chinese, American, and European equity prices fell throughout last week on worries about a worsening trade war. The hit to equities was especially sharp for industrial companies that export capital goods to China, and for technology companies that rely on Asian supply chains.
Why are investors worried? The reason is that a 25 percent tariff is a lot more onerous, and likely to be far more impactful, than a 10 percent tariff. In the past year, the value of the renminbi has fallen about 10 percent against the US dollar, thus effectively offsetting the impact of the 10 percent tariff on almost half of Chinese exports to the United States. But once those goods are subjected to a 25 percent tariff, it is likely that businesses will either raise their prices or take a major hit to their profit margins. Some US importers will probably attempt to import goods from other countries, but this will not be feasible for many products. The end result will be significantly higher prices for US consumers and businesses, effectively reducing their purchasing power. This will be harmful to the global competitiveness of the US companies that import components used in manufacturing.
Another reason to worry is that China has declared retaliation against US tariffs, thus reducing the competitiveness of US exports to China. In addition, European companies are said to be worried that the trade war between the United States and China will hurt them.21 Some European leaders have urged that the two sides return to a focus on multilateral trade liberalization, which seems unlikely at the moment.
While many analysts worry that the higher tariffs will derail the economic recovery, President Trump offered a different viewpoint. He said, “I’m different than a lot of people. I happen to think the tariffs for our country are very powerful. Tariffs will make our country much stronger, not weaker. Just sit back and watch.” Meanwhile, China announced that it will boost tariffs—from between 5 and 10 percent to as high as 25 percent—on US$60 billion of imports from the United States.22 Consequently, the US administration has announced that it will provide US farmers with financial support to offset the impact of higher Chinese tariffs on US agricultural goods. President Trump said that the money collected from tariffs will be used to “buy agricultural products from our great farmers, in larger amounts than China ever did, and ship it to poor and starving countries in the form of humanitarian assistance.”23 Yet it is reported that US farmers, as well as other exporters to China, are worried that the retaliatory measures implemented by China will lead Chinese businesses to permanently develop better trading relationships with others,24 thereby damaging the long-term prospect for US exports to China.
What is left for China to do in retaliation given that it has already imposed tariffs on most imports from the United States? China can restrict trade with the United States or punish the United States economically in many ways, such as increasing the existing tariffs; slow walking imports through customs; compelling state-run companies to stop purchasing American goods; harassing US companies operating in China; and discouraging Chinese consumers from purchasing American goods and from purchasing services from US-based companies, such as retailers or restaurants.
Meanwhile, it is reported that many US companies are now planning to shift assembly of goods from China to other countries including Mexico, Cambodia, and India.25 Moreover, even if the tariffs come down, the lingering uncertainty about the economic relationship between the United States and China may compel these companies to permanently avoid being exposed to China. In addition, some US companies are concerned that fraught relations between the two countries might cause Chinese consumers to become averse to American brands. This could be highly problematic for those US companies that have become highly exposed to the Chinese consumer market.
It has been speculated that China could respond to the US tariffs would be to sell US Treasury securities on a large scale.26 Theoretically, this could lead to a sharp increase in US bond yields and, consequently, an increase in borrowing costs for US businesses and households. That could damage the US economic recovery. Nonetheless, a large sale of Treasuries might not lead to an increase in yields if there is sufficient global demand for an asset that is perceived as the ultimate safe asset. The trade war itself creates the kind of uncertainty that often leads investors to favor safe assets such as US Treasuries. Indeed, when China did sell a fairly large volume of Treasuries a few years ago, US bond yields barely budged.27 Moreover, if yields were to increase, China would suffer a capital loss on its remaining holdings of US Treasuries. Thus, it is not clear that selling Treasuries would necessarily be in China’s interest. Meanwhile, China’s central bank currently holds roughly US$1.2 trillion in US Treasuries.
Why were the United States and China unable to reach a deal? It is reported that, in recent weeks, Chinese officials had become convinced that the United States was eager to make a deal and that, as a result, China did not need to accept US demands to provide details about the laws it intended to change.28 The Chinese perception that the United States was eager for a deal came, in part, from the fact that the US administration was putting pressure on the Federal Reserve about monetary policy. The Chinese interpreted this as evidence that the administration was worried about the fragility of the US economy and, consequently, would be reluctant to boost tariffs. After all, trade restrictions would likely have negative economic consequences and would also likely result in a drop in equity prices. Yet now the Chinese side is surprised to find that the US side recoiled against China’s perceived intransigence. In addition, it might also be the case that the US administration was worried about potential backlash from hardline supporters in the United States if it agreed to a deal with China that might be seen as inadequate or cosmetic. President Trump’s former chief strategy advisor Steve Bannon wrote an article this week in which he lauded Trump’s decision to threaten higher tariffs.29 He said that China is “the greatest existential threat ever faced by the United States.”
Although US business leaders have been nearly unanimous in their condemnation of the threat of higher tariffs on China, the US policy has been well received by Congressional leaders of both political parties.30 Notably, several leading Democrats have lauded Trump’s decision and urged the administration to take a hard line on China. One exception is former Vice President Biden, a candidate for president. He said that China is “not competition” for the United States. His comment “China is going to eat our lunch? Come on, man!” elicited criticism from within his own party.
Finally, there is a concern across Asia about the economic ramifications of the intensifying trade war between the United States and China.31 The worry is that it could disrupt existing supply chains. Consequently, several regional central banks cut their benchmark interest rates this week. The central banks of the Philippines, Malaysia, and New Zealand all cut rates. The central bank of Australia is expected to do so as well. In the case of the Philippines, the rate cut was partly due to concerns about slowing economic growth unrelated to the trade war. Meanwhile, regional currencies are under pressure as many investors worry about the potential impact on growth. Already there has been economic weakness in the region. The burgeoning trade war could exacerbate the situation.
The volume of international trade declined 1.7 percent from January to February and was down 1.1 percent from a year earlier, according to a study conducted by the Dutch government.32 This is the sharpest drop in trade volume since 2009 during the global recession. The volume of trade has been stagnant or declining since 2018 when the trade war between the United States and China intensified. The result is that the volume of international trade in early 2019 was no higher than it was in 2018.
This is an unusual situation. In modern times, trade has played a key role in generating global economic growth. Generally, trade grows faster than GDP and tends to stimulate industrial production and investment. The fact that trade is now in decline bodes poorly for the health of the global economy in the months to come. Of course, it is important to note that there are other factors aside from tariffs that have had a negative impact on trade volume. These include a weakening of global demand, trade diversion as a result of Brexit, and a consolidation of Asian supply chains within China. Still, tariffs and the threat of tariffs have played the principal role in diminishing trade. With the US decision to boost tariffs on China, and the retaliation, it is likely that the global volume of trade will decline further.
The US Federal Reserve has warned about the risks to the financial system from the sharp increase in corporate debt.33 In the Fed’s periodic report on financial stability, it noted that “borrowing by businesses is historically high relative to [GDP], with the most rapid increases in debt concentrated among the riskiest firms amid signs of deteriorating credit standards.” It drew attention to the fact that, although the volume of corporate debt increased 4.9 percent in 2018, leveraged loans increased by 20.1 percent, thereby boosting the risk profile of the corporate sector. It also said that asset values are relatively elevated and that investors continue to exhibit a high appetite for risk. It noted that, in the housing market, prices have risen faster than rents for several years. This is often a sign of a bubble. Indeed, a separate analysis by Nobel Laureate Robert Shiller found that, in real (inflation-adjusted) terms, house prices have rebounded substantially and are now almost as high as the level reached prior to the last recession.34 This is a much higher level than seen during the last century. At the same time, the Fed’s financial stability report noted that “household borrowing remains at a modest level relative to incomes.” It also said that banks are well capitalized and that leverage is modest for financial institutions compared to pre-crisis levels. Thus, a mixed picture emerges. The Fed said that, although default rates remain relatively low, the financial system is vulnerable to shocks such as a worsening trade war, a messy Brexit, or a global economic slowdown. It said a downturn could hurt the financial system because of “the rapid growth of less-regulated private credit and a weakening of underwriting standards for leveraged loans.”
Meanwhile, there has been a big jump in the volume of interest-only commercial property loans in the United States, which are significant components in commercial mortgage backed securities.35 Interest-only and partial interest-only loans accounted for 89 percent of the loans backing new commercial mortgage-backed securities in the first quarter of 2019. This was the highest share since 2009 and consistent with levels seen just before the last recession that began in 2007. While default rates remain low, the concern is that defaults will increase should there be a downturn. In addition, a drop in property values could mean a sharp loss in the values of mortgage backed securities. That, in turn, could mean trouble for the financial institutions that hold many such securities. Interest-only loans are structured so that the borrower only pays back principal at the end of the loan period. A partial interest-only loan is structured so that only interest is paid for a particular period of time during the term of the loan. Usage of both types of loans typically jumps at the tail end of the economic cycle. Thus, the sharp recent increase could be a signal of trouble to come.
The yield curve has inverted.36 The yield on the three-month Treasury bill today exceeded the yield on the 10-year Treasury bond. This had briefly happened in March as well. In the post-war era, every recession has been preceded by a sustained inversion of the yield curve, and almost every time the yield curve inverted a recession soon followed. Why is this? Consider that banks are in the business of taking short-term deposits and giving long-term loans. This provides their profit margin. When the yield curve inverts, banks have less incentive to create credit. An inversion generally leads to a decline in credit market activity and a consequent drop in economic activity. The yield curve inverts because the Federal Reserve tightens monetary policy by raising short-term interest rates. This suppresses expectations of inflation, thereby reducing long-term rates. After the yield curve briefly inverted in March, the Federal Reserve announced its decision to hold off on further rate hikes. This pleased many investors, boosted their expectations for growth, and led the yield curve to rise. Yet the latest inversion likely reflects investor concern about the negative potential impact of the burgeoning trade war. Indeed, the so-called “breakeven rate,” which is an excellent measure of market expectations of inflation, has fallen sharply in the last week. The result was a decline in the yield on the 10-year bond.
Meanwhile, another popular measure of the yield curve, which is the gap between the yields on the 10-year and two-year bonds, remains positive for now. If the Federal Reserve actually cuts short-term rates in the coming year, as some observers now expect, it is likely that the yield curve will not remain inverted.
US President Donald Trump threatened to boost US tariffs on China by the end of this week if a trade deal is not completed. Equity prices plummeted as investors feared that the trade war is suddenly worsening.
In recent weeks, there have been many news reports indicating that the US and China were getting closer to a trade deal, that a meeting between the two countries’ presidents was imminent, and that such a meeting could be an occasion to sign the much-anticipated deal.37 Indeed, as recently as Friday (May 3), US President Donald Trump said that the talks were going well. However, over the weekend, Trump tweeted that he is inclined to increase the existing tariffs coming Friday (May 10), stating that the negotiations are taking too long.38
He likely either wants to speed up the negotiations or convince the Chinese that failure to arrive at a deal soon will have serious consequences. Or, this could be a political move—the US administration could be trying to create the impression that an impending deal came about because of its toughness with China. As trade expert Chad Bown of the Peterson Institute said, “If they announce a deal later this week, it will make it appear as if he acted as tough as possible to get the deal.”39
Meanwhile, US and Chinese officials are scheduled to meet in Washington this week to work on the deal. Whether the latest tariff threat will boost the likelihood of a deal or cause the Chinese to stay away from the talks is not yet clear. China may take offense at the threat, and not wanting to appear to buckle under US pressure, it may decide to walk away from the talks. Thus, undertaking the threat may turn out to be a somewhat risky strategy for Trump. In any case, the latest word is that a Chinese delegation still intends to travel to Washington, but not necessarily this week, and not necessarily including 100 people as previously planned.40 Chinese media hasn’t reported Trump’s threat, which allows China’s government the flexibility to act on the matter.
It is worth noting that in 2018, the US had imposed a tariff of 25 percent on US$50 billion of imports from China, and a 10 percent tariff on US$200 billion imports. In his tweet over the weekend, Trump threatened to boost the 10 percent tariff to 25 percent. In addition, he threatened to apply a 25 percent tariff to all remaining Chinese imports that are north of US$300 billion per year. However, the strength of the US economy comes despite tariffs. Moreover, the tariffs and the threat of more tariffs have already had a negative impact on trade flows and business investment, thereby accounting for the slowdown in economic growth in the second half of 2018. Trump also said that the tariffs had “little impact on product cost.” However, imports on which the 25 percent tariff was imposed have dropped sharply, whereas those on which a 10 percent tariff was imposed have grown slower than previously. Evidently, the higher prices have influenced demand.41 In addition, trade has partly been diverted from China to other countries in East Asia. China has retaliated against the existing tariffs, thereby contributing to a negative impact on US exports to China. If Trump follows through on the latest threat, it is likely that China may retaliate in kind, thereby potentially creating further problems for US exporters.
Reports on the trade negotiations have indicated that the two sides have reached agreement on a number of issues, including ending forced technology transfers, protection of intellectual property, and increases in Chinese imports of US goods.42 The reports added that the remaining issues to be agreed on are: Whether China will reduce subsidies for state-owned enterprises (SOEs) and the mechanism for enforcement of the trade agreement. On subsidies, China is reluctant to agree to the US demand. Reducing subsidies for SOEs could be tantamount to changing the economic model on which China has depended for decades. On enforcement, the United States wants to delay reduction of existing tariffs until China demonstrates compliance. The United States also wants to retain the right to boost tariffs should China fail to comply and to restrict the latter’s right to retaliate against any new US tariffs. China is said to be reluctant to agree to the US terms regarding enforcement.43
Market reaction to the US threat was strong. Equity prices in the US, Europe, and Asia fell sharply while the offshore renminbi fell as well. The yield on US Treasuries fell, and the US dollar and Japanese yen rose against most major currencies. In the US, various business groups urged the administration not to follow through on the tariff threat, saying that such tariffs could boost prices, reduce consumer purchasing power, and lead to significant job losses.44 Also, the price of oil fell sharply, likely indicating that investors see a worsening trade war as potentially having a negative impact on the demand for commodities.45 Notably, shares in European automotive companies fell sharply as investors are likely worried that the US administration might follow through on previous threats to impose tariffs on automotive imports. Another industry that took a big hit was technology, which is heavily dependent on trans-Pacific supply chains.
What can we expect next? First, not all threats made by this US administration have been implemented. Thus, there is uncertainty over how the latest threat will play out. Second, it is not clear that President Trump has the authority to boost tariffs so quickly. There are processes that must be followed, including seeking comments from the public. Thus, a more likely scenario is that the process will be commenced this week, but that new tariffs might take a bit longer to be implemented.
Still, in anticipation of the tariffs, business behavior is likely to adjust. This could mean accelerating imports to avoid tariffs and shifting supply chains away from China. If the tariffs do go into effect, prices will rise and demand in the United States will likely be affected. We must keep in mind that about 40 percent of US imports from China are components used in producing final goods.46 As component costs rise, businesses will likely have to either raise prices or take a hit to profit margins.
US export competitiveness may also suffer. Some US companies are likely to attempt to source components from other countries. Retaliation by China would also hurt US export competitiveness. China’s government wants a deal but wouldn’t want to be seen as being bullied. China’s economy has already been hurt by the existing trade war and the government wants to avoid a new round of tariffs. However, the uncertainty surrounding the relationship with the United States could lead China to seek other sources of growth in the long term. This could include a greater focus on boosting domestic demand as well as engaging in trade liberalization with countries other than the US.
Finally, the US tariffs would likely be temporary—until China makes concessions. Thus, there remains uncertainty about future trading relations between the United States and China. Besides, the fact that the US administration continues to make sudden and unexpected threats, and might take unexpected actions, means that the general trading environment remains uncertain. This has already had an effect on investment, especially on investment in global supply chains. Even if the US administration doesn’t follow through on the threat, the fact that it is making the threat can have an impact on the global economy. Most businesses prefer a road map over uncertainty, even if that map involves higher costs.
The dominant role of the US dollar in the global economy has given the US government a potent weapon in its foreign policy toolkit. That is, it can use sanctions to punish countries and businesses that use the dollar for transactions. On the flip side, the use of such sanctions has lately encouraged other countries to promote the use of other currencies, thereby potentially undermining the dominant role of the dollar. This dynamic is now at work when it comes to US relations with Iran. Specifically, the US government withdrew last year from the nuclear deal that had been agreed upon by the previous US administration with Iran, Russia, China, the UK, Germany, and France. At the time of withdrawal, the United States unilaterally reimposed sanctions on Iran, but initially exempted many countries from penalties for purchasing oil from Iran using US dollars. Now, the United States has announced that it is eliminating these exemptions.47 This means that, going forward, if a country purchases oil from Iran using US dollars, its businesses and banks would face US government penalties because such transactions necessarily flow through US financial institutions. The United States is in a position to do this because most commodities are priced in US dollars, and most commodity transactions in the world take place in US dollars.
US Secretary of State Mike Pompeo said that the United States’ goal is to halt all Iranian oil exports. While the US policy might be successful in the short term, it could backfire in the longer term if other countries are successful in their efforts to encourage the use of other currencies. China’s government, for instance, has taken steps to encourage the use of the renminbi, and will likely encourage commodity exporters to accept payment in renminbi. To this end, it has explicitly pledged to maintain a stable value of the renminbi. It has also established forward contracts for commodities based in renminbi. And it has established the China International Payments System (CIPS) as an alternative to the US dollar-based SWIFT system meant to facilitate international transactions. Members of the European Union are likewise interested in boosting the role of the euro. Meanwhile, Russia is trying to reduce dependence on the US dollar, especially as the US government has sanctioned Russian businesses and people. Russia has shifted a large part of its stockpile of reserves from dollars to renminbi and especially to gold.48
What is different about the current round of sanctions imposed by the US on Iran is that they have been enforced unilaterally and on an unusually large scale. Past sanctions on Iran—prior to the nuclear deal—were imposed in conjunction with other countries. By acting unilaterally, the United States has encouraged resistance to the dominance of the dollar on the part of China, Europe, and Russia. If these countries are successful in significantly reducing their dependence on the dollar, it could presage an eventual end to the era of dollar dominance.
What would de-dollarization mean? It could mean that the United States could no longer borrow externally in its own currency on such a large scale at such a low cost. It could mean that US businesses could face greater currency exposure, especially those that import commodities. And it could mean that US borrowing costs would likely rise as the dollar would no longer be viewed as the safest asset. The British pound was once the world’s dominant currency, something that changed quickly early in the 20th century.
Economic growth in Europe rebounded in the first quarter of 2019.49 The European Union (EU) reports that, in the 19-member Eurozone, real GDP was up 0.4 percent from the previous quarter and 1.2 percent higher than a year earlier. In the larger 28-member EU, real GDP was up 0.5 percent for the quarter and 1.5 percent higher than a year earlier. Quarterly growth in the eurozone was 0.1 percent in the third quarter and 0.2 percent in the fourth quarter of 2018. Moreover, Italy experienced two consecutive quarters of declining real GDP, typically the definition of a recession. Yet, in the first quarter, Italy’s real GDP rebounded, rising 0.2 percent. France’s GDP was up 0.3 percent and Spain’s GDP was up a strong 0.7 percent. Although the figures for Germany have not yet been released, it can be inferred from the European data that Germany did well in the first quarter of 2019. This is good news given that Germany’s real GDP contracted in the third quarter and was flat in the fourth quarter of 2018. If the eurozone economy continues to do well, this could enable the European Central Bank (ECB) to avoid a controversial easing of monetary policy, which has been under discussion.
For the last few months, there has been general pessimism about the global economy given weak data from Europe, China, and the United States. Now, with the release of European first quarter growth figures, it appears that the three largest economies in the world are on the mend. Europe and the United States rebounded in the first quarter and China’s GDP growth stabilized. However, the US figures were distorted by temporary trends in inventory accumulation and trade. Besides, China continues to exhibit challenges. So, it is likely too early to say that the global economy has turned the corner.
The latest employment report from the US government indicates continued strength in the job market, with strong growth in payroll employment and a big decline in the unemployment rate. However, a survey of households indicated a sharp decline in labor force participation. Wages accelerated, but only modestly. The government releases two reports: One based on a survey of establishments and the other based on a survey of households. Here are the highlights of the reports:
The establishment survey found that 263,000 new jobs were created in April, the fastest increase since January.50 Three key industries accounted for the lion’s share of the increase. These were professional and business services, where jobs were up by 76,000; healthcare, which was up 53,000; and leisure and hospitality, which was up 34,000. There was almost no growth in manufacturing employment, which was up only 4,000. In addition, retail employment fell by 12,000 as the onslaught of online retail continued to take a toll on store-based employment. Interestingly, construction employment was up 33,000, a very strong number. The establishment survey also indicated that average hourly earnings were up 3.2 percent from a year earlier—an acceleration from the past, but a modest number nonetheless.
The survey of households found that the number of people participating in the job market (either employed or actively seeking work) fell by almost 500,000 in April.51 The result was that the participation rate declined from 63.0 in March to 62.8 in April. The survey found that the number of people working declined, but even faster than the number deemed unemployed. The result was that the unemployment rate fell from 3.8 percent in March to 3.6 percent in April—a 50-year low. How is it possible that the household survey showed a decline in employment while the establishment survey showed the opposite? One reason is that the household survey includes self-employment while the establishment survey only shows employment by business or government establishments. Another reason is that both surveys are, well, surveys. They are based on a small sample and are subject to sampling errors. In any event, the household survey results ought to restrain optimistic inferences gleaned from the establishment survey.
Overall, the report offered conflicting signals. On one hand, strong payroll job growth suggests that wage inflation ought to be accelerating rapidly. But this is not the case. From the perspective of the Federal Reserve, the job market provides reason to tighten monetary policy while actual wage behavior suggests otherwise. Meanwhile, the household survey appears to contradict the positive results of the establishment survey. From the Fed’s perspective, this would appear to provide a good rationale for its relatively neutral policy of “patience.”
In recent years, the US economy has grown more slowly than in the past. In the long term, economic growth comes about when there’s a rise in the number of workers as well as an increase in the productivity of those workers. In recent years, there has been a decline in the growth of the US labor force, and there have been only modest increases in productivity. As for the latter, there is new evidence that the weakness in productivity gains might be related to the aging of the workforce.52
A new study conducted by the Federal Reserve Bank of Minneapolis found a correlation between aging and weak growth. Specifically, it noted that, in the last 40 years, there has been a decline in the number of new businesses being created and a decline in the rate at which older businesses are folding up. This fall in business dynamism came at the same time as the share of the workforce over the age of 45 increased dramatically. In addition, the study noted that the degree of labor market mobility has also declined, a fact likely associated with an aging labor force. Younger workers tend to be more amenable to changing jobs and locations. The study indicated that the fall in business dynamism may partly explain the decline in labor market mobility. That is, creation of fewer new businesses means fewer opportunities for workers to jump ship. At the same time, the relative dearth of young workers might discourage entrepreneurs from creating new businesses as they face difficulties in hiring the workers they need. The conclusion is that declining business dynamism and labor market mobility are partly the result of an aging workforce; these factors have directly and negatively influenced productivity growth and, therefore, economic growth. Finally, the authors of the study wondered if boosting immigration might help offset these trends.
The United States-Mexico-Canada Agreement (USMCA), the proposed successor to the North American Free Trade Agreement (NAFTA), appears to be in trouble. For the USMCA to come into effect, it must be approved by the legislative bodies of all the three countries, but none of them have approved it so far. The US administration had hoped to get it done this year given that 2020 is an election year.
In the United States, there are obstacles to passage of the agreement in both the houses of Congress. In the Republican-controlled Senate, there appears to be resistance to the deal until the administration refuses to drop the tariffs on steel and aluminum. The head of the Senate committee that handles trade, Chuck Grassley of Iowa, said, “If these tariffs aren’t lifted, USMCA is dead.”53 And John Cornyn of Texas, the No. 2 Republican in the Senate, said, “I don't think there are going to be 51 votes to pass it with the tariffs still outstanding.”
Senators from farm states are especially concerned because the steel and aluminum tariffs were met by retaliatory tariffs on US agricultural exports. Yet the US administration has been reluctant to cut the tariffs and to link them to the USMCA. Commerce Secretary Wilbur Ross said, “The President is not going to take tariffs off unless there are other things that protect national security.” The administration has sought the Mexican and Canadian agreement to replace the tariffs with quotas. But neither Mexico nor Canada are amenable to this idea. US trade negotiator Robert Lighthizer said that the US policy with respect to steel and aluminum is meant to “avoid import surges and prevent transshipment; the need to reduce excess production and capacity in overseas markets; and possible mechanisms for contributing to increased capacity utilization in the United States.”
Meanwhile, the US House of Representatives, controlled by the Democrats, has been reluctant to pass the USMCA unless Mexico implements labor reform legislation. Mexico’s Congress has, indeed, passed such legislation, but Democrats in the House want assurance that the new law will be enforced. Mexican trade negotiator Jesus Seade said that Mexico is firmly committed to the new legislation and that it is consistent with the government’s ideology.54 He said, “We are soulmates, bringing their ambition to fruition. What’s frustrating and certainly very puzzling is the lack of appreciation for the scale of changes on labor. It is very difficult to imagine what else could have been done. Nothing is missing from the best practice book of the International Labor Organization.”
As for Mexico, the government’s trade negotiator said that the Mexican Senate is not likely to ratify the USMCA deal until the US eliminates the tariffs on steel and aluminum. Canada, too, strongly favors the United States cutting these tariffs before it ratifies the agreement. As a result, implementation of the USMCA is likely not imminent.
Despite a weakening economy and uncertainty due to the trade war with the United States, foreign direct investment (FDI) in China is rising, especially investment coming from the United States and Germany.55 Specifically, overall FDI into China in the first quarter of 2019 was up 6.5 percent from a year earlier, including a 12.3 percent increase in investment in the manufacturing sector, which accounted for about a third of inbound FDI. Notably, FDI from the United States into China was up 65.6 percent from a year earlier. In addition, investment from Germany was up 80.6 percent while that from South Korea was up 73.6 percent.
Why the sudden confidence of foreign investors in China? There are a number of possible explanations. First, the Chinese government has implemented a new law making it illegal for local governments or companies to compel the transfer of technology. Second, it might be that investors are relatively confident that the US and China will reach an accord in the near future, and that the result will be a stabilization of economic relations. Moreover, investors might be confident that such a deal would involve liberalization of Chinese markets and better protection of intellectual property. Third, investors are likely pleased that the Chinese government has implemented stimulus measures, including tax cuts, which are likely to cause an acceleration in growth. Finally, despite the slowdown, China continues to grow at a relatively strong pace. As such, it remains an attractive market at a time when many other markets appear troubled. Its size, and its embracing of new technologies, also make it attractive.