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What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
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With the United States now considering higher tariffs on US$250 billion of imports from China—roughly half of what the United States imports from China—China cannot retaliate commensurately. China imports far less from the United States than the United States imports from China. Moreover, US exports to China are well below the volume of Chinese exports that the United States wants to tax. A likely option for China is to impose non-tariff and informal barriers to US companies, which is not unprecedented for China. Last year, in a reaction to South Korea deploying a missile defense system with the United States, the Chinese government urged Chinese consumers to boycott Korean goods. This led to a sharp drop in sales of Korean automobiles in China and the number of Chinese tourist visits to South Korea. In addition, the Chinese government pushed a temporary shutdown of 55 Korean supermarkets in China.1 In other words, China found ways to penalize South Korea.
It can react similarly toward US companies. Indeed, it is reported that customs inspectors at Chinese ports are already delaying the processing of imported goods from the United States.2 China can also focus on the US-based services companies. There are many such companies operating in China, and include retailers, restaurants, hotels, and banks. The United States runs a services surplus with China, much of which stems from the 3 million Chinese tourists who visit the United States each year.3 China could cut this significantly. Indeed, the Chinese Ministry of Commerce noted that China will “take comprehensive qualitative and quantitative measures”4 should the United States actually impose tariffs on US$200 billion in imported goods. Of course, Chinese government could compel its state-run companies to shift their own spending on both goods and services.
As for tariffs, China can do considerable damage through strategic targeting. For example, it will impose a 25 percent tariff on imports of US oil and gas products.5 Such exports have been rising sharply, and a tariff will likely halt the growth, leading to lower profits for US-based energy companies. Ironically, US energy companies are already facing higher costs due to new US tariffs on imported steel and aluminum, as well as tariffs on imported parts from China. This demonstrates the often unintended consequences of trade wars.
An important category of Chinese imports from the United States is civilian aircraft. China can cause considerable damage to the United States by having the Chinese state-run airlines switch purchases from American to European aerospace companies. China also imports a high volume of automobiles from the United States. A steep tariff could mean that China would reduce automotive purchases from the United States and increase purchases from Europe, Japan, and Korea. Another way for China to penalize the United States is to violate the sanctions imposed by the United Nations on North Korea and, consequently, ease pressure on North Korea to agree to denuclearization. China has the capacity to influence financial markets. It could allow a sharp drop in its own currency, which could hurt US exporters. In addition, it could sell a large volume of US Treasury securities, thereby potentially boosting US bond yields.
US trade advisor Peter Navarro remarked that, “It is clear that China has much more to lose.”6 Yet the reality is that China can hurt the United States. Nonetheless, from China’s perspective, furthering the trade dispute is not necessarily desirable. At a time when the Chinese economy appears to be slowing, China can ill afford to hurt its export-oriented industries. However, if the situation worsens, China could decide to reverse a recent policy and allow stronger credit growth.7 However, the potential problem with taking such an action is that the government has been keen to slow debt growth. The sharp rise in debt over the past decade is commonly seen as a significant risk to the Chinese economy. Efforts to ease credit conditions could interrupt efforts to reduce financial risk.
At a conference in Sintra, Portugal, leading central bankers suggested that the burgeoning trade wars could have a negative economic impact, and might already be causing damage. US Federal Reserve chairman Jerome Powell said, “We have a very wide range of contacts in the business world in the US and around the world, and as we talk to them, they continually and increasingly express concern about trade developments. For the first time, we are hearing about decision to postpone investment, postpone hiring, postpone making decisions.”8 He said that while the impact of changes to trade policy are not yet factored into the Fed’s forecasts, “changes in trade policy could cause us to have to question the outlook.” European Central Bank (ECB) president Mario Draghi also expressed concern about trade. He said, “it’s not easy and it’s not yet time to see what the consequences on monetary policy of all this can be, but there’s no ground to be optimistic on that.” Bank of Japan governor Kuroda joined in, saying, “The indirect impact on the Japanese economy could be quite significant if this escalation of tariffs between the US and China continues.”9
Meanwhile, it is reported that Chinese foreign direct investment (FDI) into the United States fell 90 percent in the first half of 2018 versus a year earlier.10 This comes as overall inbound FDI into the United States has been falling for the past two years.11 The drop in Chinese investment likely reflects uncertainty about future rules regarding trade and FDI.
Saudi Arabia and Iran have different views about the pricing of oil, and those differences played a role in the recent discussions among members of the Organization of Petroleum Exporting Countries (OPEC).12 Saudi Arabia is concerned that elevated oil prices might weaken the global economy. Prices have risen sharply since mid2017 for several reasons, including the production-cutting agreement reached between OPEC and Russia, stronger global demand, declining production in Venezuela, and fears of a decline in output in Iran following the US withdrawal from the nuclear deal. Concerns about higher prices weakening the global economy may already be coming true. The slowdown in the European economy might be attributable to the rise in the price of oil. Thus, Saudi Arabia wants OPEC to boost production in order to cause a reduction in prices.
Iran, however, cannot boost output, and lower prices will likely be especially harmful to Iran. As such, it is keen to reap the maximum revenue from its limited production capacity. It therefore initially opposed having OPEC allow an increase in production, which would be a reversal of the group’s decision to cut production two years ago. Nonetheless, OPEC and Russia have now reached an agreement to boost oil production by 1 million barrels per day.13 The goal is to prevent prices from rising further. Iran agreed to go along with the decision to increase production, perhaps expecting that the decline in output will have only a modest impact on prices.
Rebecca Porter, an economist with Deloitte UK, provides some comments on the latest action by the Bank of England:
The Bank of England voted to hold the UK interest rates at 0.5%, as widely expected. The markets now expect that rates will be raised in August, given that the central bank’s chief economist joined two other members of the Monetary Policy Committee in voting for an immediate hike in borrowing costs. The bank also indicated that it is likely to start selling its £435 billion (US$574 billion) stockpile of British government bonds once rates reach around 1.5%, sooner than the previous 2% guidance. Recently, the European Central Bank also announced it will end its quantitative easing program by the end of the year, but signaled that any interest rate hike was still distant.14
In contrast and in a growing sign of confidence, the Federal Reserve raised interest rates recently for the seventh time since 2015 and signaled that it may raise rates twice more this year. This opens up an unusual divergence between the UK and US monetary policies, which have tended to move in sync. The Fed has gradually raised rates from a low of 0.25% to the current 2% while the UK rate stands at 0.5%, the level set 9 years ago at the height of the financial crisis. The gap between the US and UK rates is wider today than at any time in the last 35 years.
The United States announced that it will impose a 25 percent tariff15 on imports from China, valued at roughly US$50 billion. The United States says that the products targeted will mainly be related to China’s technology industry because the tariffs are meant to penalize China for theft of intellectual property. However, the list of products includes automobiles, helicopters, bulldozers, and other industrial products unrelated to the technology industry. In addition, the United States could impose tariffs on semiconductor products.
Many US tech industry executives expressed concern that this could lead to higher prices for US electronic products, potentially hurting both US consumers and the competitiveness of US technology exports.
As expected, China promptly announced retaliatory 25 percent tariffs on imports from the United States, valued at roughly US$50 billion, but it did not immediately provide a list of products. In response, the US side stated that it may consider imposing tariffs on an additional US$200 billion of imports from China. Thus, the stage appears to be set for a tit-for-tat trade war.
The latest action by the United States comes after intense negotiations between the two sides. After an initial round of talks, the US side announced that tariffs would be set aside, following a commitment from China to boost imports from the United States. But later the United States said that it would impose tariffs anyway, leading to a new round of talks that did not result in the two sides reaching an agreement. Hence, the US decision to impose tariffs. The potential risk now is that the significant tariff action could boost prices and thereby reduce consumer spending power. It could also reduce competition for inefficient industries— thus protecting them from disruption—and cause significant disruption to the global supply chains, compelling companies to reduce cross-border exposure and cross-border investment. Many US agricultural and industrial businesses are concerned about what comes next.16 Many agricultural producers worry that retaliation could affect their products, while many industrial companies worry about the potential threat to the profitability of the existing supply chains. While the initial reaction of the US equity markets was relatively muted, shares of companies with a large exposure to the China market fell sharply.
Although the US trade policy has been focused on China, relations between the United States and its traditional allies seem to have reached a low due to trade disputes. The question now is how to interpret the unusually harsh and personal comments exchanged between the United States, the European Union, and Canada following the recent G7 summit. Is it merely an entertaining sideshow that has little to do with the actual state of affairs, or could it portend trouble, auguring a decline in trade and investment, and an unwinding of the global rules-based system of economic relations that was actually created by the United States? Moreover, does it bode poorly for the continuation of the geopolitical alliance that has been the basis of foreign policy for the leading democracies for the last 70 years? And, if that alliance unwinds, whose interests would it serve?
Here are some thoughts on the current dispute:
The main cause of contention is likely the fact that the US chose not to exempt its allies from tariffs on steel and aluminum, and it also threatened to impose tariffs on automobiles. The US side claims that its allies impose far higher tariffs on US goods than the US does on goods imported from its allies. Indeed, the US administration often refers to the nearly 300 percent tariff imposed by Canada on imported dairy products. Does the United States have a legitimate grievance? It is true that Canada, and others, impose steep tariffs on particular goods, but so does the United States. It imposes steep tariffs on sugar and sport-utility vehicles, to protect domestic producers from competition. The result is higher prices for US consumers and higher profit margins for domestic producers of those products. Yet on a broader basis, the tariffs of the United States, the European Union, and Canada are roughly similar and fairly low. On a trade-weighted basis, the average US and EU tariffs are 1.6 percent and the average Canadian tariff is 0.8 percent.17 The difference is not significant, and Canada’s average rate is lower than that of the United States. Thus, the imposition of new tariffs by the United States, and the consequent imposition of retaliatory tariffs by its trading partners, is likely to mean significantly higher prices for consumers and businesses, less competition, less investment in improvements in efficiency, and a disruption to the global supply chains that global companies have created over the last several decades. For now, the degree of protectionist action has been modest, although that could change. The real impact for now could be that the uncertainty about the future of the trading system is having a chilling effect on business investment, especially cross-border investment.
Alex Cole, an economist with Deloitte UK, offers some thoughts on the continuing political debate in the United Kingdom over Brexit.
Brexit negotiations entered another crucial phase this week. Domestically, events in Parliament have taken center stage as members of parliament (MPs) in the House of Commons debated the terms of the government’s proposed European Union (Withdrawal) Bill. This is the legislation aimed at ensuring that the United Kingdom has a smooth transition out of the European Union and that the EU law is no longer supreme in the United Kingdom.
Debate has focused on one key issue: how much say should Parliament have in the terms of the United Kingdom’s withdrawal from the European Union? At the heart of this debate is whether Parliament should have a “meaningful” vote on the Brexit withdrawal deal and, if yes, when. While the government has committed to letting Parliament be involved in the ratification of the withdrawal, it is firmly against allowing MPs to potentially veto any deal or drive the direction of talks with the European Union.
Such is the division over the issue that Phillip Lee resigned as the justice minister in the government, saying he could not support “how our country’s exit from the EU looks set to be delivered.”19 Former Conservative Party leader and Brexit-backer Iain Duncan Smith said that giving more power to Parliament over Brexit would be “disastrous.”
On Tuesday, June 12, the government won a number of key votes in Parliament on the withdrawal bill, but reportedly had to offer MPs several concessions to do so. Although the text of the concessions had not been published at the time of writing, it is widely reported20 that they will include a new deadline of November 30; if no deal is reached with Brussels by then, the government will return to Parliament to determine the next course of action.
Away from Parliament, talks with the European Union have not yet managed to reach an agreement over the Irish border. The key issue at hand is a so-called “backstop,” a provision intended to ensure an invisible Irish border if a more preferable solution cannot be found. As per the UK proposals, Britain would agree to apply the European Union’s customs tariffs on goods arriving from outside the European Union, thereby negating the need for further customs checks at the Irish border. The May government has added that it believes the “backstop” plan is will unlikely be required after 2021 because new permanent arrangements would be in place by then. However, the European Union has rejected these proposals due to their failure to address the need for regulatory alignment of goods, and the notion that they could be time-limited even if new permanent arrangements have not been agreed at that point. Also, there is currently no proposal from the United Kingdom regarding people movement and at-border checks on livestock. The European Union’s proposed “backstop” that the United Kingdom agreed in concept in December 2017, but has now rejected, would effectively involve Northern Ireland staying in the European Union’s customs union and Single Market until another solution is found, with the rest of the United Kingdom outside, with no time limit.21
These divisions, within the UK government and with the EU counterparts, have likely raised the stakes ahead of the European Council meeting on June 28-29, a summit that is supposed to serve as a prelude to a wider agreement over the terms of the United Kingdom’s withdrawal this October. If these vital issues are not resolved by October, the timeline for the entire Brexit process may still change.
The European Central Bank (ECB) says that it will finally end its program of asset purchases (known as quantitative easing, or QE) by the end of the year.22 At the same time, the ECB left its benchmark interest rates unchanged, indicating that monetary policy remains historically easy. The end of QE will come about gradually, with the pace of asset purchases tapering off over the course of the year. The choice to end QE while keeping interest rates low indicates that the ECB is increasingly confident that inflation, while still relatively low, is likely to move in the desired direction.
It also represents the start of convergence between the monetary policies of the ECB and the US Federal Reserve. The latter concluded its program of QE some time ago and is now in the process of boosting interest rates. The prospective end of QE comes as the new Italian government is considering boosting spending and, consequently, borrowing. If that happens, the decision by the ECB to no longer purchase government bonds could lead to a significant increase in Italian borrowing costs. That, in turn, could precipitate a crisis if investors lack confidence in Italy’s commitment to fiscal probity.
Interestingly, financial markets responded to the ECB’s decision by sharply pushing down the value of the euro against the US dollar. This means that investors were likely focused on the decision to keep interest rates low, rather than on the decision to halt asset purchases.
Equity prices fell on the news, as investors anticipated that higher interest rates might hurt corporate earnings, especially for highly leveraged enterprises. Fed chairman Jerome Powell hinted that the economy is now sufficiently strong that it no longer requires support from the monetary policy. However, the future direction of the Fed policy will, of course, depend on the data. So far, the data appears to indicate that inflation is accelerating quickly. If this continues, the Fed will likely tighten further, and maybe even faster.
While monetary policy tightening is well under way in the United States, and while the ECB has signaled an end to its aggressive policy of asset purchases, the world’s third most important central bank, the Bank of Japan (BOJ), indicated that it will stay the course of easy monetary policy. Specifically, the BOJ said that it will retain its negative benchmark interest rate, continue to cap long-term bond yields, and remain engaged in sizable asset purchases. It noted that inflation remains modest and unlikely to change soon. Thus, monetary stimulus is warranted, even though the economy continues to grow “moderately.”24 The Japanese monetary policy is likely to further reduce the value of the yen. That, in turn, should likely help to boost inflation as well as improve the competitiveness of Japanese exports.