Back to the future
The Goldilocks global economy is coming under pressure. After a strong end to 2017 – GDP growth of 4.0% from the G20, the G7 picking up to 2.4%, and 2.8% from the small advanced economy group that I track as a leading indicator – there are some early indications that global growth may be approaching a high water mark.
This is reinforced by growing political risks. Global equity markets have bounced around through March on US steel and aluminium tariffs (and subsequent widespread exemptions) and then frequently changing sentiment on the outlook for US/China trade relations.
"Part of this is Trump Administration political noise, but there are also real tensions."
Different parts of the US system are variously focused on reducing the trade deficit, responding to China’s approach to trade and investment, and addressing national security concerns. And although China will go some way to avoid trade conflict, the period of reform and opening up seems to be largely over. President Xi’s closing speech at the People’s Congress was uncompromising, committing to ‘ride the mighty east wind of the new era’.
One useful perspective on these trade tensions is the experience in the 1980s as the US and Japan locked horns. Japan emerged as a serious source of competition from the early 1980s, and there was a sense that Japan was not playing fair (protectionist measures, industry policy to support national champions in sectors from auto to consumer electronics). In response to growing trade deficits with Japan (~1% of GDP), the US tried to open up the Japanese market to US exports and imposed tariffs and voluntary export restraints.
But these measures were not effective in reducing the bilateral trade deficit. Tight monetary policy (as Paul Volcker tried to tame inflation through high interest rates) and the loose fiscal policy of the Reagan Administration were the macro drivers of a rapidly widening current account deficit.
These realities led to the Plaza Accord in 1985 in which the G7 countries agreed to a managed depreciation of the USD against the yen and the Deutschmark. The USD subsequently depreciated by about 50% against these currencies. The Louvre Accord in early 1987 halted this process, and the USD levelled off. From 1988, there was an improvement in the US trade deficit – and the bilateral deficit with Japan reduced.
Fast forward three decades, there are some parallels with the current situation – although on a bigger scale. There are long-standing complaints about access to China’s market and its economic policy approach. And the US trade deficit in the year to December was $570 billion (2.9% of GDP), of which China accounted for about $340 billion (1.7% of GDP). My sense is that the Trump trade team are reaching for a 1980s playbook to respond to the perceived problem of the trade deficit – and to a visceral sense of the strategic threat from an emerging power.
I take three lessons from the 1980s experience. First, it was macro policy rather than trade measures that led to an improvement in the US trade deficit. Similarly, the announced tariff measures on China are unlikely to directly reduce the bilateral trade deficit. It may be that some cosmetic changes can be made that improve the headline trade deficit at low cost, such as changing the location of supply chains. Even better, it may be that these announcements pressure China to address over-capacity or provide a more level playing field for foreign firms. But the underlying US trade deficit is likely to remain in the context of US fiscal loosening and monetary policy normalisation.
Second, to the extent that the US remains focused on the bilateral trade deficit and China does not undertake meaningful reform, these trade tensions are likely to persist. During the 1980s, success was declared many times but the underlying issues were not resolved. Similarly, the current political noise should not distract from the structural drivers of these tensions: the politics of an enduring bilateral trade deficit, the challenges associated with China’s trade and economic policy, and national security concerns. And although China will want to avoid US trade sanctions, significant further reforms are unlikely in its current political context. This ongoing friction between US and Chinese interests heightens the potential for deeper economic conflict at some point, even if not immediately.
The third lesson is that trade tensions have the potential to spill into other areas of the global economy. As in the 1980s, it is possible that the US (or China) reaches for exchange rate policy to pursue their trade agenda (although the current situation is different in that the USD has depreciated by over 8% over the past year against the RMB). Restrictions on foreign investment and capital flows are already being implemented by the US and the EU, and more could come – leading to a more fragmented, multipolar system. And unlike Japan, China is explicitly a strategic competitor: these economic tensions could also be expressed through geopolitical rivalry.
There are many ways in which these issues could play out, including the US moving on after a few quick PR wins (like KORUS). But although I don’t expect a trade war, there is also meaningful potential for trade tensions to escalate over the next few years – and to broaden into other areas of the global economy. Countries and firms exposed to the global economy are right to be jumpy, and the market volatility seen in the first quarter of 2018 is likely to continue.