US- China trade war has hurt the INR that has depreciated sharply against the USD. (Read our note on INR). How does the trade war impact India? The impact is more indirect than direct through financial and currency markets risk aversion, inflation that can be imported and a fall in world trade driven by negative sentiments.
At this point of time, US President Trump is posturing more than looking to cut down US trade deficit with China sharply as tariffs on USD 50 billion of imported Chinese goods will hardly work to lower trade deficit. However the posturing is having a negative effect of markets and if it can lead to constructive trade talks, then US president’s purpose will be served in efforts to lower the trade deficit.
The ongoing trade war between the US and China has caught global attention as President Donald Trump wants to level the playing field for U.S. companies in the global economy, but his combative stance has unsettled business plans for the companies across the globe. The whole idea of a trade war began when US President Donald Trump decided to unilaterally impose a tariff of 25% on steel imports into the US and a tariff of 10% on aluminium imports. While this was intended at all countries, it soon became obvious that the target was China. After all, the US ran a trade deficit of USD 375 billion with China.
Chart 1: US biggest trade deficits in 2017
The US has also fired the first shot in a trade war with three of its biggest trading partners by deciding to begin levying tariffs on imports of steel and aluminium from the EU, Canada and Mexico. On 15th June, Trump announced USD 50 billion in tariffs on imports from China ahead of G7 summit. China responded to U.S. announcement with trade threats of its own: It vowed to impose tariffs with “equal scale, equal intensity” on imports from the U.S., and said in a statement on its website that all of the country’s earlier trade commitments are now off the table. The EU is targeting iconic products like Harley-Davidson motorcycles and Levi’s jeans.
U.S. in the year 2017 has imported USD 505.6 billion worth of goods from China and exported USD 130.4 billion worth of goods to China, which result in USD 375 billion in trade deficit for U.S. with respect to trade with China. U.S trade with China stood at 16.4% of the total trade in 2017, which has declined to 15.1% so far in 2018. Tariffs on USD 50 billion of goods from China is around 10% of imports from China.
If the trade war intensifies, there is a possibility that a diminished US-China trade engagement could have positive results for countries such as Brazil and India from a trade perspective, at least in the short run as the trade war will open unexplored territory to trade goods. But in the long term, a full-fledged trade war is bad news. It invariably leads to a higher inflation and low growth scenario.
On June 16, India’s ministry for commerce reportedly notified the World Trade Organization (WTO) that it would hike tariffs on 30 imported American goods, by up to 50% over the current duties. These include motorcycles, heavy machinery, chocolates, almonds, and shrimps. This hike is in response to the US increasing the duty on aluminium and steel imported from India in March this year and after receiving a cold shoulder from Washington DC on its request for exempting India from the higher tariffs announced by the US on steel and aluminium imports.
What if trade war turns out to be true?
If the trade war turns out to be true than the emerging economies will feel the heat as the cascading effect of higher inflationary pressure will drive U.S. Federal Reserve to raise rates faster than it would have done otherwise. Within the US domestic economy, higher tariffs on a range of imported products escalate the threat of higher consumer prices, caused by importers passing on their increased costs of raw material.
An increase in interest rates in the US has its own implications for emerging economies such as India, both for the equity and debt markets. The U.S. Federal Reserve is so far on track to raise interest rates at least two more times this year after it delivered its second interest rate hike this year in its last concluded FOMC meeting. Further, many Fed officials have indicated that Federal Reserve could potentially raise rates faster to prevent the US economy from overheating.
What does a US-China trade war hold for India?
The real trouble of US-China trade war could be if it spreads across more countries. For India, the direct impact may be limited but there may be a lot of indirect implications.
- India’s Trade deficit could come under pressure. India has already seen its monthly trade deficit approaching the USD 15 billion mark in the last few months. A trade war will widen the trade deficit, make imports more expensive and reduce the forex cover.
- A wider trade deficit and higher import prices will be imported-inflation. When inputs get costlier, it gets reflected into the final cost of manufacturing in the form of higher cost of production that adds to inflation. As inflation moves higher, we could see a sharp fall in the domestic purchasing power and that could further depress the real rate of growth.
- When inflation moves up, it has the tendency to push up the inflation expectations. Inflation expectations are the key driver of interest rates and as a result the RBI may be constrained to increase the repo rates. With inflation going up across the world, we could see a situation where global bond yields start moving up and the RBI may not have much of a choice except to raise rates sharply to prevent capital outflows.
- The INR could come under pressure in the global currency markets. There is a limit up to which the RBI can manage the rupee. Normally, trade wars tend to degenerate into currency wars. That is because every country will try to boost exports by weakening the currency.
- On the corporate front, the business could get squeezed between two extremes as the inputs cost will go up due to higher import costs to which the company will either have to pass on the burden to the customer or absorb the costs which will hit the margins. At the same time, higher interest rates will push the cost of borrowing higher, impacting profitability of the companies. This will be more for high debt companies.