Last month, American President Donald Trump announced import duties of 25 per cent and 10 per cent on steel and aluminium respectively. The move came under attack from the European Union, with EU Trade Commissioner Cecilia Malmstrom saying at a conference in Brussels that the imposition would “put thousands of European jobs in jeopardy, and it has to be met by a firm and proportionate response”. The EU retorted by proposing a 25 per cent tariff on US steel, clothing, and other industrial goods.
The US then went on to levy a 25 per cent tariff on more than 1,300 Chinese goods. And China responded on Wednesday by levying additional duty on 106 American products. Analysts, however, feel that this trade war may be shortlived, and impending negotiations will help in defusing the tension. There are three possible reasons.
First, the federal law that President Trump has used to issue a notice seeking public comments for the imposition of 25 per cent customs duty on over 1,300 Chinese items requires his administration to seek “consultations” with China before imposing the levies. US Commerce Secretary Wilbur Ross said on CNBC that he expected trade actions between the US and China to lead to a “negotiated deal”. China’s retaliatory move does not explicitly indicate when the additional tariffs would take effect.
Second, the Chinese government said it would appeal to the World Trade Organisation’s Dispute Settlement Body (DSB) for adjudication. This requires consultations before China presents its case to a tribunal. If the appeal is admitted, trade analysts predict that China could have an upper hand, given the record of plaintiffs almost always ending up on the winning side. The US, however, has so far ignored the WTO.
Third, the retaliatory tariffs by China, which are on the lines of the action taken by the EU earlier this year, are targeted to hit the US where it hurts, potentially sparking dissent and pressure from domestic lobbies. China imports about 60 per cent of the global soybean production, and about 40 per cent of this import is from the US. Midwestern states such as Iowa, a leading producer of soybean, are likely to be hit by the Chinese levy. Iowa and other agrarian states had voted for Trump in the presidential election.
Earlier, in response to the Trump administration announcing higher tariff on steel and aluminum imports, the EU had retaliated by targeting American products from key Republican-run states, including the imposition of higher duties on Harley-Davidson motorcycles made in Speaker Paul Ryan’s home state of Wisconsin, levies on bourbon made in Senate Majority Leader Mitch McConnell’s state of Kentucky, and duties on orange juice that would impact Florida — widely seen as a key swing state. Indications are that the build-up of pressure within the Republican party itself could force Trump’s hand on this issue.
Will India be impacted?
If the trade war were to intensify — and that’s a big if — 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. In case of soybean, for instance, one of the key items in the list, there could be a cascading impact in terms of openings for India to enter other markets, according to the Soybean Processors Association of India.
The bulk of China’s annual soybean import of around 100 million tonnes is for domestic consumption; the rest is used in the manufacture of soybean oil and meal for export. If the levy hits China’s import, exports could be dented, a space that India could potentially fill to meet the demands from other countries.
But in the long term, a full-fledged trade war is bad news. It invariably leads to a higher inflationary and low growth scenario. Inflation is generally good for assets such as gold, while having a negative impact on currency and some sectors in the equity market.
Bigger worry: interest rates
A greater worry for India could be the indirect impact — the potential cascading inflationary impact of the decision in the US itself. 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. This could force the Federal Reserve to frontload its interest rate glide path — raise rates faster than it would have done otherwise.
An increase in interest rates in the US has implications for emerging economies such as India, both for the equity and debt markets. The Fed is so far on track to raise interest rates at least two times this year; market analysts, however, say Fed Chair Jerome Powell could potentially raise rates faster to prevent the US economy from overheating.
The Fed is also slated to pursue its scheduled reversal of the easy money policy of the last decade. The central bank had said in September 2017 that it would start shrinking its balancesheet by selling treasury bonds and mortgage-backed securities that it accumulated after the Lehman Brothers crash in 2008, in order to inject liquidity in the market.
From the current $20 billion a month ($12 billion of treasury securities that are being allowed to mature each month without being replaced, alongside another $8 billion of mortgage-backed securities), the sale of such securities is slated to go up in the future, according to details available from the January 30-31 meeting of the US Federal Open Market Committee. With this, the Fed would gradually wind down the $4 trillion in holdings that it acquired during the phase of quantitative easing.
Even a minor disruption in US financial markets can have major implications for India. The three external risk factors — higher tariffs, rising interest rates, and elevated bond sales — come at a time when the domestic banking system is grappling with a renewed stress of bad loans. The Indian economy, especially financial markets, will need to brace for significant volatility and stress from the combined effects of global and domestic challenges.
Outflow of money
For India, the impact of inflation action by the Fed will be significant through the channel of interest rates. Yields in US markets have been inching up since mid-2016, and have risen from a low of around 1.5% per annum to over 2.8% now. The yield on benchmark US bonds hovered around 5% in 2007, a year before the start of the global recession that forced central banks of developed countries to cut interest rates to near-zero. While a reversal to pre-2008 levels will only be gradual, the rise in yields could be faster than anticipated.
The Indian government securities market has been falling for the past seven months on cues of rising US yields and projections of increased local inflation. When yields rise, prices of bonds fall, resulting in mark-to-market losses for PSBs. Indian banks, stressed by bad loans, may have to incur mark-to-market losses of up to Rs 20,000 crore in the January-March quarter, analysts say.
Rising interest rates in the US could mean a potentially rough ride for the India’s equity market. Higher US rates will lead to outflows from emerging market bonds and equities as American investors will look to chase higher returns in their home. While a surge in domestic inflows is a reassuring factor for Indian equities, higher interest rates do make the option of investors borrowing cheap money in the US and investing in Indian equities significantly less attractive.