The United States is now well and truly engaged in a global tariff war. Despite a 90-day moratorium on the country-specific tariffs announced by US President Donald Trump on April 2, a uniform 10 per cent tariff on all imports and the 25 per cent tariffs on imports of autos, steel and aluminium remain in place. Tit-for-tat responses have pushed China-US trade to a complete breakdown.
Financial markets across the world have been gyrating wildly even after the moratorium announcement. Expectations of a global recession are gaining substantial ground as producers desperately try to find ways around more expensive supply chains, declining profit margins and, most damagingly, the whipsawing uncertainty about the immediate future.
We are also seeing signs of stress in US bond markets with long-term yields beginning to trend up. This last bit is an independent source of worry since yields on long-term bonds tend to fall when investors rebalance rising risk on their equity portfolios by switching towards bonds. The resultant rise in the demand for bonds increases their price, which reduces the yield on them. The concurrent decline in yields and stock returns in the US suggests that foreign investors are liquidating their US financial assets. Bond market stress is often the precursor to a financial crisis. It appears that it was the bond market gyrations that convinced Trump to suspend the tariffs.
The unfolding economic mayhem is straining the minds of policymakers globally. The responses so far have ranged from tariff retaliations by China and Canada to countries reaching out to strike deals with the US. Making deals, however, requires a clear sense of what the US wants. The formula used to calculate the tariffs suggests that the US is targeting bilaterally balanced trade — exports close to imports for each country in its trade with the US. This is the reason Trump summarily rejected the EU proposal of both regions dropping their tariffs on each other to zero. While that is what true reciprocity would involve, the US rejected it because its target is balanced trade with the EU and zero tariffs will not guarantee that.
Balanced trade is an unconventional target for policy since trade deficits also reflect imbalances between national savings and domestic investment. Thus, events such as the discovery of productive investment opportunities in a country can induce it to borrow abroad or sell equity in new projects to foreigners to finance the savings shortfall. This shows up as a trade and current account deficit. Similarly, long periods of low interest rates due to accommodative monetary policy or large public budget deficits due to fiscal expansions can reduce national saving rates. These too show up as trade and current account deficits. Hence, most countries do not target balanced trade.
More generally, when we import goods and services from foreigners we have to pay for them. There are two ways to pay: We can either sell some of our goods and services to our foreign partner or we can sell them some of our assets. When a country runs a trade deficit with another, it is paying for the excess purchases by selling some of its assets to its trade partner. This is no different from the way we run our own households or businesses. When a firm invests in a new factory and doesn’t have enough retained earnings, it borrows from markets or banks to finance the gap. This is the firm’s counterpart of a trade deficit. Similarly, when a household borrows to finance a family wedding, that is a household trade deficit. By levying tariffs, the US is, in effect, expressing extreme unhappiness with foreigners for accepting US assets as payment for the trade deficit.
The global conditions created by the threatened US tariffs represent both a challenge and an opportunity for India. As the world teeters on the edge of a recession, the negative effects on global demand are going to create risks for Indian exports and growth. Moreover, there is the associated problem of having to compete with ultra-cheap goods from China as it looks to find other outlets to compensate for the loss of its US market.
On the upside, this will likely also lower the cost of imported goods and components used in India, which should reduce inflationary pressures in the Indian economy. This will create space for monetary policy to become more accommodative in order to support growth. India will also likely reap some benefits from multinational companies like Apple looking to reorient their production chains away from China. With its large supply of semi-skilled labour, India is well-positioned to attract some of this business.
The first order of business has to be to quickly strike a trade deal with the US. The caveat here is that just lowering tariffs may not be enough to satisfy the US, since it wants balanced bilateral trade. This will be a tricky negotiation, but India has to protect its service sector exports to the US. As of now, the US has not included services in its tariffs. But this could change. A deal that commits India to buying more goods from the US (possibly by switching some imports to the US) while protecting Indian service sector exports may be a pill that has to be swallowed.
The US has also been demanding easier access to Indian markets for their agricultural goods. This may be the opportunity to usher in agricultural reforms by using the trade negotiations as political cover. Concurrently, India needs to jump-start negotiations on trade agreements with other trading groups, including the EU, ASEAN, CPTPP, MERCOSUR as well as bilateral or multilateral treaties.
Lastly, India needs to use this opportunity to lower its average tariff rates, which have been inching upward over the past few years. Now is the time to correct that. Forcing domestic producers to confront foreign competition is the surest way to make them internationally competitive.
The world trading order is changing in real time and India has to be proactive. Economic crises are often the best opportunities to enact economic reforms. Some bold policy risk-taking at this moment may provide the economy with just the tonic that it needs.
The writer is Royal Bank Professor of Economics, University of British Columbia, Canada
