Tradespotting: Choose protectionism. Choose higher inflation. Choose weaker trade and growth

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The future of global trade, which has slowed despite a pick-up in global GDP growth, is hogging the headlines, with the spotlight on both the US and UK.

US President Trump and his team have so far focused on (1) substituting US imports for domestic production, with Trump adopting a carrot-and-stick approach (2) trade in goods, particularly manufactured goods and (3) trade with China and regional trading partners and in particular Mexico.

There is in theory nothing irrational in President Trump wanting to boost domestic production and exports, narrow the $500bn trade deficit and spur US employment.

However, his current approach may in practise fall well short of delivering the improvement in US trade and jobs which he seeks. In a more extreme scenario, his tactics could at least in the near-term lead to higher US inflation and weaker trade, creating headwinds for both the US and global economy.

The high-labour cost US economy should be looking to better compete with the likes of Germany, not China. But the quality and desirability of exports matters.

The Dollar’s strength, over which the Trump administration has little or no control, will likely continue to weigh on the overall competitiveness of US exports while at the same time fuelling cheap US imports.

A stronger Renminbi is not the solution as exporting nations other than the US may be better positioned to capitalise on such a relative-price change, while the USD-cost of imports from China may rise.

If the US imposed higher tariffs on imports from China and other countries (such as Mexico), it would take time for US-based companies to boost production given insufficient quality and capacity in US manufacturing.

Moreover, China and other exporting nations such as Mexico and Canada may respond to higher US import tariffs by increasing their tariffs on imports from the US. This would put US exporters at a clear disadvantage vis-à-vis other exporting nations.

 

Future of global trade (and growth) subject of much debate

Few other issues in recent months have hogged the limelight as much as the future of global trade. The United States’ status within global trade was at the heart of US President Donald Trump’s election campaign and since his victory on 8th November the ability of the US to compete for exports and jobs on the global stage has increasingly taken centre stage in a policy program slowly coming into focus.

At the same time, the British vote on 23rd June to leave the European Union (EU) has lead to much soul-searching about the future relationship of the UK – one of the world’s largest exporter of services – with the EU and other trading partners. France will be holding presidential elections in less than three months and one of the leading candidates – Front National leader Marine Le Pen – has promised to take France out of the EU if elected. While she only has a very remote chance of being elected President, in my view, the possibility of France – the world’s sixth largest exporter of goods – exiting the EU is making headlines (see EM currencies, Fed, French elections and UK “reflation lite, 25 November 2016).

Growth in global trade recovered rapidly following the great financial crisis, in parallel with a swift recovery in global GDP growth, before both slowing sharply in 2011-2015 (see Figure 1). However, while global GDP growth stabilised in Q2-Q3 2016 and rose to an estimated 3% year-on-year in Q4 2016, growth in global trade has slowed sharply since mid-2015 to below 1% yoy. This raises the important question of whether the albeit modest pick-up in global GDP growth will eventually pull trade growth higher or whether slowing trade growth will curb and potentially reverse the recent turnaround in global GPD growth.

Olivier Desbarres tradespotting Fig 1 and 2

 

Trump focussing on imports, manufactured goods and trade with China and Mexico

US President Trump and his team have so far focused on:

  • Substituting US imports for domestic production, rather than exports per se, with Trump adopting a carrot-and-stick approach. He has promised to cut corporate taxes and regulation in a bid to make US-based companies more competitive and lure foreign-based US companies back home but explicitly threatened to impose border taxes of up to 35% on exports to the US by foreign-based US companies;
  • Trade in goods, particularly manufactured goods, rather than services in a bid to increase blue-collar jobs and;
  • Trade with China and regional trading partners and in particular Mexico. President Trump has threatened to impose tariffs on Chinese exports to the US and declare China a currency manipulator if China does not further open up to trade with the US and if the Renminbi does not appreciate. He also wants to renegotiate (and potentially dismantle) the North America Free Trade Agreement (NAFTA) with Mexico and Canada and this week signed an executive order withdrawing the US from the 12-nation Trans-Pacific Partnership (TPP).

There is in theory nothing irrational in President Trump wanting to boost domestic production and exports, narrow the United States’ $500bn trade deficit on goods and services and spur US employment, particularly in manufacturing. After all it is what many country leaders seek for their own economies.

However, as I argue below, his current approach may in practise fall well short of delivering the improvement in US trade and jobs which he seeks. In a more extreme scenario, his tactics could at least in the near-term lead to higher US inflation and weaker trade, creating headwinds for both the US and global economy. The smarter route to make US-based companies more competitive and encourage (US and foreign) companies to relocate to US is arguably via lower and simpler corporate taxes, better infrastructure and greater investment in research and development in order to improve the quality of US goods.  Tariffs and trade wars, as history has often shown, are not the solution.

 

Focus on substituting US imports for domestic production

President Trump’s focus has been squarely on substituting US imports for domestic production rather than trying to boost US exports per se, although the two are of course interlinked. If foreign-based US companies relocate to the US this would in theory help reduce imports as well as increase exports –emphasising “in theory”.

There is arguably some logic behind this relative emphasis. In USD-terms, the value of US merchandise exports fell 8.5% in 2014-2016 while the USD-value of imports fell 4%, which at first glance would suggest that the US has an export, not an import problem (see Figure 2). But this does not take into account relative changes in the USD-unit price of US exports and imports, which in turn partly reflect the Dollar’s appreciation in recent years. Indeed, in volume-terms, US exports rose by an albeit modest 2.1% in 2014-2016 but imports surged 11.6%.

So while the volume of US merchandise exports has only slightly lagged exports from the rest of the world (see Figure 3), the volume of US merchandise imports has risen far more rapidly than imports from the rest of the world (see Figure 4). I would caveat that monthly global trade data tend to be volatile, as seen in the surge in the rest of the world’s exports in November 2016 for example.

Olivier Desbarres tradespotting Fig 3 and 4

That is not to say that President Trump is not seeking to increase US exports of goods and services which as a percentage of GDP are considerably smaller than in other major economies (see Figure 5). To put it in perspective, the ratio of US exports of goods and services to GDP was, when ranked, 157th out of 164 countries for which the World Bank published 2015 data.

Olivier Desbarres tradespotting Fig 5 and 6

 

Focus on trade in goods, particularly manufactured goods, rather than services

President Trump has repeatedly emphasised his goal of getting foreign-based US manufacturing companies to relocate to the US and has made few explicit references to United States’ trade in services. This emphasis on goods rather than services is not altogether irrational. As Figure 7 shows the annual US merchandise trade deficit, which is hovering around $745bn, has doubled since early 2000 and shows little sign of narrowing. In comparison, the US services trade surplus has doubled to $250bn since late-2010.

However, this services trade surplus has treaded water since mid-2014 and President Trump could in time conceivably turn his attention to the US services sector. In the United Kingdom, which also runs sizeable merchandise trade deficits and services trade surpluses (see Figure 8), Prime Minister Theresa May’s government has arguably paid as much, if not more, attention to the services sector, and in particularly the financial sector’s contribution.

Olivier Desbarres tradespotting Fig 7 and 8

Within merchandise trade, President Trump has zeroed in on the still reasonably labour-intensive manufacturing sector and on creating blue-collar jobs. Again, at first glance, this appears to make sense. US manufacturing has created over 800,000 jobs since early 2010 but still employs 1.7 million fewer workers than it did a decade ago (see Figure 9). Put differently, the manufacturing sector has created only one job for every three lost. It currently employs about 12 million workers, only double the number in Germany despite the US economy being five times as large as Germany’s.

Olivier Desbarres tradespotting Fig 9

There is indeed still some slack in the US labour market and the US economy is not at full-employment, as I argued in US economy not at full employment (13 May 2016). For starters, the average number of weekly hours worked has edged lower. Moreover, the potential pool of available workers, which I measure as those unemployed, working part-time and not in the labour force but wanting a job, fell from 49 million at the turn of the decade to 41 million in late-2015[1] but has since flat-lined (see Figure 10). It remains 4.5 million higher than before the great financial crisis, which has likely contributed to cap weekly earnings growth in the private sector. The net result is that growth in aggregate weekly payrolls for private-sector workers[2] has slowed to around 4% year-on-year from 5% yoy in early 2015 (see Figure 10).

 

Focus on China and regional trading partners in particular Mexico

The focus on the United States’ trade with China seems justified at first glance. The US merchandise trade deficit with China amounted to $367bn in 2015 or half of the total US merchandise trade deficit, dwarfing the deficits which the US runs with other countries (see Figure 11). To put it in perspective, the US trade deficit with China was equivalent to sum of the United States’ next nine largest country trade deficits (with Germany, Japan, Mexico, Vietnam, Ireland, Korea, Italy, India and Malaysia), as depicted in Figure 11.

In comparison, as depicted in Figures 12 and 17:

  • The United States’ merchandise trade deficit with Russia in 2015 of $9.3bn was only the United States’ 17th largest country-specific trade deficit.
  • The United Kingdom just creeps into the United States top-40 largest country-specific merchandise trade deficits…in 40th place, with the US running a sub-$2bn deficit with the UK.

So Russia and the UK are far more equal trading partners with the United States than China and therefore the scope for President Trump to improve the United States’ trade balance with these two countries is arguably smaller, on paper at least. This may partly explain – with the emphasis on partly – why President Trump has so far been rather conciliatory about a future trading deal with the UK and to my knowledge not publicly mentioned future trading arrangements with Russia.

 

President Trump’s approach to US trade and jobs likely to hit a number of stumbling blocks

While on paper President’s Trump’s objectives may partly stand up to scrutiny, the path he is seemingly intent on taking is likely to be littered with economic, not to mention geopolitical challenges.

 

Quality matters, not just price

The high-labour cost US economy cannot and presumably does not want to compete with low labour-cost economies such as China for the manufacturing and exports of low-cost, low value-added goods. That would arguably be a massive step backwards for the advanced US economy. It makes far more sense for the US to focus on exports of high-valued added goods and services which require a skilled labour force, technology and capital. In that sense, the US should be looking to better compete with the likes of Germany, not China.

But that is where the quality and desirability of exports matters. There is a reason, and it is not just price competitiveness, why the US exported fewer than 500,000 cars to China in 2015 – one tenth of the number of cars Germany exported to China. The US has also fallen behind in the exports of “Advance Technology Products”, with its trade deficit of $91bn in 2015 (or 15% of its total merchandise trade deficit) double the deficit a decade ago (see Figure 13).

Strong dollar impediment to US competitiveness and trade

President Trump’s promises to cut corporate taxes and regulations would arguably make US-based companies more competitive. But the Dollar’s strength, over which the Trump administration has little or no control, will likely continue to weigh on the overall competitiveness of US exports while at the same time fuelling cheap US imports.

The US Dollar Nominal Effective Exchange Rate (NEER) has appreciated about 25% in the past three years (see Figure 14). In comparison, the Japanese Yen has appreciated only 3%, while the Euro and Sterling have depreciated 4% and 8%, respectively. Turning to the currencies of the countries which Trump has seemingly set his sights on, the Renminbi has appreciated about 2% while the Mexican Peso has lost almost a third of its value. While Trump may well manage to encourage and/or force US and foreign companies to move from Mexico to the US, the Peso’s rapid depreciation has, all other things being equal, if anything increased Mexico’s attractiveness to foreign companies.

 

Stronger Chinese Renminbi a non-solution to a complex problem

One theory doing the rounds is that President Trump is merely threatening to impose tariffs on Chinese goods and officially declare it a currency manipulator to force Chinese policy-makers to revalue the Renminbi in a bid to ultimately increase Chinese imports from the US. There are number of problems with these tactics and strategies, in my view, assuming that China refused to unilaterally lower its import tariffs.

The Renminbi is under depreciating pressure as a result of China running only a modest 2.5% of GDP current account surplus and large capital account outflows (estimated at $730bn in 2016) and the People’s Bank of China (PBoC) has already used up $750bn of its FX reserves in the past two years to slow the currency’s downturn (see Chinese Renminbi – Squaring the circle, 6 January 2017). Assuming that FX outflows from China do not slow materially near-term, it is not clear that the PBoC would be willing to step up its FX intervention in order to appreciate the Renminbi.

If somehow the Renminbi appreciated markedly going forward, this would make US exports to China more competitive but it would also likely make other countries’ exports to China more competitive (all other things being equal). These countries, including exporting powerhouses such as Germany which in 2015 ran a massive 8% of GDP trade surplus, may be in a better position than the US to take advantage of a stronger Renminbi and Chinese demand.

Moreover, if the USD/CNY exchange rate did fall, the USD-value of imports from China would rise. Assuming US companies were still unable or unwilling to compete with China in the production of low and medium-value added goods, consumers may struggle to substitute imports from China for imports from other low cost-base economies as few countries’ export sectors have the depth and breadth of China’s.

So near-term US imports would become more expensive, boosting imported-inflation and/or weakening US consumption/imports and potentially GDP growth. Finally, US companies (whether or not US-based) which import Chinese components for assembly and re-export would potentially face higher input costs, which they be unable to recoup via higher sale prices, putting pressure on profit margins. This is arguably the situation which UK consumers and retailers currently face due to Sterling’s collapse post-EU referendum.

 

Tariffs on imports could cause more harm than good to US economy

If the US went a step further and imposed higher tariffs on imports from China and other countries (such as Mexico), US-based companies could be incentivised to boost production to meet domestic demand. But again this is not a process that would happen overnight as there is simply insufficient quality and capacity in US manufacturing to fill the gap. One constraint would be the tightness of the US labour market, as depicted in Figures 15 and 16. Employment is at an all-time high and the unemployment rate of 4.72% is near a decade low. The employment growth rate has slowed but that is perhaps to be expected in an economy which has created over 14 million jobs since early 2010, in which the number of unemployed has fallen by 7.5 million and the share of full-time employed has risen from below 80% to 81.7%.

Moreover, China and other exporting nations such as Mexico and Canada may respond to higher US import tariffs by increasing their tariffs on imports from the US. This would put US exporters at a clear disadvantage vis-à-vis other exporting nations and potentially weigh on US exports and growth. Such retaliation may also extend beyond trading barriers of goods and services to foreign direct investment and other capital flows as well as and regional cooperation.

 

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.


[1] It is admittedly difficult to gage what share of those who say they want a job are truly able and willing to work. In the same way, it is conceivable that some part-time workers are unable or unwilling to become full-time workers while some of the unemployed may not have the skill-set which matches demand. So adding all three groups together (unemployed, part-time workers and those not in labour force who want to work) may not give a totally accurate picture of the potentially available pool of workers. However, the overall trend is of informational value in my view.

[2] Aggregate payrolls estimates are the product of estimates of average hourly earnings, average weekly hours, and employment.

 

Appendix

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