Since the president of the United States, Donald Trump announced the increase in tariffs on China imports on March, 2018, the world is experiencing something like never before. The trade war, had been raising tension all across the world. Now, economists have been advocating free trade all these while due to the many benefits that come with it. However, many world leaders seem to have skipped this chapter of the economics textbook. The move started by Trump had even prompted several other countries to review their tariff laws, altogether increasing the barriers to trade. Nevertheless, the spotlight still falls on the two main economies as of 2018, US and China, and how each country’s government has been increasing the tariffs on each other’s products in a tit-for-tat manner. Six months have gone by since the first announcement; how are the economies of both countries holding up? This article will seek to explain the effects of the trade war, particularly on US and its trade balance. The main focus of this article is to explain the causes behind these movements and perhaps show whether the aims of the trade war started by Trump has been realised, or not.
Trade Balance Position of US and its Movements
When Trump announced the tariffs on China imports, among others, the main goal of the US government is to reduce the trade deficit that US has been experiencing all these years. Trump stressed the need to fix the trade deficit with China, stating that China is “rigging the system” by intervening to distort the market, which “cannot be tolerated”. Nevertheless, things are apparently not going as planned. The US trade deficit with China rose to a 5-month high in July 2018. This seem to point to the fact that the trade war started has no practical benefit on the trade balance of US. However, US might very well impose another round of tariffs on China or even increase the current tariffs, in order to achieve its objectives. The worsening trade balance has not been foreseen by Trump’s administration. Is it merely due to bad luck, or is the government just being foolish? In the next section, we will discuss the possible reasons for this decline.
Analysis of Trade Balance Movement of US
Intuitively, if higher tariffs are imposed on imports, the prices of imports will increase, therefore rendering imports less attractive compared to domestic products. This will cause a decrease in imports, hence a relative increase in the exports. However, this does not seem to be the case when it comes to the US-China trade war. This section will try to explain this phenomenon.
1. The Retaliation of China
One of the main reasons is the role of China itself in this trade war. In retaliation, China has announced tariffs on 128 US products. Research showed that tax policies in biofuel will increase the market price of these products. Similarly, the new tariffs imposed by the Chinese government will make US products relatively more expensive compared to domestic China products. Therefore, US exporters will face a decrease in the demand of these goods. This will lead to fall in US exports, thereby not improving US trade balance as predicted. Another thing to note is that China is one of the biggest importer of US goods. As of 2017, 8.6% of US exports are to China, amounting to $130.37 billion.
Figure 1: Year-to-date Exports of US (US Census Bureau, 2018)
The fact that China is the third largest importer of US goods will mean that an increase in the price of US goods due to tariffs imposed by China will result in a significant decrease in US exports. Therefore, the trade balance of the US will worsen.
2. Expectation of Future Price
Although the trade balance of the US is predicted to worsen, there is still a spike in the exports of soybean oil to the China. This is because China is stockpiling on the soybean oil before the tariff is implemented on the July 6th. In fact, this is because the price of a good is predicted to surge in the future, thereby increasing the demand for that product now. Not surprisingly, US imports have also increased as shown in Figure 2.
Figure 2: US Imports (Trading Economics, 2018)
US imports reached $261.2 billion in July 2018, of which around $47 billion worth of products are from China, a record high in 2018. Steel imports from China have increased by 5% for the year, because of the expected increase in price of steel due to tariffs. However, analysts have predicted that the unforeseen rise in the trade activities between the US and China will not last long. In the long run, the trade activities will adjust accordingly to the price of goods after tariffs, thus worsening the trade balance of US.
3. Exchange Rate Movement of US and China
The next explanation for this phenomenon is related to the exchange rate of each of both countries. A domestic currency that is appreciating will mean that the price of goods and services produced by that country is relatively increasing. When this happens, the demand for that country’s goods will decrease, thereby worsening the balance of trade of that country. It can then be concluded that, if a country’s currency has appreciated, the exports of that country will decrease. In this case, the US Dollar (USD) has been appreciating relatively to the Chinese Yuan (CNY) from May 2018 to November 2018.
Figure 3: USD to CNY Exchange rate Chart (YCharts, 2018)
Intuitively, this makes US goods relatively more expensive. Therefore, the demand for US’s goods fall, hence decreasing US exports and worsening the trade balance. However, as demand for US products decrease, the demand for USD will fall as well, hence causing the USD to depreciate. This is why the USD is forecasted to depreciate relative to the CNY in the next 6 to 12 months, provided that the Chinese government do not devalue the CNY as it did in August 2015. Analysts predict that the CNY will be more flexible in future due to the decrease in intervention by the Central Bank.
Figure 4: Forecast of major currencies (Citibank, 2018)
This means that although the exchange rate for USD/CNY might affect the balance of trade of USA in the short run, ultimately, the trade balance will return to normal in the long run, for the trade war effects to the US will be significant in the beginning but will decrease later.
4. Increasing Cost of Production
Lastly, the newly-introduced tariffs might affect the trade balance of US indirectly through the productivity of US factories. When a trade barrier is imposed on imports entering US in the form of tariffs, domestic producers are said to lose productivity. In fact, trade liberalisation will increase productivity among domestic producers. This is because there would be now less competition compared to when foreign producers are in the market. The domestic industry will be protected by foreign producers that try to penetrate the domestic market with more competitive prices. Due to the loss of productivity among US producers, the relative cost of production will rise, hence causing the price level of products to increase. An example can be taken from the UK when it initiated Brexit. A 2017 research estimated, using empirical evidence, that costs of productivity with trade barrier in UK is 2 to 3 times larger than if UK had joined European Union. A price inflation will deter other countries from buying US products, inducing the demand for these products to fall. This event will reduce the amount of US exports significantly, therefore worsening the trade deficit of the US.
It is clear that the trade balance of the US has been deteriorating these few months due to the trade war. This trend must not have been expected by the country, more specifically, Trump and his economic advisory team. Surely, they will come to the realisation that the trade war has more of a bane than a boon, to both US’ own economy and to the world’s economy as a whole. If US wishes to compete with China on the international trade markets, this is certainly not an economically-efficient strategy because the overall welfare has been reduced to the trade war. China is only going to come out stronger from this trade war, benefiting from trade with the countries that US used to trade with before imposing tariffs on them too. This fact is obviously not going to impress the Americans. The few possible solutions to this plight is for US and China to come to an agreement on the correct amount of tariffs to be imposed; correct in the sense that both countries benefits from the agreement. If a solution to this is not figured anytime soon, and the trade war is allowed to continue, then expect the economy to be in dark times in the near future.
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Download the article here:Copy-of-US-China-Trade-War-Revisited.pdf
Author – Lee Yang Ler