A Note on Trade Wars and Its Nuances

As we are aware of, the United States and China have been locked in a trade war since the beginning of this year, with the first tariffs being imposed on solar panels to the tune of 30% by the United States, and China imposing 25% tariff on cars, airplanes, soybeans etc. This trade war is still ongoing and is affecting international trade on an unprecedented scale. This article sheds light on some of the salient features and major events that have occurred within the duration of the trade war’s existence.

Before we proceed however, we need to understand exactly what a trade war is and why nobody would actually want it. A trade war is when a nation imposes tariffs or quotas on imports and foreign countries retaliate with similar forms of trade protectionism. As it escalates, a trade war reduces international trade. A trade war starts when a nation attempts to protect a domestic industry and create jobs. In the short run, it may work. But in the long run, a trade war costs jobs and depresses economic growth for all countries involved. It also triggers inflation when tariffs increase the prices of imports. And, of course, we cannot stress enough on the fractured diplomatic relations between the fighting countries and other nations that get caught in the crossfire.

Moving ahead, the primary feature of note is that this is not the first time America had imposed tariffs, that too under the ruling influence of the Republican Party. Back in the days of the 1929-1930, when the Great Depression was about to start, the Smoot-Hawley Tariff Act was passed by the then 31^st President of the United States, Mr. Herbert Hoover. This Act was presumably a last-ditch effort to protect the interests of the growing American industries, and raised the tariffs for over 20,000 imported goods. However, it was not received well and surrounding countries such as Canada also increased tariffs for American imports.

Moving onto the intentions, the primary political motivations was Trump acting on his pre-election promises. In that, he was of the opinion that China was infringing on intellectual property rights by enticing American companies to invest in China, thereby gaining access to American knowhow. He believed that the trade war would stifle China’s progress, but a crucial factor is China’s rapidly-growing consumer market, which would anyways attract companies who would invest, not wanting to face extreme losses due to the trade war.

America is the world’s largest steel importer. Trump believed the tariffs would protect the 147,000 workers in the U.S. steel and aluminum industries. But they could hurt the 6.5 million workers in U.S. industries that import steel, which wasn’t taken into account. Moreover, China strategically targeted 106 products with tariffs and also penalized two other U.S. exports: sorghum and Boeing airplanes. It specifically targeted industries located in states that supported Trump in the 2016 election, following the competitive Mercantilist philosophy of international trade.

Going through a salient timeline of events, we can see that on March 8, 2018, President Trump asked China to develop a plan to reduce the $375 billion U.S. trade deficit by $100 billion. China was amenable to the idea as part of China’s economic reform plan is to reduce its reliance on exports. But it cautioned there isn’t much it can do, since the deficit is fuelled by high U.S. demand for low-cost Chinese goods. Then, the situation worsened, with President Trump putting forth five demands to China, which were:-

1. End subsidies to tech companies.
2. Stop stealing U.S. intellectual property.
3. Cut tariffs on U.S. goods by 2020.
4. Open China to more U.S. investment.
5. Reduce the trade deficit by $200 billion by 2020.

However, China didn’t acquiesce to the demands, sparking the continuation of the trade war. The trade war became so bad that other countries started paying the price. For example, on August 10, 2018, Trump announced he would double the tariffs on aluminum and steel imports from Turkey. He was trying to obtain the release of jailed American pastor Andrew Brunson. Turkey claimed that he was involved in the 2016 coup to overthrow the government. The U.S. move lowered the value of the Turkish lira to a record low against the U.S. dollar. This renewed fears that the poor health of the Turkish economy could trigger another crisis in the eurozone.

Another significant fact about trade wars is that a full-blown trade war will often feature the combination of a tariff war and currency war. In practice, exporting countries will, in response to imposed tariffs, resort to currency manipulation, moving to cheapen their money to offset the impact of the tariffs. But a competitive devaluation among trade partners makes a currency war meaningless. Once countries realise that currency wars do not work, they resort to all the tools available to set up barriers to block trade. This seems evident amid the escalating US-China trade feud. The slump in the renminbi in past few months is stoking fears in markets that China’s policymakers are deliberately pushing the currency’s depreciation in an effort to offset the US tariff hikes. Also, this move is being made to further lower the market prices of the goods in question, leading to further instability, according to the optimal tariff theory, which claims that that if a country imports a large enough market share of a good, imposing tariffs can actually cause changes in the world market price that can be beneficial to the consumers in that country.

In this situation, the best bet for China is depreciation as a more effective way to do damage control: with a mild depreciation against the dollar, the tariff impact could be largely offset. However, China risks capital flight if it were to let the currency weaken too much. In such cases, China could possibly sell U.S Treasury bonds and instead buy European/Japanese sovereign debt, which again could only be a temporary measure at best. Only time will tell if this situation can improve.