Beware of retaliatory protectionism – OMFIF

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With geopolitics being the second driver – after inflation – of central bank reserve managers’ operations, financial markets may be underestimating the looming dark cloud. Rather than financial mistrust, we may increasingly need to prepare for political mistrust. The threat of “beggar-thy-neighbour” policies – from the US and China to anti-Russian sanctions and the confiscation of reserves – could grow, and without renewed political stimulus, stagflation will deepen.

Geopolitical factors were brewing before the invasion of Ukraine, as evidenced by US tariffs under President Donald Trump, US-China frictions over trade and Taiwan, European populism and the UK’s exit from the EU. ‘European Union. More acutely, shocks to the energy market from the invasion will be pervasive, falling hardest on Europe, more directly dependent on Russian energy and heading into winter. But, given the linkages, high energy prices are dampening growth elsewhere, adding to consumer price index baskets and threatening a more inward-looking approach.

If protectionist forces were to grow, on top of any international “blame game” after Covid-19, inflation would escalate in the first place. But it would surely be more of the “bad guy” – a cost push induced by tariffs, weaker currencies and commodity shortages, rather than a demand push. Central banks should turn a blind eye to aggressive tightening as economies stagnate. This bodes more for the rising inflation of the recessions of the early 1980s and 1990s than for the overheating of the late 1980s and mid-2000s. The inflationary flame of demand can go out without action aggressive policy.

Until the Russo-Ukrainian war, the notion of a slowdown in international trade had appeared outside of most official projections. And, even including it, global growth is generally expected to continue, even if the balance of risks is “squarely on the downside” (Chart 1)

While Joe Biden is a less confrontational US president, he has been loath to roll back his predecessor’s trade restrictions. For financial markets, trade frictions can (like Brexit in the UK) be a longer-term “crack in the ice” than an overnight “cliff edge” event. A disparity can occur, at least initially, between the goods and services sectors, and widen to countries whose “cheaper” imports can fill the gap. This potentially offers a reversal of the rotation of goods over services under Covid-19.

Figure 1. Major economies are expected to continue to grow…

IMF real GDP growth projections (p): global, advanced and emerging/developing economies (% y-o-y)

Source: IMF updated global economic projections of July 2022 (after 2023 for information purposes)

Figure 2. …assuming global trade growth is largely unchanged

World, US and Chinese trade (exports plus imports)* as a percentage of their respective GDP (all in %)

Source: World Bank data (*goods and services)

The world’s appetite for international trade has, as a percentage of GDP, more than doubled over the past 50 years (Figure 2). Yet, without caution, an unnecessary puzzle piece of the 1930s – retaliatory protectionism – could fall into place. In 1930, it was triggered by the Smoot-Hawley Tariff Act which raised US tariffs by up to 20% on more than 20,000 imported goods. This hit the few trading partners of the United States (notably Canada and Europe) and prolonged the depression.

The US Congress under Trump has pushed back on a broad approach. If necessary, however, the then US president has the ability – without Congressional or World Trade Organization approval – to invoke Section 301 of the Trade Act of 1974 more fully. It would impose tariffs on countries it sees as engaging in “unfair” trade practices against the United States. It may be a last resort. But, for the preventive financial markets, the fear would then be of a stampede, triggered by a political confrontation between the United States, China and an EU already absorbed by the fallout from the war.

Trump’s 2018 tariffs on steel and aluminum imports, and the administration’s investigations into alleged violations of intellectual property rights in China and auto imports (targeting Europe and Mexico) seemed powerful first steps. They have not been repealed. If added, they could trigger retaliation unless there are more conclusive trade talks, which likely never happened before the US midterm elections this fall and the 20th National Congress. Chinese. Although not widely used since the WTO was established in 1995, US disaffection with the WTO and Biden’s need to curry favor after November could raise hopes of play this card.

The impact this time of protectionism, whatever the source, would be more complicated than in the 1930s.

First, the economic and financial links suggest that the repercussions would be greater. Retaliation—whether it be give-and-take tariff increases, qualitative hurdles, and/or competitive currency depreciations—would trigger second-round effects that would offset much of the growth impetus from fiscal stimuli Covid-19 of 2020. In this case, fiscal coffers should reopen if central banks continue to normalize monetary conditions.

A strong dollar would reinforce this. In 1930, Canada “fighted back” even before SH became US law. The United Kingdom and France sought new partners and Germany moved to autarky. Canada then forged closer ties with the UK – an early precedent to the EU deal it signed in 2016.

The wider range of affected countries would include emerging markets whose “cheaper” imports would then fill the void. If the United States was the initial trigger, Mexico (which depends on the United States for 80% of its exports and the bulk of remittances) and Canada (despite new post-Free Trade Agreement northern American) would be particularly affected. China could react by devaluing its currency more aggressively, although this is a double-edged sword given China’s external debt. This could trigger competitive writedowns in Southeast Asia.

Second, although the United States is a relatively closed economy, the deflationary return could be much larger than expected. A devaluation of the renminbi that hurts China’s balance sheets would challenge its commitment to US Treasuries just as the US budget deficit widens. With US mortgage rates factoring in long yields, this could come back to US households. And tariffs on importing countries would surely disrupt supply chains (already tested by transport strikes in the UK), as well as the capacity and cost of domestic companies that outsource their production. Installing chains elsewhere can be more expensive in a protectionist world.

Figure 3. QE in the 1930s was not – like today – short-lived

30-year US Treasury bond yield and 3-month US Treasury bill rate (both %)

Source: Refinitiv data feed

If so, restricting immigrant workers would limit the labor pool, contribute to hiring difficulties and skills shortages, and jeopardize something in short supply: potential growth. The National Bureau of Economic Research estimated in 2018 that undocumented workers threatened by Trump contributed 3% of private sector GDP. Yet, accounting for 9% of the value added of the agriculture, construction and leisure sectors, their relatively unskilled and low-paid jobs were not very attractive.

Third, the most direct vulnerability to protectionism is probably not in the United States (whose trade dependence is limited) and China (where dependence has declined), but in smaller, open economies. These include Southeast Asia (Malaysia’s and Thailand’s trade – exports plus imports – each exceeds 100% of GDP, Vietnam’s 200%, Singapore’s over 300%); Australia and New Zealand (40% and 44%); United Arab Emirates (162%); and Central Europe (Germany 89%, UK 55%, Netherlands 156%).

For other emerging markets, the prospects of a more protectionist scenario and a strong dollar would be less encouraging. Obvious vulnerabilities exist, such as non-commodity-exporting sovereigns with high exposure to short-term external debt and foreign savings needs, including Turkey, Argentina and Ukraine. For most of the others, external debt ratios are lower, with fewer monetary anchors to protect. And if domestic debt tensions build, they too can resort to quantitative easing.

So the question after 14 years of QE exceeding $25 billion is how major central banks normalize monetary dials without unintended consequences. Their inflated balance sheets suggest they cannot catch us off guard. If we look at the 1930s, US QE took place without interruption from 1937 until the effective independence of the Federal Reserve in 1951 (Figure 3). Now, with passive quantitative tightening, the Fed should normalize its balance sheet by 2025. But, if protectionism grows, that – and a return to historic policy norms globally – may be optimistic.

Neil Williams is Chief Economist, OMFIF.

This article will also be published in the next edition of the OMFIF Bulletin.

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