The global economic outlook significantly worsened over the last week with no clear sign of reversal. The US designated China as a currency manipulator after the Chinese yuan depreciated past seven to the US dollar. The underlying reasoning is that China is manipulating its currency to help exporters. Earlier, as the possibility of a trade truce faded, along with the emergence of reports that Chinese firms have been asked to not import agricultural products from the US, President Donald Trump announced tariffs on an additional $300 billion worth of imports. The rise in trade tension resulted in a wider sell-off in risk assets. Stocks and emerging market currencies declined.
Although China has used its currency to push exports in the past, it is difficult to argue that the Chinese government intends to do the same thing even now. Other things being equal, slower growth and lower exports, partly because of higher US tariffs, are likely to weaken the yuan. Also, it is not in the interests of China to significantly devalue its currency at the moment. While a weaker yuan will indeed help exporters, it will affect plenty of businesses that have piled up foreign-currency debt over the years. In fact, China burned reserves worth about a trillion dollars defending its currency after the 2015 devaluation. A significant depreciation at this juncture could result in capital flight and complicate macroeconomic management.
The focus on currencies with increasing tariffs on imports from individual countries reflects the basic problem with the Trump administration’s view of global trade. China is not alone. Mr Trump has accused the European Union, too, of currency manipulation. The distorted view of the world’s largest economy will only increase uncertainty and impede global growth. For instance, risk aversion in the global financial system and the safe-haven demand have pushed up the Japanese yen. A stronger yen can complicate economic management in Japan. But an effort to intervene in the currency market could attract the wrath of the US.
The International Monetary Fund reduced its growth forecast for developing and emerging Asia largely because of the impact of tariffs on trade and investment. The trade tension is also affecting the US. For instance, as the Federal Reserve Bank of Atlanta has shown, investment in manufacturing declined by 4.2 per cent in 2018 because of trade tension. The Federal Reserve recently reduced interest rates for the first time since the financial crisis and markets expect it to cut rates further. Trade tension is being seen as a major risk to the current economic expansion in the US.
This has implications for India as well. For instance, Mr Trump has targeted India for higher tariffs. Also, India has not done well to increase tariffs on a range of items in recent years, including in the last Budget. Aside from bad optics, it is not in India’s interests to increase tariffs. The trade-related problems will affect India through both the financial markets and trade channels. India will need active policy intervention to avert adverse consequences and capture possible opportunities, such as attracting firms that are moving out of China. Regrettably, India is not well prepared to deal with the changing global economic environment. The absence of policy adjustment would exacerbate the slowdown.