Originally published in The Australian.
Trade wars, populism, and geopolitics. The world is quickly becoming more fraught as complex forces threaten to disrupt and reshape the global economy in profound ways. In this context, the Lowy Institute launched the Global Economic Futures project aimed at better understanding this rapidly changing global economic landscape, where it might take us, and the key choices to be made.
The project examines the future shape of the global economy especially given rising tensions between the world’s two largest economies – the United States and China – and the possible implications for, and changing roles of, major regional economies, including Australia, India, Indonesia and others.
Originally published in The Australian.
After a week of turmoil following President Donald Trump’s decision to impose additional tariffs on imports from China, global markets are cheerful again. Shares are recovering and currency markets have stabilised. The bond rally is fading. No new retaliatory actions have been announced by either side, and it remains the plan (according to White House adviser Larry Kudlow) to convene the 13th round of China-US trade talks in Washington next month. Global economic concern has moved on to a sharp downturn in the German economy that has very little to do with a trade war between China and the US.
All good. But to the extent the financial market recovery reflects confidence that the US and China remain on a path towards a resolution of their trade dispute, it is likely to be very fragile. This is because the dynamic of the continuing trade squabble between the US and China has now changed in a way that makes it very much harder to conclude a deal.
Globalisation, the economic theme that has dominated economic policy making in most countries for the last half century, is at risk of reversal.
Before Trump’s decision 1 August to impose a 10% penalty tariff from next month on the $300 billion of imports from China not already covered by the earlier 25% tariff, the US and China were negotiating a package of concessions and enforcement mechanisms that could resolve the trade dispute. It has been a very difficult discussion, but at least it focused on the main issues in dispute.
Since the decision to impose additional tariffs from 1 September, however, the substantive negotiation cannot proceed without another ceasefire agreement between the US and China. There will have to be a negotiation to enable negotiations to resume. This is because if the US does indeed impose new tariffs on 1 September, China will quickly retaliate. It is difficult to imagine how the substantive negotiation would then resume somewhat later in September. After all, the negotiations resumed at the end of July only because the US agreed not to impose the threatened additional tariffs.
At the heart of the dispute is the same collision of incompatible demands that have been evident since the end of April. The broad package of measures on intellectual property, investment restrictions, and so forth appears to have been agreed, though there is still a wide gap on quite how much more China is prepared to buy from the US. But while China insists the penalty tariffs lifted as part of the deal, the US wants them to remain in place until China demonstrates that it is implementing its commitments.
Trump’s eruption on 1 August appears to have been provoked by this basic difference. Over the last year, China has cut imports of US soybeans by half. Trump expected more purchases of soybean and other US farm products in return for his withdrawal of the threat of additional tariffs at the June G20 summit. In line with its basic position in these talks, China appears to be insisting that any concessions it makes, including buying more US farm products, should be linked to the removal of tariffs – not to the withholding of additional tariffs.
If that interpretation is broadly correct, the US and China now have a three-week window to sort it out. Unless it is sorted out in those three weeks, there is a pretty good chance the substantive negotiations will not resume in September. If not September, there is every likelihood negotiations will not resume at all before the US presidential election in November 2020. Between now and then the dispute would wreak mischief in the world economy.
The obvious pre-negotiation agreement is for China to signal increased planned purchases of soybeans and other US farm products, while Trump finds reason to postpone the September deadline he set himself to impose additional tariffs.
Unless an understanding of that kind can be reached fairly soon, the recovery of financial markets over the last week or so is based on entirely false optimism and may be reversed when the planned September talks are suspended – as they well may be.
While optimism has returned, the sharp sell-off after Trump’s 1 August announcement was an emphatic reminder that this trade squabble is not routine or background noise in a world now concerned with more novel developments.
Equity markets evidently think it is still front and centre, and they are right. Very few disputes have the capacity to send global markets into a swoon. This one does – and for good reason.
If the economic relationship between China and the US continues to unravel, if they move further towards independence from each other, further towards hindering each other’s growth and success, then the entire idea of globalisation, the economic theme that has dominated economic policy making in most countries for the last half century, is at risk of reversal.
For financial markets transacting across the world, themselves the product of this globalisation, this is not just another event risk. Given a sufficiently serious, prolonged, and deepening dispute, global financial markets would not be able to act in the way they do. That is why equity markets sold and bond markets rallied after the plan for additional tariffs was announced. It was a useful reminder of what will happen if the talks really do break down and usher in new rounds of retaliatory measures. Both sides will have taken note.
The United States has labelled China a currency manipulator. The move sent shock waves through markets early this week and left many speculating what may come next.
Trump has repeatedly called for lower interest rates and a cheaper currency to help him win his trade war with China (and the next US election).
Most recognise that while China engaged in extensive currency manipulation in the past, it is no longer doing so, even by the US Treasury’s own standards. In fact, in recent years China has if anything been acting to prop up the value of the renminbi, after destabilising capital outflows were experienced in 2015 and 2016. For similar reasons, China truly “weaponising” the renminbi is highly unlikely. The risk of prompting renewed capital outflows is a bigger threat to China’s economy than Trump’s tariffs.
True, the renminbi has breached 7 to the US dollar – a level the People’s Bank of China (PBoC) had previously acted to defend. But there is nothing magical about the 7 marker, a point PBoC governor Yi Gang has made publicly. Weighted against its major trading partners (which provides a more holistic view), China’s currency has weakened in the last few months but is still close to where it’s averaged since 2016, suggesting no great misalignment. Trump’s tariffs also imply some depreciation of the renminbi is to be expected as the Chinese economy adjusts to weakening exports.
It is also well-recognised that designating China as a currency manipulator by itself carries limited direct implications. US Treasury Secretary Steven Mnuchin will now take Washington’s case to the International Monetary Fund (IMF). But the IMF has already very recently concluded that China is not manipulating its currency and in any case would only launch its own consultations with China if it found that it was. Other measures the US might adopt include denying Chinese firms US government contracts and taking currency manipulation into account in trade negotiations.
In other words, the designation itself lacks teeth.
Nonetheless, the move to label China a currency manipulator is significant. First, it will provide political cover for Trump’s tariffs and perhaps other forms of escalating economic conflict. Second, Beijing’s decision to allow, rather than resist, movement beyond 7 to the dollar would appear to reflect a willingness to antagonise Trump (given his predictable reaction) and therefore also engage in escalating economic conflict even if it is not actually weaponising the renminbi itself.
What if Trump does in fact try to directly counteract China’s alleged currency manipulation? One possible avenue for doing so would be for the US Treasury to begin implementing countervailing currency intervention – an approach suggested by economists at the Peterson Institute for International Economics for use in response to actual currency manipulation. This would work by purchasing Chinese yuan denominated assets to bid up the value of the renminbi and cancel out the effects of any currency manipulation by Beijing.
But if China hasn’t been manipulating its currency lately (which the Peterson economists agree it has not), then, rather than combatting manipulation, the US would instead be acting as a currency manipulator itself. The US would simply be seeking to push down the dollar to gain a competitive advantage. Not only would this be hypocritical but, if successful, it could also prove highly destabilising to the global economy. The political whims of the US President would now be trying to dictate the value of the world’s reserve currency upon which most global trade and cross-border finance is anchored, and to which global investors flock in times of uncertainty.
It would also raise big questions about the sustainability of America’s persistent current account deficits and the willingness of the world’s investors to continue financing this, and in doing so granting the US the “exorbitant privilege” of borrowing as much as it wants in its own currency.
The US Federal Reserve would also be left in a bind. Trump has repeatedly called for lower interest rates and a cheaper currency to help him win his trade war with China (and the next US election). Fed chair Jerome Powell has repeatedly asserted the Fed’s independence. But the more a populist American president destabilises the US and global economies, the more a technocratic Fed feels compelled to offset this by lowering interest rates. A perverse relationship that unfortunately seems destined to continue.
Ultimately, if Trump wants a weaker dollar and shows he is prepared to act, then there will be little stopping this from becoming a reality. Afterall, who would want to hold the US dollar then?
While President Donald Trump’s bull-in-a-China-shop approach to reforming international trade doesn’t appeal, it is possible that some of his objectives might make sense. This was the logic behind comments by former Barack Obama adviser Daniel Russel, suggesting that Australia should join the US in opposing “unfair and predatory economic and commercial practices that we have seen for so long by the Chinese”, such as intellectual property theft and lack of reciprocity in trade.
While a united approach strengthens any argument, we may not agree on just what deserves to be included in the reform agenda. Reforming and reinvigorating the World Trade Organisation might be a good place to start. But reinforcing US objectives on intellectual property (IP) might be problematical.
It is worth remembering that when America was at the same stage of development that China now is, it copied English cloth-weaving technology without paying IP royalties and its citizens read English books (famously, Charles Dickens) without paying copyright.
The current IP system is a very imperfect way of encouraging and rewarding innovation. The patent and copyright framework has been so distorted by vested interests that the main beneficiary may be the army of patent lawyers and the legal process which support them.
The current framework offers incentive for future innovation by providing past innovators with a monopoly – and monopolies are never first-best economics. We are still giving copyright protection to Mickey Mouse, long after the creator died. Trivial inventions (e.g. single-click internet purchases) were given legal protection. Pharmaceutical patents are “evergreened” to extend their life by minor tweaks of the formulation.
It is worth remembering that when America was at the same stage of development that China now is, it copied English cloth-weaving technology without paying IP royalties and its citizens read English books (famously, Charles Dickens) without paying copyright fees.
Times have moved on, and China should pay legitimate IP charges, but before we get too righteous about China’s predatory actions, we might recall that we are promoting an imperfect system which is heavily weighted in favour of IP owners such as the US, and against countries which are predominantly IP users such as China and Australia.
What about demanding reciprocity on trade? Until now, it has been accepted that developing economies are not required to be as pure in open trade as advanced economies. As China’s manufacturing technology is now on a par with advanced economies, pressure for greater openness is legitimate. But is China a greater offender than, say, India – a chronical laggard in openness?
The fundamental element which stands in the way of cooperation with the Trump trade agenda is his bilateral mindset, while Australia’s interests are overwhelmingly multilateral.
With resumed contact between US trade negotiator Robert Lighthizer and China’s negotiator Vice Premier Liu He, the 12th round of trade talks between the US and China may take place in Beijing before the end of July. But the clock is now ticking very loudly. Contrary to the messaging from Beijing and Washington, both US President Donald Trump and China’s President Xi Jingping need a deal – and they need it soon.
Trump knows that, with a deal, China will buy more than a trillion dollars in additional exports from the US. Other than the corporate tax cuts in 2017, it would be the biggest policy win of his first term. Without a deal American consumers will be hurt by the extension of 25% tariffs to another $325 billion imports from China, this time on the kind of household goods where voters will notice higher prices. American farmers will be hit again by reduced exports to China.
In a typical trade negotiation, the two sides would at this point be looking for compromises.
For his part Xi needs a deal not only because US tariffs are hurting China’s exports, but also because he knows that the longer this quarrel continues the more China-based manufacturers for the US market will have to move production to Vietnam and Malaysia.
Both know that unless there is a deal by the end of the year, the talks will be hostage to an unpredictable US presidential election campaign. Trump’s opponents, Democrat and Republican, portray themselves as even more hostile to China than the President, constraining his freedom to accept a deal.
Both also know that continuing the trade quarrel is of no advantage to either side. In the first five months of this year China’s goods exports to the US were down 12% compared to the same period last year. US goods exports to China were down even more, by 19%. The US bilateral trade deficit with China accordingly increased. That is not what the White House had in mind in initiating the quarrel a year ago.
If this chance of a deal passes it will be a long time before there is another. By then the quarrel may be very much harder to resolve, and the impact on the global economy more damaging and more extensive. On a new round of talks, therefore, much depends
The problems are formidable but not insuperable.
The US wants a deal in which China buys at least $200 billion a year more in imports from the US, while signing up to tighter rules on intellectual property, foreign investment and trade related subsidies. For its part China can can go along with much of what the US wants but in return wants the 25% penalty tariffs imposed on $250 billion of China’s exports to the US removed. China probably also wants the US to pull back on sanctions on China’s high technology businesses, such as Huawei.
As I argued in a Lowy paper last month (Averting a global calamity: Trump and Xi at the G20), despite the generally pessimistic assessment in both Washington and Beijing, the surprise of the 11 negotiating sessions so far is how close to final agreement the two sides now are. Visiting them in Beijing, analysts and officials had little to say about the issues everyone discussed a year ago – intellectual property protection, forced transfers of intellectual property, investment rules or tariff levels (other than the penalty tariffs each has imposed on the other). The issue of subsidies is unclear but otherwise the substantive issues are agreed, or close to agreement. They are covered in the draft agreement presented by the US side in April. Importantly, earlier US demands, impossible for China to accept, appear to have been dropped.
On some of the issues in dispute China has already moved. The March National People’s Congress for example legislated to give foreign firms equal access to incentives as domestic firms (“national treatment”), to tighten intellectual property protections, and to replace discretionary approvals of foreign investment with a list of those industries in which foreign investment remains barred (a “negative list”).
The remaining big disagreements in the trade negotiation are about enforcement. China wants the penalty tariffs removed with the agreement; the US wants to keep them on until it is satisfied China is observing the agreement. China is willing principle buy an additional $200 billion in imports from the US each year, but not until everything is agreed – including removing those penalty tariffs imposed by the US on China over the last year. The US is said to want China’s commitments legislated by China; China says it will make its laws, not the US. They are important disputes, but are they so intractable they can prevent a final agreement both sides need?
In a typical trade negotiation, the two sides would at this point be looking for compromises. For example, in the deal China might agree to buy an additional $200 billion plus from the US each year, for a minimum of six years, but perhaps not reaching the maximum annual rate until all US penalty tariffs are removed. The US might agree to remove penalty tariffs, on a schedule which would see them removed completely within a year or so. During that period China would implement requirements of the agreement. Meanwhile the US would not impose further tariffs. Huawei would as today be denied only those US products relevant to national security.
It will be able to win very specific and public assurances but the US must be aware it is unlikely to win a right to approve or disapprove China legislation implementing any agreement. No serious nation could accept this. When the US asked to inspect Australia’s proposed legislation implementing the 2004 US-Australia free trade agreement before it had been submitted to the Australian parliament, the Howard government refused.
If there is to be a deal at all before the presidential race takes over, it needs to be in place when Trump and Xi meet at the APEC leader’s summit in Santiago, Chile, in mid-November. A meeting between the two leaders on the sidelines of the UN General Assembly in September could help push things along.
Recognition of the need for greater government intervention in the economy is increasingly shaping the US political debate, with this shift paralleled among prominent economists.
The race is on to see who will take over as Managing Director of the International Monetary Fund (IMF) following the nomination of the incumbent, Christine Lagarde, as President of the European Central Bank (ECB).
Will the informal gentleman’s agreement between Europe and America that has prevailed since the creation of the Bretton Woods institutions in 1945, and sees the IMF headed by a European and an American leading the World Bank, continue? Almost certainly. This, notwithstanding pressure that the governance structures of these international institutions should change in line with developments in the global economy, particularly the rise in importance of emerging markets.
Much of the commentary is about the candidate’s nationality rather than the relative attributes they would bring to the position.
Speculation over who will take over from Lagarde has produced a Melbourne Cup field of contenders. The prevailing view is that it will again be a European. The gentleman’s agreement continued with the recent appointment of an American, David Malpass, as President of the World Bank and as such it is assumed that America will not rock the boat and will support a European for the IMF position.
The European contenders include Mark Carney, the outgoing Governor of the Bank of England, who is a Canadian citizen but holds an Irish passport. Another is Benoit Coeure from France, a member of the Executive Board of the ECB. Still others include Mario Draghi, an Italian and the outgoing President of the ECB, Kristalina Georgiva, a Bulgarian who is currently Chief Executive of the World Bank, French Finance Minister Bruno Le Maire, former UK Chancellor of the Exchequer George Osborne, Jens Weidmann, President of the German Bundesbank, and Dame Minouche Shafik, an Egyptian born British/American who is the Director of the London School of Economics. There are many others.
Non-Europeans are being mentioned as possible candidates, too. Agustin Carsten is one such name, a Mexican who is General Manager of the International Bank of Settlements. Also mentioned is Tharman Shanmugaratnam, Chairman of the Singapore Monetary Authority and Senior Minister, and Raghuram Rajan, former Governor of the Indian central bank. Again, there are many others.
In discussing the chances of possible candidates, much of the commentary is about their nationality rather than the relative attributes they would bring to the position. For example, the focus has been on such nationality matters as: is Carney sufficiently European because he obtained an Irish passport (as did many UK citizens following the Brexit vote)? Or can another French national (Coeure or Le Maire) get up given the previous two Managing Directors came from France? Or can a candidate from central Europe (Georgiva) gain sufficient support from the rest of Europe? Or is a UK national (Osborne) a realistic European contender given Brexit? Draghi’s problem is his age, at 71 he is over the IMF age limit.
As for the non-Europeans, the main handicap is that they are not European. Emerging markets have a very poor record in supporting an emerging market candidate. When Dominique Straus-Khan stepped down as IMF Managing Director in 2011, there were two candidates, Lagarde and Carsten. Carsten did not receive endorsement from emerging markets other than Mexico, and Australia and Canada were the only major economies to support him. It is hard to see the emerging markets getting behind one candidate this time.
While the political jockeying is well under way, the IMF continues with the fiction that there will be an open and merit-based selection process. And the IMF Executive Board continues with the fiction that it will play a decisive role in making the selection.
Against the background of long-standing angst that the governance processes of the IMF needed to be reformed, the Executive Board announced in 2016 that it had adopted an open process for selection of the Managing Director where individuals may be nominated by Fund Governors or Executive Directors, the Executive Board would draw up a short list, and the candidates would be interviewed by the Board to assess their relative merits. The Board would then make a selection, either by consensus or majority vote. Sounds good in theory, but it is irrelevant as to how the next Managing Director will be chosen. The backroom political deals will be done well before the Board gets involved.
To state the obvious, the aim should be to determine who is the best suited for the position, because it is a tough but important role. Chris Hafner from the professional services firm Grovelands, says the new Managing Director has to be “a tremendous communicator both politically and in the media, and able to take a far sighted view of markets and fiscal policy”.
Lagarde is widely considered to have been a successful Managing Director, although she has some critics. Peter Doyle, a highly critical former IMF employee, says her successor will have to deal with the messes she leaves behind, in particular a US$56 billion IMF loan to Argentina. In his view the criteria for the next IMF head should be “no European, no politician, no amateur”.
While the IMF has many shortcomings, Lagarde has demonstrated that its head has to have well-honed political, diplomatic and communication skills and be someone with a significant international presence. The Managing Director is afforded head of state status and must go toe-to-toe with the leaders of the major industrial economies, emerging markets and the smallest and poorest economies as well have the skills to build a consensus in very difficult circumstances.
Among the crop of potential candidates, the one best suited and with the required international status is Mark Carney, former Governor of the Canadian Central Bank, former Chair of the Financial Stability Board, and current Governor of the Bank of England. Should he get the position, it would be unfortunate if this was seen as being mainly because he was technically a European and this was the best chance of Europe maintaining its hold over the position. Conversely, it would be unfortunate if it was seen as maintaining the gentleman’s agreement that the IMF head should always be a European. That said, Carney would make a very good IMF Managing Director.
With forecasts of a slower global economy, central banks around the world are contemplating easier monetary policy. The problem is that monetary policy is already in “easy” mode and has been that way for a decade. This presents serious constraints on just how much more monetary policy can do. Other policies are needed.
The Bank for International Settlements (BIS, the central bankers’ club in Basel, Switzerland) has explored the quandary in its just-released annual report.
The conventional monetary instrument – short-term interest rates – is already close to zero in Europe. Even the United States, where the Federal Reserve funds rate is around 2.4%, doesn’t have much flexibility to move before it, too, runs out of room. In past recessions, interest rates have typically been moved down by around 500 basis points – in 2007, from over 5% to almost zero – and this shift isn’t possible now.
In any case the constraints go beyond the problem of the “zero lower bound”.
There is the commonly held view that monetary policy works more effectively in constraining expansion than it does in stimulating slow growth – in expansionary mode, it is “pushing on a string”. This is, of course, an over-simplification. The bold use of monetary policy after the 2008 global crisis was effective in preventing a repeat of the 1930s depression and fostering the recovery. But this experience also demonstrated that context matters: the expansionary setting of monetary policy had to battle against strong headwinds, as households and companies were constrained by their damaged balance sheets. Fiscal policy was also in austerity mode.
In short, monetary policy may be less effective in current circumstances, not because of some intrinsic weakness, but because the context in which it is operating is unhelpful. At present, for example, lower interest rates may not be powerful because consumers and businesses have used the low rates of the past decade to expand their borrowing, and many are now facing leverage limits.
There is, however, a more powerful argument against unusually low interest rates, especially if maintained for a long period. Monetary policy works by setting the short-term interest rate below the equilibrium market-determined rate. This creates distortions which are generally helpful when the economy is weak, by bringing forward expenditure decisions. But if maintained for an extended period, the beneficial effect weakens, so that expenditures brought forward “leave a hole” in future expenditures. Low interest rates encourage excessive risk-taking, facilitating projects which are not viable when interest rates return to normal. “Zombie” firms remain in business, so resources don’t shift to better uses.
As evidence of these enhanced risks, there is mounting concerns about leveraged loans and the increased proportion of BBB-rated paper in bond-fund portfolios, only one downgrade away from no longer being eligible as “investment grade”.
Intuitively, the sort of zero or sometimes negative interest rates now seen in Europe don’t make much sense. Negative real (i.e. inflation-adjusted) interest rates are widespread. The doyen of economic textbook writers, Paul Samuelson, once remarked that if real interest rates were zero and expected to remain so, it would pay to flatten the Rocky Mountains to reduce transport costs.
In short, there isn’t much room to lower interest rates, and in any case, doing so has dubious benefits.
In short, there isn’t much room to lower interest rates, and in any case, doing so has dubious benefits.
If interest rates have done all they can, what about the “unconventional” monetary policy which Europe, America and Japan used over the past decade? There are still controversies over quantitative easing (QE): former Federal Reserve Chairman Ben Bernanke, who initiated this policy in America, said (in jest, to be sure) that “QE works in practice but not in theory”. Opinions differ, but the general view is that it did, indeed, work in practice to lower longer-term bond yields, which should have encouraged expenditure. At the same time, the common view is that it is an unreliable instrument, with its effectiveness depending on context.
A deeper concern is that QE fuzzes the border between monetary policy and fiscal policy. At the same time that the Fed has been buying long-term bonds in its QE operations, the US government has been running big budget deficits, funded by bond sales. These decisions are institutionally separate, so it can’t be said that this is “monetising the deficit” – with its long-held concerns about unconstrained budget profligacy. But QE has succeeded in keeping bond yields very low, emasculating the “bond-market vigilantes” who pressured then president Bill Clinton into budget restraint. Donald Trump clearly feels no compunctions about pressuring the Fed to lower interest rates, so Fed independence is under threat, and a readiness to return to QE leaves the Fed vulnerable.
The BIS is a cautious institution, so its advice is hedged and nuanced. The message between the lines is that interest rates are already unusually low. The BIS sees a case for “normalising” policy – i.e. returning to equilibrium, but for the moment, given the fragility of the global economy, interest rates should be held steady. If they are lowered further (as seems quite likely) macroprudential policy needs to be active to avoid this leading to financial instability.
Given this message that monetary policy can’t do much more, the BIS steps outside its narrow central-banking remit to recommend that countries with fiscal space (i.e. not weighed down by excessive public debt) should use fiscal policy if the economy slows. Reprising Samuelson, they might have said this is a great moment to issue long-term public debt at essentially zero real interest rate, to fund projects which increase productivity – but maybe this doesn’t include flattening the Rockies.