By Ellie Westhorpe
Since July 2017, both the U.S and China have been locked in an escalating trade battle as the two largest economies fight for world dominance. Rather than trying to diminish trade barriers worldwide, Trump’s administration has worked to seal the United States behind vast protectionist measures, imposed by Trump’s new nationalist agenda. In his 2016 campaign, Trump had announced that he would be targeting his major trading partners in an attempt to crack down on what he called ‘trade abusers’. He repeatedly claimed that the United States was ‘being taken advantage of by its trading partners‘ and commented on how the ‘bad trade deals were to blame for the loss in jobs and deepening trade deficits‘, which the U.S economy had been experiencing. The countries in which he decided to target included Canada, Mexico and the EU, along with China being his main focus.
Long before he became President, Donald Trump, had accused China of using unfair trading practises which deliberately devalued its currency; the Renminbi, though China has railed against this. Trump’s anti-China agenda has been driven not only by his economic concerns about the U.S trade deficit but also by his belief that China poses great threat to the U.S economy. This had come about after Trump had accused China of stealing intellectual property from American firms, forcing them to transfer technology to Chinese businesses. According to the presidents administration, it was as a result of these actions which caused its trade balance deficit with China to reach $375 billion in 2017
Over time, tensions have grown strong and in 2018, Trump had ordered for two rounds of tariffs to be imposed on billions worth of Chinese imports, in an attempt to shield the domestic market from Chinese competition and push China towards a new trading agreement. These tariffs totalled to a hefty sum of $250 billion and in response led to the implementation of retaliatory tariffs by Chinese officials on $110 billions worth of U.S imports.This year-long ‘U.S-China trade battle’ has followed similar patterns to that of the 1980’s U.S trade dispute with Japan, however the difference being that the previous trade friction did not turn into a full blown trade war like the one we have seen today.
To help clarify, a trade war is an ongoing dialogue between two nations in which each country tries to undermine the economic prowess of the other. Trade wars are seen as protectionist dealings, which are conducted by implementing tariffs and duties onto the imports of foreign goods. Higher taxes on incoming foreign products, make them more expensive relative to the goods found in the home market, this gives a price advantage to local businesses, allowing them to thrive from increased international competitiveness.
China’s secret weapon?
China has begun running out of solutions in order to combat the protectionist measures placed by Trump’s administration. New figures have shown that China had reported a quarterly current account deficit of US$28.2 billion in March 2018 – it’s first current account deficit in nearly 17 years. As Beijing does not buy nearly enough goods compared to what the U.S import, they cannot impose tariffs on an equivalent volume of U.S products. With U.S tariffs set to escalate even further and the Chinese economy experiencing a vast economic slowdown, China has been looking at other ways to gain back its competitiveness.
China’s monetary policy has come at the forefront this past year as China begins to loosen both its monetary and fiscal stance in attempt to preserve its current account surplus. Though, Chinese officials have repeatedly vowed that they would not use the renminbi as a retaliatory weapon. Data has shown, in the wake of Trump’s tariff operation, the renminbi has devalued once again. Unlike the U.S government, the People’s Bank of China directly exerts control over the value of the renminbi’s exchange rate, in order to maintain macroeconomic stability. Each day the PBoC sets the RMB exchange rate and allows it to trade in a 2 percent band around this target point. With enormous control over its currency, some may argue that Beijing has found a way to alleviate the impacts of the American duties by intentionally letting its currency slide to 6.91 against the U.S dollar, as seen in October 2018.
This poses great concern as to whether China could ‘turn this trade war into a unwelcoming currency war‘ as stated by economist, Brad Sister of U.S Foreign relations.
Theoretical approach to China’s devaluation
To help explain how a renminbi devaluation will help China to gain back its competitiveness, we can look towards an elasticity approach to the Balance of Payments, known as the Marshall-Lerner condition. This theory provides an analysis of the impacts to a country’s current account balance, due to changes in its exchange rate. In this theory, the Marshall-Lerner condition states that an exchange rate depreciation will lead to an improvement in the country’s current account balance, only if the sum of the demand elasticities for exports and imports is greater than unity (>1). To help make this clear, the elasticity of a country’s exports and imports is the responsiveness of their quantity demanded to a percentage change in their prices. If this condition is not satisfied (<1), the country will then face a current account deterioration, which will likely lead to a worsening of its trade balance.
Marshall-Lerner Condition : 
The equation above denotes the Marshall-Lerner condition in which CA signifies the current account balance, S is the exchange rate, M is a country’s imports, X is a country’s exports and is the elasticity of demand for both exports and imports.
The central idea of this theory is that there are two direct effects of a currency devaluation on a country’s current account balance. The first property is said to be the price effect of a devaluation, while the other is said to be the volume effect. In order for the condition to hold, the volume effect must exceed that of the price effect, so that the fall in export prices drives up an increase in the volume of exports, while the increase in the price of imports will lead to a fall in its volume of imports. This will subsequently improve a country’s balance of trade and its competitiveness.
When looking at data provided by the ‘trading economics’ website, we can see that China’s current account balance had deteriorated to -$34,100.05 USD billion, after the first round of U.S tariffs were announced in March 2018. This saw China reporting its first current account deficit in over a decade, as its export prices inflated to 103.2 from a 98 index, the previous month. This led to China’s import volumes exceeding that of its export volumes (1739.09 USD HML < 1796.78 USD HML), as the price of Chinese exports in foreign currency became more expensive. This led to a worsening of China’s current account balance, which we have made evident.
Nevertheless, we can see from the graph that this current account deficit was short-lived, as China retaliated with a currency devaluation, in order to gain back its international competitiveness. This depreciation saw the renminbi weaken from 6.321415(USD) in March 2018 to 6.466318 (USD) a quarter later, which had facilitated an improvement in China’s current account balance to $53.29.00 USD billion in June 2018. This fall in export prices to a 100.2 index, led to China’s export volumes increasing to 1989.45 USD HML in April 2018, which triggered a reversal in China’s current account balance back to its renowned trade surplus- as stated by the ML condition.
The data has therefore shown an improvement in China’s current account balance, however when observing a further depreciation of the renminbi to 6.855803 in September 2018, the adjustment in China’s trade balance was relatively insignificant.
We can therefore look towards an extension of the ML condition, known as the J-curve effect.
This phenomenon refers to the initial deterioration of a country’s current account balance as a result of slow adjustments in its trade volumes, following a devaluation. These slow movements are said to be as a result of time lags in both consumers and producers responses to the currency devaluation or may be likely due to the heighted uncertainty associated with Trumps protectionist agenda.
As this trade dispute is only in its early stages, we cannot say for certain if this depreciation has satisfied the Marshall-Lerner condition, as this is a long-run conception. Future data may prove that China’s deprecation has helped gain back its international competitiveness. However, we are likely to see China’s current account disappear if Trumps tariff operation persists. This has been predicted by Antony Mueller in his blog ‘ Are China’s High currency reserves a threat to the United States’.
Do tariffs impose more harm than good?
It has been made clear, that the tariffs imposed by Trumps administration have not been as effective as they have initially set out to be. This had come about after the tariffs levied on China’s import prices had been offset by a weaker renminbi, leading to the balance of trade deficit between these two countries reaching -$419,162.00 US Billion in 2018.
We therefore have to question whether these tariffs are causing more harm than good to the U.S economy?
In spite of what Trump had tweeted in August 2018, recent data has proven that Trumps tariff operation has caused more damage to the businesses and industries in which they were meant to protect.
In a report by the National Bureau of Economic Research, found that ‘After accounting for higher tariff revenue and gains to domestic producers from higher prices, the aggregate welfare loss to the U.S economy was $7.8 billion‘.
Though, tariffs in theory are used as an expenditure-switching intervention, which would allow the domestic economy to benefit from better terms of trade, tariffs are in fact likely to cause more harm to the country’s overall competitiveness, as tariff costs are passed down to consumers through higher prices.
Not only this, but a weakening of China’s currency risks the possibility of a ‘contagion effect’, which would likely see a cascade of other trade distortions globally. Pressures are already being felt by other major currencies, like the Euro, as they begin to follow similar patterns to that of the renminbi. The threat of China experiencing a prolonged economic slowdown will likely lead to a disorderly slump in the growth of emerging countries, as they rely heavily on the economic giant, for their export trade. Therefore an ongoing dispute between these two countries is likely to see a dampening of emerging-market growth, which is it forecasted to slow to 4.5 percent in 2019.
With trade talks set to resume this week, it is time for the U.S president to end his short-sighted protectionist agenda and agree upon a suitable trading agreement with its largest trading partner. Though, Trump himself has reassured the world that the two countries are ‘very close’ to a final agreement, he has made clear that the U.S will remain with its protectionist stance, until China proves itself as a strong ally. Failure to achieve a trade deal would likely see the U.S more than double its current level of tariffs on Chinese imports, leading to further economic ramifications on global trade and governance.
In conclusion, I understand that it is expected of a country to protect its global competitiveness, but an escalating trade battle between the world’s two largest powers is no way likely to benefit anyone.
This blog post was originally written by Ellie Westhorpe as an assessment for the Third Year module International Macroeconomics. It has been reposted on the School’s Blog with the authors consent, only minor editorial changes have been made. The original blog can be viewed here.
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