The current trade war may do to India what US-Japan conflict of 1980s did to China

The current episode of trade war, the US administration is seeking to raise tariffs on imports from countries which run a trade surplus with the US. China being the largest trade surplus country with the US is at the centre of the conflict.

In the post-Cold War era of past three decades, the world has largely been unipolar, mostly dominated by the US.

China has laboured hard for over five decades, since the beginning of cultural revolution in 1966, to emerge as a potent global force. In the past three decades it has subsidised the global economy by providing cheap labour and capital. It has funded a large part of the US and EU fiscal deficit by investing in their treasuries, which in turn has kept global markets afloat during the global financial crisis. It also helped the developed economies in protecting their environment by letting them relocate most of their polluting industries to China.

There is no surprise if China now seeks to move into higher orbit by asking to be treated at par with developed countries. To meet this end, it has cracked down massively on polluting industries by shutting huge capacities. Tightened financial regulations and committed more access to its markets.

The US obviously finds its hegemony challenged, and making efforts to protect its dominance. Besides, the incumbent US leadership also has a large constituency to please for his re-election in 2020. This constituency desires protection from cheaper Chinese imports, local manufacturing growth and larger market for US agriculture produce.

In my subjective and mostly intuitive view, this war will open the way forward for the world saddled with mountains of debt, sitting on the verge of environmental disaster and struggling for growth. The war if escalated will rebalance the global equilibrium and open opportunities for many emerging economies. To the question, whether the gains will happen without pain, I must answer with an emphatic NO.

Nonetheless, I feel India may actually emerge winner in post trade conflict. It is pertinent to note the outcome of US-Japan trade conflict in 1980s.

In the 80s, the US had massive conflict with Japan as trade deficit of the US with Japan increased to over 80 percent of total deficit. This was higher than the current deficit with China.

In September 1985, Japan signed Plaza Accord with the US to settle the dispute. This deal was signed after the US threatened to impose 100 percent import duty on Japan. The US also had alleged that Japan had stolen technology from it. Key market reactions to Plaza Accord were as follows:

Japan let its currency appreciate. This led to sharp rise in JPY vs USD.

Appreciation of JPY led to property bubble and stock market bubble in Japan. This eventually collapsed in early 90s which was followed by 20 years of bear market.

The US stock market did quite well from 1985 onwards led by IT sector. October 1987 crash of Dow was only big drawdown following Plaza accord.

China replaced Japan as the big exporters to the US.

Now the question is how will China react under the current circumstances?

China may further devalue currency to mitigate hikes in imports duty by the US. This implies worsening of trade conflict and is unlikely.

China undertakes structural reforms which will be good for it in the long term. These include (1) allowing capital account conversion; (2) make economy less reliant on exports.

China has already seen significant reduction in trade surplus. It will certainly see massive capital inflow if it cuts restrictions. These reforms in fact would be the current equivalent of the Plaza Accord.

There is greater chance of this scenario emerging, without the damaging impacts of the Plaza Accord, like the property bubble in Japan, assuming that China shall learn from Japan's mistake and will successfully avoid them. Though, it may mean that China will be less accommodative than Japan was in post Plaza Accord period.

In the worst case, if a global recession does ensue, the failure of trade resolution talks, the fear is that India and other emerging economies may suffer as global capital would seek refuge in safe havens. However, this fear of ‘risk off’ may be premised on wrong notions.

Higher import duties could lead to some rise in US inflation and put pressure on Fed to hike interest rates. However, this looks highly unlikely, since the worst anticipated negative impact is seen as 50bps on US inflation. This will be still below the normal level. Moreover, if rise in duties and consequent fiscal improvements lead to stronger US dollar and lower global commodity prices even 50bps rise in inflation may not materialise.

Another, strong view in the market is that the US administration is raising the trade war tempo just to cloud the growth outlook and keep US Fed, and perhaps ECB also, on the path of easing monetary policy. An adjustment in policy stance and a new episode of quantitative easing shall automatically slow down the trade rhetoric.

We in India therefore need not worry a lot about the ongoing trade conflict. For, this may enable us to establish a strong manufacturing base that has eluded us for the past seven decades. We may get to share a larger pie of manufactured export to developed countries especially the US. Implying that this trade conflict may do to us, what US-Japan conflict of 1980s did to China. But remember, availing this opportunity shall require much more than tax rate cuts and rhetorical ease of doing business improvement. A serious change in the mindset of entrepreneurs, policy makers and most notably bureaucrats, is a prerequisite.

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