While in our small paradise we were worried about the depreciating rupee-dollar exchange rate that surpassed Rs. 160 last week, world attention was grabbed by something more shocking – the opening gunshots of a trade war between US and China. Looking at this more closely, however, we saw that there are peculiar policy mixes too in the two countries.
The US wants to see a “cooling down” of its aggregate spending through interest rate hikes. In contrast, China wants to see “heating up” of its own through bank reserve cuts. This means that US is on cool ground and, China on hot ground, when they enter the trade war.
From an economic point of view, all these are not isolated random events. While they bear important policy implications in both the US and Chinese economies, the rest of the world is not at all free from complications.
Let me elaborate about it in simple terms. By bringing Sri Lanka’s exchange rate into the picture, I haven’t diverted to an irrelevant issue; let us connect that too, into our main discussion.
US and China
The US and China are the two biggest economies in the world, producing about 40 per cent of world GDP; the US is producing 25 per cent of world GDP and China 15 per cent. Although the two countries are at different stages of development, they both are big enough to make a big impact on the world economy.
Both countries are important for the rest of the world as the healthy outlook of these two economies can sustain growth, investment, trade and jobs in the rest of the world. If the economies of the two countries are slowing down, there will be many reasons for other countries to worry about themselves.
Hit by the financial crisis in 2008/2009, the US economy was recovering gradually over the past few years. The policy makers do not want to see what is called “over-heating” of the economy in the recovery process.
Chinese economy, which was growing fast – thanks to its policy reforms in the late 1970s, started to slow down in the recent past. China is still a developing economy, in spite of its big size of the country with 1.3 billion people. Therefore, it needs to sustain its higher growth rate for a longer period.
Cooling down in the US
About two weeks ago the Federal Reserve Bank (Fed) decided to raise what is called the “federal fund rate” by 25 basis points to a target between 1.75 and 2.00 per cent. Federal fund rate is one of the monetary policy tools that the Fed can use to control the money stock in the US economy and, thereby all the interest rates in the economy.
The federal fund rate applies to overnight lending among banks on the basis of their excess reserves at the Fed. In fact, over the past three years, the Fed has been raising the federal funds rate gradually. Though seemingly a minor matter of some decimal points, it influences all interest rates to rise in the US and, then to bring about implications for the rest of the world as well.
Interest rate is one important determinant of aggregate spending. The US has already been an economy of which aggregate spending is more than what it could finance – a symptom of over-heating. It wanted to contain not only its over-heating, but also its habit of “over-eating” while maintaining a healthy growth rate and a moderate inflation.
When credit is cheap, or rather money is cheap with lower interest rates, aggregate spending is high. Therefore, interest rate – the price of money – is raised to contain aggregate spending. It makes less and less room for over-heating and over-eating.
There is, however, a limit for everything; you can’t keep raising interest rates without limits, as at one point it can be counter-productive hindering growth recovery.
Heating up in China
China did something contrary: The People’s Bank of China (PBOC) – the Central Bank-, earlier this week decided to cut the reserve requirement ratio (RRR) applied for some of the commercial banks by 50 basis points. The RRR, which is known here in Sri Lanka as SRR – statutory reserve ratio- is the reserve requirement imposed by the PBOC on commercial bank deposits.
In China, the RRR is as high as 16 per cent for large banks and 14 per cent for small banks. Reduction in the reserve requirement releases more funds for lending; as the PBOC announced, the RRR cut will release an additional Chinese Yuan 700 billion (US$ 100 billion) for lending .
In effect, there will be more credit available in the Chinese financial market at lower interest rates. In fact, China has also been practicing the reserve cuts for sometimes now, as its economy has slowed down.
Economic implications that are anticipated through a reserve requirement cut are contrary to what you see in the case of the US. More credit at lower interest rates will raise aggregate spending, stimulating economic growth. In fact, China’s problem was not “over-eating” but “under-eating”. Therefore, the policy makers have to encourage people to increase a “little bit more of the eating” so that the output growth can be accelerated.
The over-eating habit of the US has trade implications too, because part of the aggregate spending is for imports. The US’s largest import supplier is China which has supplied over $500 billion worth imports last year. The worry for the US is not that, but that its biggest bilateral trade deficit is also with China.
In fact, the US has a persistent trade deficit which is a clear indication that its aggregate spending is more than permitted by the level of income that it can afford to. On top of that, about half of its trade deficit is with China.
The US fired the first shot of the trade war by imposing a 25 per cent tariff rate on imports from China worth $50 billion – about one-tenth of total Chinese goods imported to the US. China retaliated doing the same with the same magnitude; it also imposed 25 per cent tariff affecting its imports from the US.
The imports that are subject to new tariff rates will be expensive in both countries affecting their users – the consumers and the producers. In the US, the new tariff affecting Chinese goods together with the domestic interest rate hike will contain aggregate spending, but at a higher cost. The higher cost will be paid by the users of Chinese imports.
In China, which needs stimulus for the economy, aggregate spending gets affected by the higher prices due to new tariffs on US imports. However, the burden of the tariff is cushioned by the reserve requirement cut that would ease aggregate spending.
The rest of the world will also have to feel the pinch of the trade war through higher prices and, a contraction in world trade. However, the war is just begun and, it is not yet clear where they are moving in the years to come.
Exchange rate issue
As the increase in the US interest rates occurred, portfolio investments in the rest of the world began to observe their domestic currencies depreciating. The dollar outflows in Sri Lanka too exerted pressure on short-term rupee-dollar exchange rate.
What is fundamentally important is, however, not the short-term fluctuations of the exchange rate, but its long-term movement. We can’t blame the US or Chinese economic policies for the long-term depreciation of Sri Lanka’s exchange rate over the past 40 years.
(The writer is a Professor of Economics at the Colombo University. He can be reached at email@example.com)