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Donald Trump’s protectionism depends on the dollar

Donald Trump put ‘America First’ front and centre of his pitch to business elites at the World Economic Forum in Davos last week. WEF is a club for business leaders, financiers and politicians who mostly share a suspicion of nationalism and a belief that globalisation is good. But Mr. Trump, surely knowing this, went to sell his country.

“America is open for business and we are competitive once again.” He praised his administration’s efforts in cutting taxes, slashing regulations and renegotiating trade agreements. The results, he boasted, were billions of dollars of announced investments in the United States.

However, competitiveness in international markets can also arise from a cheap currency. The US President didn’t mention this anywhere in his speech, but one had the impression that if his other policy proposals fall flat, the option of pushing down the dollar would be the last resort in his fight against so-called unfair trade.

At face value it seems that movements in the US trade balance have had little to do with the real effective exchange rate (REER) in recent times, as the chart below shows. To improve the fit of the two series, we would need to lag the real exchange rate by three years, but it’s implausible that it takes that long for businesses to react to changes in the real exchange rate.

There will never be a perfect relationship between REER and the trade balance, especially the US trade balance, for a number of reasons: because not all trade is price-sensitive; because the dollar is a safe-haven currency and the world’s reserve currency of choice; because many commodity contracts are priced and settled in dollars; and because speculation allows investors to take bets on the future path of national economies.

However, it remains the case that REER is the variable that ‘co-moves’ most closely with the trade balance. Sometimes the REER responds to the trade balance, driven by international capital flows and demand shocks; and other times it’s the trade balance that responds to changes in the REER. That said, the discrepancies of the 2000s – during which the dollar consistently fell but trade deficits grew – look rather large and need some explanation.

The 1990s saw the US boom relative to the rest of the world, with growth averaging close to 4% under Bill Clinton. It was these fundamentals that led to the dollar appreciating strongly during the decade as foreign capital flowed in, a process that accelerated immediately after the Asian Financial Crisis in 1999. The Clinton Administration also favoured a strong dollar because it kept inflation and interest rates low and put pressure on domestic producers to improve their competitiveness through investment. But it also caused the trade deficit to rise sharply.

While the dollar fell against most DM currencies after the US fell into recession in 2002, it continued to rise against currencies of key emerging economies which represented around half of US trade deficit in goods at the time. The dollar continued to rise against the Mexican Peso until 2007 and remained flat against the Chinese Renminbi until 2005, causing the trade deficit to keep rising. Mexico and China alone accounted for over 40% of America’s 2006 trade deficit.

It was largely China’s dollar-renminbi peg between 1995 and 2005 that distorted the relationship between REER and the US trade deficit after 2002. Large-scale capital export from China to the US also maintained a distended trade deficit until 2008.

Accusations of currency manipulation by the United States’ trading partners pre-date Trump by almost twenty years. In 1988, the US Congress passed the Omnibus Trade and Competitiveness Act, which called for more action to be taken against nations which were identified as fixing their currency to steal an advantage. It was only in 2005, ten years after China had begun holding the renminbi at 8.28 yuan to the dollar, that Congress’s threat of tariffs against China – on the grounds that the peg turbo-charged the US trade deficit by preventing the renminbi from rising – caused the country to abandon the policy.

In the immediate aftermath of the Global Financial Crisis, China halted its ‘managed appreciation’ and resumed its dollar peg at 6.83 yuan to the dollar for over two years, which led to new accusations of currency manipulation as the US trade balance started to tick up again.

Since the end of 2011, the dollar has rallied, benefitting from the combined effect of being the first major economy to recover from the GFC and, more latterly, being the main recipient of the ‘search for yield’ process that has followed loose monetary policies around the world. But as of yet, the trade deficit has yet to deteriorate further, although the most recent figures suggest it is rising.

Last year, the dollar lost close to 10% of its value on a trade-weighted basis and it is now common to hear talk of the dollar as now being ‘weak’. But this is not so. By recent standards, the dollar is still relatively strong, and on a short-term basis there is scope for capital repatriation from the Trump tax reforms to push the dollar up this year.

Fundamentals, however, suggest that unless the dollar falls over the medium run, and there is good reason to think it will (the return of Europe, the strength of EMs, normalisation in policy outside the US), the trade deficit should rise, and this creates a source of political risk from Donald Trump.

Trump cares about the trade deficit. He thinks that a large deficit means that the US is somehow losing money. It is also true that his core voters – blue collar, manufacturing workers – struggle with a strong dollar. If his tax and regulatory reforms fail to bear fruit for the people that he claims to represent – with firms using the benefits of depreciation expensing to fund stock buybacks rather than capital investment – we would not be surprised if this unpredictable President turns to more drastic action on currency and trade restrictions, including managed interventions and tariffs. And that would create all kinds of problems for businesses that use international supply chains, central banks that have independent mandates and – in extremis – whole economies that depend on the rules-based international trading system.

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