US tariffs are ostensibly to reduce the trade deficit, but we are skeptical that it will work, due to rising input costs, retaliatory tariffs and ongoing growth differentials. At same time, the funding of the US imbalance is still smooth and has actually improved.
When trying to work through the impact of US tariffs on its trade balance, one ought to keep in mind Orson Welles caution that if you want a happy ending, that of course, depends on where you end your story. If one stops with simply the US tax on imports, it should reduce the quantity of imports by raising prices. One might be tempted to conclude that the trade deficit would fall because of lower imports.
However, the story does not naturally end there. The higher priced imports would allow domestic producers of those goods to raise prices as well. Those goods, like steel or aluminum, are often inputs into products that will be exported. The higher priced inputs boost the cost of exports. Higher priced exports may dampen demand. The import intensity of exports may vary from product to product, and from producer to producer, the increase in import duties can raise the prices of exports, producing a fall in both imports and exports. This was the gist of a new report on the NY Fed’s website here.
On top of this, for a fuller picture, we need to incorporate the retaliatory tariffs as well, which also raise the prices of US exports. Some countries, including China, have tried to calibrate the retaliation to minimize boosting input prices needed for their exports. It seems more likely, then that the US import tariffs are going to produce a meaningful improvement in the US trade balance.
There is an additional force that is serving to widen the US trade deficit, and that is the growth differential. The US Congress approved extensive tax cuts and spending increases that will push up US growth, which was already growing above trend. Ironically, the stimulus advocated by the “American First” administration will boost aggregate demand in the US that cannot be fully supplied by domestic producers. Foreign producers will fill the gap and at higher prices.
In the first half of 2018, the US trade deficit widening 7.2% over H1 17, which itself was 9.6% larger than H1 16. More broadly, the US current account deficit is deteriorating. Data for Q2 will not be released until the middle of next month, so the deterioration is largely before the trade tensions.
Over the past four quarters, the US current account deficit averaged a $116.4 bln deficit or 8.6% larger than four-quarter average through Q1 17. It has grown by nearly the four-quarter average through Q1 15.
In our framework, the more important a dollar driver than the current account deficit is how it is financed. The US Treasury International Capital report is useful even if not comprehensive or timely. The June report will be released Wednesday. Through May, the TIC report showed that foreign investors bought a net $424.65 bln of US stocks and bonds. This is to say that in the first five months of 2018, the US appears to have imported sufficient foreign savings to fund most of the annual current account deficit. Moreover, portfolio inflows this year are running well ahead of last year’s pace ($268.3 bln) and the 2016 pace ($102.9 bln).
Investors are always interested in what the largest holders of US Treasuries, China and Japan, are doing. However, it is Russia that has attracted the attention recently. The TIC data showed a sharp decline in Russia’s Treasury holdings from $96 bln in March to a little less than $15 bln in May. This is the least since 2007. Recall that the US 10-year yield peaked in mid-May near 3.12%. after approaching 2.70% in early April and beginning the year near 2.40%.
Part of the decline may have been reflected portfolio adjustment, but part may be a response to the sanctions. The sanctions and threat of more could have encouraged some liquidation, but the problem where to place the funds. However, the liquid and deep markets mostly offer lower yields. That said, Chinese bonds are an exception. To be sure China is an exception. Its 10-year yield pays around 60 bp more than US Treasuries and Russia may find the currency risk acceptable or manageable.
Alternatively, Russia may have switched custodians and slipped through the TIC methodology. The threat of sanctions could have encouraged the shift to a custodian outside of the TIC system. We note that Belgium holdings of Treasuries rose by $25 bln in the April-June period. Many have suspected that Belgium’s Treasury holdings are mostly related to Euroclear and may have been where China had placed some of its Treasuries. In terms of market impact, whatever Russia to Treasuries and dollar did not seem to have much effect. Treasury yields are lower and the dollar is stronger.
The US trade deficit is likely to widen due to growth differentials and the impact of taxes on imports. The financing of it does not look problematic now. That could change, but with the ECB on hold until next year and the German and Japanese yield curves negative through seven years, international savings will still find a home in the US.