From Financial Folly to Trade Troubles?

Op-ed in the Business Standard, New Delhi

December 24, 2008

If 2008 was the year of finance, 2009 could well be the year of trade. If 2008 was dominated by commodity prices (which soared in the first half) and equity prices (which collapsed in the second), events in 2009 will be influenced by the fortunes of currency prices, especially the dollar.

As the grim excesses of the financial sector have begun taking a toll on the real sector, the nascent signs of emerging trade protectionism are unmistakable. The skirmishes have begun and the theater is global-some form of trade restrictive measures have been imposed or are being seriously contemplated in the United States, European Union, Brazil, Russia, Indonesia, and yes, India too. Whether skirmish turns to serious battle will depend to a great extent on the movement of the dollar and US-China economic relations.

Since the onset of the financial crisis, and despite the United States being at the epicenter of the financial crisis, the dollar has appreciated against the major currencies. If the dollar remains at this level or appreciates further, trade frictions will almost certainly escalate. A strengthening dollar is bad news for freer trade on two counts. On the macroeconomic side, a strong dollar will add to recessionary pressures in the United States. With consumption and investment collapsing, net exports and government remain the two sources of boosting demand. But a rising dollar will serve to reduce net exports, placing all the burden on the fiscal stimulus package to prevent the US economy from sinking further into recession.

On the political side, a rising dollar will fuel protectionist pressures in the United States as the manufacturing sector faces heightened competition from abroad. This combination of recession and strengthening currency significantly increases the risks of trade protectionism. It is often forgotten that the most serious outbreak of protectionism in the United States happened in the 1980s because this combination of factors made even Ronald Reagan, the champion of free markets and free trade, give in to protectionist pressures and enact a series of trade-restrictive measures, directed largely at the country that was then considered the competitive threat-Japan.

In the current circumstances, protectionist pressures will find a less unsympathetic ear in a Democratic administration and Congress that have placed middle-class concerns as front and center for policy action. And it is no secret that one key source of middle-class concern is a growing anxiety about globalization.

If the theater of conflict in the 1980s pitted the United States against Japan, this time it will see the United States in a face-off with today's hypercompetitive economy, China, because of the latter's exchange rate policies. To be sure, the Chinese yuan has appreciated by about 10 percent since the crisis because of its umbilical association with the rising dollar but also because the currencies of China's competitors-Korea, Brazil, Mexico, and India-have declined substantially. China can therefore legitimately claim that it has "moved" on rectifying its undervalued currency. But the level of the undervaluation, by most calculations, remains substantial, and its trade surplus shows little sign of dramatic change, so the Chinese currency will remain a bone of contention. China taking any action to stop or reverse this ongoing process of currency correction, in response to its own economic downturn for example, could be the spark that makes a serious trade confrontation more likely.

What are the consequences for India? On trade, Indian policymakers and the Indian private sector have operated until recently under the assumption that markets in the major industrial countries, including the United States, will remain open regardless of what India does. Indian willingness to let the Doha round collapse, even if it meant being vulnerable to the charge of being a recalcitrant trading partner, was simply a manifestation of this sanguine calculation. And this calculation was reasonable because there was never a serious risk that restrictions could be placed on India's software or textile exports.

If, however, recession grips the world and the dollar appreciates, India will be forced to revisit that assumption. Now, there is a possibility of India's export markets-and indeed those of all emerging markets-becoming less open, and hence undermining Indian growth prospects. A corollary is that India and other emerging markets may have to contribute to keeping those markets open, which may have to take the form of offering to open up India's markets. The days of India setting its trade policies unilaterally without some assessment of their impact on the global trading system or some consideration of the demands of its trading partners may be numbered. Put differently, the globalization of India's trade cannot coexist for much longer without the globalization of India's trade policies.

This financial crisis, bad as it is and worse as it is likely to get, will still not approach the calamitous proportions of the crisis of the 1930s. An important reason is that policymakers have learned what to do and what not to do in such perilous times. A good illustration relates to the fiscal and monetary policy response. In the United States, the new government has signaled its willingness to spend enormous sums of public money, even at the risk of impairing sovereign balance sheets to limit the economic downturn. And central bankers, especially the US Federal Reserve Chairman, have thrown caution to the winds and embarked on a Mugabe-esque course of "debauching the currency," to use Lenin's famous phrase, because of their belief that such actions are needed to avoid a repeat of the 1930s.

But the 1930s saga involved not just the sin of omission on macroeconomic policies (when the US Fed stood watching as credit and the banking system collapsed) but also the sin of commission on trade policies. Trade protectionism, initiated in the United States by the infamous Smoot-Hawley legislation, and the imitation it begat in Europe, also contributed substantially to the vicious downward spiral in world trade and economic activity that created the Great Depression.

Now, not just industrial countries but also emerging markets such as India have a serious responsibility to work to ensure that global markets remain open. A new cooperative enterprise on trade is urgently needed. Its name is...well, let's just say it is not Doha.