It was John Nash who pointed out the definition of an Irrationality. He said that Irrationality is never absolute, it concerns the objective of the (economic) participant. I often see lay people make this mistake when observing the behavior of other people.
Declaimer: This article was originally in October 2018, and some of the data points may be outdated
Governments, for example, are often judged by the media/ lay people as irrational, because of the assumption that ALL their actions have a profit-making motive because that is how we would think. But governments often have social/ political motives, which override economic motives. In currency markets, you might find RBI intervention which is focused on calming markets rather than making money. In the process of intervention, they seem to make an obscene amount of money, simply because they buy low and sell high, the ultimate dream of any trader. It’s the same with LIC, which for donkey’s years, has been called in to stem the rot (like in IL&FS just now), but they have often accumulated these assets for paise on the Re.
The Theory of Negotiation
When we observe Trump, we must always remember the Bigger Madman Theory of Negotiation, something that terrorists, for example, are taught in High School. The idea is to extract concessions by creating the perception that you are crazy and not really in charge of your senses. That is why a guy with a belt tied around his waist, finds it easy to get right of way on anything, provided he can look suitably serious (ask the NWFP School of Hijacking). Trump has mastered this art and is going around the world like Don Quixote, tilting at various windmills. Or so the ordinary bystander would think…
Sometimes it works, and sometimes it doesn’t. Mostly, this strategy works with sane people…. which would be the countries of North America, Europe, and even poorer democracies like India. But when you try the autocracies of North Korea, Iran, and mother of them all, Russia/ China, it’s not so easy to extract concessions from someone who is genuinely suicidal. And this is where things get uncertain.
China may have decided to take the tariffs on the chin. There will be some damage, to their easily substitutable exports (garments, for example; or furniture). But their top exports to the US are now electronics ($150 bn) and machinery ($100 bn), while the lower end is all less than $10-20 bn each. I suspect that in the top 2, China holds significant ‘stickiness’ from being part of global supply chains, which will not bear the disruption of tariffs, at least in the short run.
This is where the new NAFTA is a significant development because it allows North America to emerge as a new competitor to China, with suitable safeguards for ‘slipping in’ Chinese products through these trading partners. In the short run, it puts China under pressure, limited by its ability to hurt the US (not enough imports to make a difference) and facing a substantial diversion of US imports, first at the lower end (India might benefit not a little from this) and then at the higher end (from the developed country FTAs with North America/ Europe).
The Trade Wars
While it is quite a setback, it won’t kill China. The net loss could be about 0.5-1% of GDP, which is quite a shock in the short run but can be made up over the long run. Net of alternative markets, the net impact is about 0.5% of GDP, not the end of the world for totalitarian China. Hence the decision to hardline its way through the Trade Wars.
What is Trump looking for? Mostly, he is looking for a standing ovation from the stadium, but maybe, just maybe, he also has a larger plan. One of the chips that must be on the table would be China’s support of the Iran sanctions. To strike a quick deal with Iran, he will need unified sanctions; the same with North Korea. So there are wheels within wheels, and he could be looking to settle all of them at the same time. Which is why he has not shown much interest in settling anything till the November elections. And the oil market is on tenterhooks till the Iran Sanctions kick in. China might stop buying from Iran if it gets some relief from the US tariffs, and that might make Iran give some rope to the US on a new deal. If all of this is already in the backchannel negotiations, then Trump would want to time it politically, with his domestic constituencies in mind.
Where does India fit into all this? We are a bit player, affected marginally, except in the case of oil, where we have our back to the wall. If the Iran Sanctions push up the cost of oil to $100, then we could derail our growth, and inflation and be set off into a death spiral. Every 1$ oil price spike increases our Trade Deficit by $1.2 bn, so $20 more would set us back by $24 bn, about as much as the damage so far. It won’t be long, but it would create short-term panic in the Dollar: Re, and the RBI would have to lose serious Fx Reserves.
The lower Re would make up some amount, which would bring in better export growth, now running at 15%. And if we can control imports, it would inflict pain on our importers but would keep the Trade Deficit under control. So there are multiple moving parts, but I don’t see much space for any optimism, except for this whole thing to suddenly unravel dramatically (like the NAFTA renewal announcement). Which brings tremendous uncertainty to markets.
The Trump Trade Wars
For one, nobody can call the top of the Dollar: Re. Simply because the oil spike is artificially created and it sits at the root of the Trump Trade Wars. And equity markets should keep a wary eye on all this, ignoring it would be at their peril. While the current obsession with liquidity issues and the bond yield spike will die a natural death as the government steps in, the market should not start discounting many long-term improvements in the economy unless this whole (Trump) situation is sorted out.
What can go wrong? Plenty, at least from India’s viewpoint. The eyeball-to-eyeball confrontation with China could deteriorate, and China could devalue its Yuan. That would set off a spate of compensatory devaluations. It might not achieve much, because the US would only impose even more tariffs. And China would lose long-term credibility on the capital account.
Oil could spike, even if for a short while. Emerging Markets, which are stretched to their highest-ever oil prices in their respective domestic currencies, would face serious political destabilization, especially in those countries facing elections. It would look like a repeat of the Taper Tantrum of 2013. Sorting it out would take some doing. A bond offering to NRIs who leverage their personal Balance Sheets would be a repeat. It’s going to extract a tidy pound of flesh from the country’s economy and its Balance Sheet, but we will survive.
But to look beyond that, it would make sense to keep your checkbooks ready, both in the currency and equity markets. While oil will see long-term structural shifts in demand (China has already announced that 20% of its trucks will shift to EV and LNG by 2025), we will see negative demand for oil within the next 5 years. And that will start the marginalization of oil as a source of energy. I believe that this Oil Shock if it happens, will be the time the world starts to shift to Electric.
I have tried going without my car for the last 1 year, in Delhi. I have seen a 99% drop in my commuting cost, with a huge increase in punctuality. Indians are averse to change till they are forced to, but this might just be the kind of shock that jolts them into action. I believe it would be very good for us in the long run. I was just saying.
