For representative purposes.
| Photo Credit: iStockphoto

The story so far: Donald Trump, the President-elect of the U.S., has promised to impose tariffs of up to 60% on Chinese imports to correct the huge trade deficit the U.S. has with China and also as a punitive measure to make China reduce the subsidisation of its domestic production, which make Chinese goods cheaper and attractive to American consumers as compared to locally produced American goods. He has also threatened to impose 10% import tariffs on imports from European Union.

What will be the impact?

The imposition of tariffs by the U.S. will raise the domestic price of such products in U.S. markets. If the tariffs are across the board and cover a large part of consumer goods sold in the U.S., then it will increase domestic inflation. However, if it helps to reduce the overall trade deficit of the U.S., it may improve the value of the U.S. dollar and moderate domestic inflation. If the tariffs shift consumption away from Chinese goods and other imported goods, it will boost domestic production and increase domestic supply of consumer goods and help moderate inflation.

However, if China and other countries which are threatened by U.S. tariffs, respond with appropriate tariffs of their own on American goods, triggering another round of global trade wars, the intended policy impact of the action on the trade balance between the U.S. and its major trading partners, may not materialise to the desired extent.

On the contrary, it could have a debilitating impact on global commodity prices, and worsen inflation in most countries.

How will it materially translate?

Consider the following hypothetical example: Assume a shirt costs 724 Chinese yuan in China and is sold in the U.S. market for a $100, based on the current U.S. dollar-Chinese yuan exchange rate of $1:CN¥7.24. Let us also assume, that the same shirt can be supplied by U.S. manufacturers domestically for $105 or 760.2 Chinese yuan. Since they are overpriced, Chinese producers capture the U.S. market and set the domestic price of a shirt in the U.S. at $100. At this price, U.S. producers are unable to compete with Chinese producers in supplying U.S. markets.

Now if the U.S. imposes a 10% import tariff on imported Chinese shirts, under its America First policy, the price of a shirt in the American market will rise to $110 or 796.4 Chinese yuan, based on the above-mentioned dollar-yuan exchange rate. At 796.4 yuan per shirt, Chinese imports are no longer attractive to American buyers. The American producers are happy as they make a profit of $5 as their cost of producing a shirt is $105 while the tariff-inclusive price in the U.S. market is $110. The Chinese exporters will have to bear the 10% import tariff on their exports, which in Chinese currency is equal to 72.4 yuan at the prevailing Dollar-Yuan exchange rate. If the Chinese government decides to support its textile exporters, it can adopt any one of the following policy measures: provide a State subsidy of 72.4 Yuan per shirt; devalue the yuan by 10%; or lower its Central Bank interest rate and increase stimulus spending in the economy, so that the dollar-yuan exchange rate depreciates by 10% to reach $1 equals 7.964 yuan.

At this exchange rate, the Chinese garment exporters will receive 796.4 Chinese yuan per shirt, pay the U.S. import tax of 72.4 Chinese yuan and retain 724 Chinese yuan per shirt as their export earnings, the amount they got per shirt prior to the 10% import tariff. The risk to the Chinese economy could be in the form of a rise in its domestic rate of inflation due to a devalued or depreciating currency. But if these policy interventions help in boosting domestic production and exports, the risk may be offset by increased GDP growth.

Bhagwan Das is former head and associate professor of economics, Loyola College, Chennai.