In Anticipation of Trade War

The increase in US interest rates was followed by some of the world\'s major central banks, such as the ECB and the People\'s Bank of China. BI chose not to change its benchmark interest rate, because it thought the impact was minimal.

Kompas/Heru Sri Kumoro

A. Prasetyantoko

The volatility of share prices in the domestic stock market intensified last week. First, the decline in share prices was due to the announcement of Jerome Powell, the new governor of the US Federal Reserve (Fed), who for the first time led the Fed meeting and immediately raised the reference rate by 25 basis points to 1.75 percent.

The increase in US interest rates was followed by some of the world\'s major central banks, such as the European Central Bank (ECB) and the People\'s Bank of China (PBC). Bank Indonesia chose not to change its benchmark interest rate, because it thought the impact was minimal.

Second, it was due to US President Donald Trump\'s decision to impose import tariffs on Chinese products. At the end of last week, the Jakarta Composite Index fell 0.70 percent to close at 6,210 points. That comes not long after the index had touched its highest level around 6,600 at the beginning of the year. The rupiah exchange rate has also weakened to trade near Rp 13,800 per US dollar.

Why, despite the strong domestic economy, does the financial sector tend to be vulnerable to external events? Our small and open economy is sensitive to global dynamics. Moreover, lately the phenomenon of global imbalances has again surfaced. These global imbalances are also believed to be the main cause of the global financial crisis in 2008. A decade later, the issue of global imbalances remains relevant.

President Trump\'s decision to raise tariffs on goods imported from China, especially steel and aluminum products, cannot be separated from the widening US trade deficit. In 2008, the US deficit of goods and services reached nearly $700 billion, especially in trade with China. On the other hand, China\'s foreign exchange reserves jumped from about $450 billion in the early 2000s to about $2.5 trillion in 2009. The increase occurred due to a massive trade surplus, especially against the US.

In an effort to resolve the financial crisis, the US government issued bonds on a massive scale, and China became one of the largest debt holders. From the eyes of the layman, China is considered to have "stolen" US people’s wealth through trade. It then controls the US government by controlling the ownership of bonds.

The campaign promise to fight the huge trade deficit is believed to be one of the factors that won Trump the election. Now Trump is beginning to realize his promise to restrict Chinese products, so that the practice of "theft" can be stopped.

That decision is bound to ruffle a few feathers. First, the restriction of Chinese products entering the US has a negative impact on domestic businesses, particularly in the aviation, automotive and other industries that use steel and aluminum as raw materials. Second, the US actions will invite retaliatory actions, which could lead to a trade war.

The Chinese government has announced plans to impose import tariffs on 128 types of US products worth about $3 trillion. The global financial markets are reacting negatively, with almost all global indices in decline. Maybe this financial sector turmoil is temporary. However, global imbalances are not a short-term phenomenon. They are a fundamental issue that has not merely an economic dimension, but also a political one.

Why does the US exempt main trading partners like South Korea, Japan, Australia and other NATO countries in its tariff policy? Obviously, the US wants to focus on China, with the aim to bring China to the negotiating table.

Martin Feldstein, professor of economics at Harvard University, is one of a handful of experts who understand Trump\'s decision. According to Feldstein, China has indeed planned a systematic "theft" in all fields on a regular basis and with measurable approaches, including stealing intellectual property. In essence, the relations between China and the US are colored by complex dynamics, economic dimensions, politics and even the military.

Dynamics

Then, how do we react to those dynamics? It cannot be denied, in general the world is moving toward protectionism. The volume of global trade will weaken in the future. As a result, we cannot expect our exports to increase in the medium term. In the short term, we may benefit from rising commodity prices, which can push up our export value. However, in the medium term, the increase in commodity exports to traditional markets can no longer be taken for granted.

The agenda is clear. We should diversify export products and find new markets. In addition, our dependence on the foreign services sector should also be significantly reduced. Why is that important? Because the trade balance, especially in services, will determine the flow of foreign funds into the domestic market. The decline in exports and dependence on foreign services will cause the current account deficit to widen. The current account deficit should be reduced by attracting more foreign capital through various instruments, particularly portfolio investments.  However, an increase in the dominance of foreign funds in our financial markets will make our financial sector more vulnerable to global shocks.

Another major strategy is to increase funding from domestic sources, so that dependence on foreign capital can be gradually reduced. The problem is, even if the measure is correctly implemented, its results can be enjoyed only in the next few years. Deepening financial markets is a long-term issue that will solve two major problems at once, namely stability and intermediation.

In the short term, we must focus on maintaining stability. First, the monetary authorities should be ready to sacrifice foreign exchange reserves to prevent the rupiah from depreciating sharply. Second, the financial authorities should anticipate turmoil in the stock and bond markets, so that prices would not fall sharply.

In the longer term, there are two main goals. First, improve the competitiveness of export products while reducing the dependence of the services sector. Second, deepen the financial market, so that the share of domestic investors will continue to increase.

A. Prasetyantoko, Economist, Atma Jaya Catholic University