Why The Mutual Assured Destruction Of Global Protectionism Could Very Well Be Upon Us

We are at a point in the September beta ramp, when the market seems to go up on all news: good, bad, worse, worst, and completely irrelevant. After all there are just 10 more trading days in which funds needs a market rise of at least another 5% before they can sleep confident that tomorrow their largest LP won't send in that dreaded redemption notice. Yet there is still one potential gray swan that the market appears to not have factored in - the emergence of full blown protectionism, which will impact the core game theory relationship between the US and China at its very foundation, and begin a process of ever-escalating defection between the two fiat system dilemmatic prisoners. What could bring this disastrous development to the fore? Why Washington, D.C. of course. And if you are about to say that there is no chance of something like that happening in the nearest term, especially before the mid-terms, not so fast. Here is Goldman's Alec Phillips explaining why the passage of a protectionist law in the next few weeks is not only possible but probable.

From Goldman Sachs

The congressional focus on China’s exchange rate policy has increased significantly ahead of the upcoming midterm election, and at this point legislative action is a more serious risk than it has been since Congress first took up China-focused tariff legislation in 2005.  In response to this rising pressure, the US yesterday filed two complaints in the WTO regarding Chinese trade practices, and Treasury Secretary Geithner took on a somewhat more aggressive posture in today’s congressional hearings.

Activity on this front seems likely to escalate further over the next few weeks. There is a clear possibility that the House of Representatives will take up legislation that would allow for tariffs on certain imports from China.   But while House passage would represent an important escalation of the debate, the more important issue is whether the Senate will act on the issue, and ultimately whether a new tariff regime could become law.

We think that the risk that such legislation is enacted this year is still fairly low. There is little time left on the legislative calendar, and not yet a clear legislative strategy. That said, we also don’t expect this issue to disappear after the election, given that the current political reaction is driven by the weak economy and labor market as much as it is by the political cycle. 

Congress has ramped up its focus on US-China economic relations, driven by the upcoming election as well as the sluggish economic recovery. At this point legislative action is a more serious risk than it has been since Congress first seriously took up tariff legislation in 2005.  Over the last week, we have seen several developments in US-China economic relations:

  1. The US has initiated dispute settlement proceedings in the WTO regarding Chinese trade policies. The US Trade Representative (USTR) challenged China’s imposition of countervailing duties on certain US steel products, and the difficulty that US firms have in getting access to the Chinese market in payment card services. 
  2. Secretary Geithner’s testimony reflected mixed views.  Geithner’s comments today were more confrontational than usual, noting that efforts to date haven’t yielded progress and that appreciation has been too slow and too limited, and expressing a general concern about the ability of US businesses to do business in China. While he stopped short of supporting pending tariff legislation, he implied that a legislative remedy could be appropriate if designed correctly. On the other hand, Secretary Geithner also made it clear that the Treasury sees little benefit in naming China as a currency manipulator in its semiannual report, as doing so would escalate US-China trade tensions without providing a specific remedy.  
  3. Democratic leaders are considering reviving exchange rate legislation before the election.  House and Senate leaders appear to be considering bringing China-focused legislation to their respective floors for consideration. Chairmen of the relevant committees appear less inclined to act, but also have less influence on the congressional agenda over the next few weeks.  No decision has been made, but with nearly 150 members of Congress sponsoring the House version of the legislation, House Speaker Nancy Pelosi is under significant pressure to allow a vote, and may also find it politically advantageous to do so.  

From here, we expect the political risk around this issue to increase further over the next few weeks and expect it to recede only gradually thereafter:

  1. Passage of currency legislation in at least one chamber of Congress before the election is very possible… The bills pending in the House and Senate differ from one another, but both would essentially do two things: first, the Treasury would be required to identify currencies that are undervalued or overvalued as a result of “protracted large scale intervention”, based in part on analysis from the IMF. Second, as a result of such a finding, affected US industries could seek relief through countervailing and antidumping duties equal to the calculated undervaluation. However, an important distinction between prior proposals and the current legislation is that the latter would not impose an across the board tariff on imports from China, but rather would require US manufacturers to apply for case-by-case relief for specific products.
  2. ...But enactment still seems like a long shot. If the House does indeed pass legislation, the Senate could come under more pressure to act. However, Senate passage is more difficult, since considering even minor legislation in that chamber can take almost a week. In addition, as noted above, the bills in the House and Senate are different, and would probably need to be reconciled, requiring additional time. The Senate will be in session for only three more weeks before the election, and the House potentially for only two more weeks, so the calendar is a major obstacle. On the other hand, we suspect that many proponents of the legislation would actually like to see it enacted. In the past, some lawmakers supported the concept of retaliatory tariffs in part because they never expected them to become law. The obstacles in front of this legislation are great enough that it probably still won’t reach the president’s desk this year, but it is no longer as clear that Congress is “bluffing.”
  3. Another semiannual report will be submitted to Congress, but probably not until after the election. The Treasury is required to submit its next semiannual report on exchange rate policy six months after the last report, which was due on April 15 but wasn’t submitted until early July. Thus, depending on one’s interpretation of the requirement, the Treasury would be required to submit the report to Congress by October 15—two weeks before the upcoming midterm election—or could wait until January 2011.  The Treasury has indicated only that it will submit its report on a “timely” basis, but it seems fairly likely that this will not occur until after the election, particularly in light of the fact that there is no penalty for a late submission. Given Secretary Geithner’s view expressed today that the report is counterproductive, the risk that the Treasury names China in its report seems as low as ever.
  4. Further WTO disputes are likely. The USTR’s decision this week to initiate dispute settlement proceedings in the WTO seems unlikely to be its last.  If the Treasury comes under additional pressure from lawmakers regarding trade relations with China, it seems likely that additional complaints could be filed. Intellectual property-related issues and subsidies in the renewable energy sector seem likely areas for additional action before the WTO if the administration decides to take further action.
  5. Tension will persist after the election. Although discussions of exchange rate policy have hit an acute phase due to the upcoming election, the issue won’t recede quickly. First, discussions are apt to continue following the US elections; for instance the G-20 summit in Seoul on November 11 is likely to focus on this topic among others. Second, the sentiment currently on display in Congress is driven as much by the weak economy and labor market as it is by the campaign season. A look at tariffs imposed over the last 50 years demonstrates a much tighter relationship with the unemployment rate than it does with the US political cycle (see for instance “Trade Policy: Storm Brewing or Tempest in a Teapot?” US Daily, September 16, 2009).

Alec Phillips, Goldman Sachs