Trade Wars!

To badly superimpose a famous decree: A long time ago, in a galaxy far, far away…..there were trade wars! OK, so that isn't a verbatim quote of the famous, scrolling text of Star Wars Episode IV: A New Hope and certainly doesn't capture the glamour, thrill, excitement and joie de vivre of that fun film. But perhaps that is what China with the rest of the world is looking for - a new hope. So what does that have to do with currencies and more so for the USD? Patience, young Skywalker.

Trade wars tend not to have much long-term impact on GDP as whole, let alone a directional change in the currency. Yet this latest round of "tires for chicken" protectionist action between the U.S. and China is hardly necessary at a time when neither economy really needs it. In fact, the currency market knee jerk reaction has been notably USD favorable (albeit slightly), the conventional wisdom being that the market seeks risk aversion. But is this the right side of this trade? I don't think so, if there is indeed a lasting impact of some protectionist outbreak. Obi Won, I don't understand?

Let's examine the latest round of trade war, better perhaps noted as short burst fire fight between the chickens and tires via the U.S and China. The dispute has political costs for both sides. In China, officials stated that tire tariffs would "affect" the employment of 100,000 Chinese and would cost China $1B USD in exports per year, though we don't know if that means Chinese factory workers lose their jobs. Add to it that the economic value of the Chinese sectors affected by the simmering dispute is relatively small, less than three-tenths of 1 percent of China's $337.77 billion in exports to the U.S. last year. So did Darth Vader hit a small outpost in Tatooine, or was it the rebel force placing a shield around Dagobah to protect Yoda?

Looking at the effect on the U.S. is less clear because China hasn't imposed sanctions. China said Sunday it will investigate complaints by Chinese industries that U.S. companies are selling chicken and auto products in the local market at below-market value. But China already has a partial ban on U.S. poultry in retaliation for a similar U.S. ban on Chinese poultry. U.S. poultry companies said they stand to lose $370 million this year versus the U.S. exporting $1.9 billion in vehicles and components to China in 2008, according to U.S. trade statistics, but it is unclear how much of these exports would be affected. All of this pales in comparison to the total U.S. exports to China last year of $69.73 billion. Can Luke save Leia? Can Vader scuttle the rebel force in time?? Can peace exist in the galaxy?

As for the current skirmish, under World Trade Organization (WTO) rules, the nations have around 60 days to settle the dispute through consultations. Failing that, the WTO could set up a dispute settlement panel. But the real impact comes from investment flows and confidence that this fight does not escalate, making money managers the real "force" that has been awakened by this unusual light saber rattling.

President Obama has decided to test a safeguard measure that was incorporated as a U.S.-imposed condition for China to join WTO in 2001. This is part in parcel of the President's pledge to have fair trade. The implication is timing and scope. President Obama has shown himself to be a labor union populist and thus very much willing to use trade sanction muscle to align his administration's goals to strategic economic sector unions. China, partially blindsided by this political act, has responded with its own set of sophisticated legal strategy, which is to determine if U.S. poultry and car parts were "unfairly dumped" in the Chinese market and per WTO rules declaring U.S. tariffs illegal. In fact, the countries most affected by trade protectionism are China, U.S., Japan, Germany and France. Additionally, the following industries are affected in declining order, including machinery, food, financial services, agricultural goods, grains, basic materials, textiles, transport material, chemicals and metal products ( basically everything every human on the planet needs to live). So where does this lead, Yoda?

While both Obama and the Chinese are relatively inexperienced in global trade tit-for-tat, it does potentially represent an opening bell to out an outright "galactic war". Much of the motivation behind China and the U.S. is highly political as they are both protecting mature and dying industries. But what happens when the hand of government extends itself like Darth Vader's grip to value-add areas like German solar firms having issue with Chinese panel makers in undercutting their prices by 20 percent, South African firms claiming anti-dumping duties on certain pharmaceutical products from India, Brazilian anti-dumping claims against Turkey for steel and pipe fittings, the EC seeking countermeasures against olive oil imports from Mexico, the US seeking VAT on integrated circuits from China, Norway seeking safeguards for salmon against the EC, Argentina seeking safeguards against import of footwear from France and Germany? And so goes the endless list of products, services and grievances that stay in the netherworld that hardly sees the light of day in the "Cloud City."

In other words, mutually assured destruction is what keeps the skirmish from escalating into a full-fledged battle. However, the danger is that the stakes being played by politicians and lobbyist in protecting a voting base and perhaps jobs. The Obama administration is testing these waters as the U.S. has had a history of a winning hand through its $2.3 trillion economy as a hammer. That the USD was driven up on the news is a short-lived phenomenon because on a trade-weighted basis the U.S. budget deficits combined with steady trade deficits drain the country of cash, and thus are a near-term drag on the buck. The real issue is whether there is truly a new contender, a "rebel force" that can withstand the assault, however small it may appear. While there may be little noticeable directional impact on the USD, watch the forward markets in oil, gold, commodities, textiles, metals, etc. as a barometer for USD weakness should G10 partners decide to make more of this "trade war." May the force be with us!