IS TRUMP TRYING TO REPEAT HISTORY?

A Brief History:

Crude oil price decline

On December 18, 2015 U.S. lifted sanctions allowing export of crude oil without a license to other countries. Previously, crude oil produced in U.S. was allowed to be exported only to Canada, U.S. territories and Pacific Rim countries. This was done amid an ongoing oil price crisis, where the price of crude oil had seen unprecedented decline from approximately USD 120 perbarrel to below USD 40 per barrel due to oversupply or excess crude present in the world trade markets. The oversupply had been primarily attributed to China’s economic slowdown, Libya’s return to production and deflation in Japan and Europe due to which oil imports had reduced drastically. Another factor leading to oversupply was significant reduction in imports by the U.S. due to increased production of tight oil from shale rocks. Producing oil through fracking and hydraulic fracturing became so profitable that U.S. is on its way to become world leading producer of oil. As U.S. reduced its imports the world suffered from economic slowdown and crude oil prices fell.

This decline in crude oil prices has led to a battle for market share among producers. Oil producing countries such as Saudi Arabia, Iran and Iraq which can sustain production at low cost are not ready to cut production.While countries such as Venezuela require a high selling price of crude oil for profitable extraction, and thus have entered recession. Meanwhile, U.S. is exporting its oil and had a market share of more than 1% of the exports in 2016 up from 0.3% in 2013. This battle for market share is expected to continue for some time till the demand of crude oil catches up with its supply. However, the demand is only likely to increase if the demand of petrochemical commodities and crude derived chemicals increase, possible only if the price of petrochemicals falls under current world trading scenario.

The petrochemicals and chemical manufacturers have been benefitting from the decline of crude oil prices due to fall in raw material costs thereby increasing the profit margin from sale of downstream products.Large petrochemical and chemical manufacturing economies such as U.S., China,Russia and India have reduced their financial burden as a result of improved margins from sale of downstream products. The reduced cost of raw material(crude oil) is being passed on slowly to customers primarily as an outcome of market related factors. Thus, despite raw material prices being cut by almost half, the petrochemical and chemical prices are still high and the industry highly profitable.

Donald Trump has been elected as the president of United States and will assume office from 20th January, 2017. Donald Trump’s election manifesto has been circulating around re-negotiating trade ties with Canada and Mexico, reducing taxes and environmental regulations for manufacturing sector so as to promote in-house manufacturing and increase in unskilled jobs and to reduce current trade deficit with China (labeling China as currency manipulator). These policies if well implemented will result in global trade war resulting in fall of prices goods and services in the manufacturing sector.

US China Trade relations

U.S. debt stood at 19.98 trillion as of December 2016, with public debt at USD 14.4 trillion and intergovernmental holdings at USD 5.5 trillion.Of this, USD 3.841 trillion debt was in from of treasury bills, notes and bonds held by foreign countries, including China which accounts for 1.115 trillion or approximately 29% of this debt.

In 2015, U.S. trade deficit with China amounted to USD 365.7 billion.U.S. was importing goods worth 481.9 billion from China while exporting goods worth 116.2 billion to China. Reason behind this trade deficit can be attributed to the manufacturing sector in U.S. which had been exporting raw material to China in exchange for importing value added products, through a cheaper currency (yuan). This was profitable for U.S. manufacturing companies,as many of them have plants in China as joint ventures with the countries state owned enterprises. However, this put its currency (dollar) at risk. As more trade occurred with China, Chinese manufacturers deposited more of dollars with their banks in exchange for yuan. These banks exchanged the dollars with the central bank (PBOC) which in turn used these dollars to buy U.S. treasuries and bonds thereby increasing U.S. debt with China.

However, amidst all this China’s currency (renminbi; unit:yuan)which was loosely pegged with the U.S. dollar till august 2015, relaxed yuan to dollar conversion rate and related yuan’s value to its closing value on the previous day. With this renminbi became 5th official reserve currency of the IMF along with US dollar, Euro, British pound sterling and Japanese yen. The currency relaxation resulted in fall of yuan’s value against dollar. PBOC managed this devaluation by using its dollar reserves to buy back yuan from Chinese banks, resulting in dollars being put into circulation reducing lowering their value, and taking yuan out of circulation, hence increasing its value. Thus,China can effectively manage the yuan versus dollar exchange rate through sale and purchase of U.S. treasury bills. This has be termed as either currency manipulation or management. The intent here is clear. China has been manipulating (managing) its currency to control prices of its exports in return for having a competitive edge in order strengthen its economic growth which had been slowing due to reforms.

This currency management (manipulation) can also be observed with U.S. dollar which had kept interest at zero and having world’s largest debt till 2014. Japan keeps its currency low by doing same as China and buying dollars in form of U.S. treasuries. Even the European Union is managing its currency by buying securities from its member banks to add liquidity to capital markets. In other words, all exporting nations benefit from a lower currency.

Looking into the future

Donald Trump’s manifesto suggests that he wants to reduce the current trade deficit with China (labeling China as currency manipulator) and hence reducing imports. This is only possible if the U.S. starts importing goods from some other country or starts manufacturing on their own. Importing goods from other countries is not a viable option as it would just result in increasing the trade deficit with some other country. The possible solution here is to decrease its trade deficit and hence its debt through in-house manufacturing and export. U.S. is expected to gradually decrease its imports and increase it in-house production of goods similar to the case of crude oil where imports declined and production from shale oil increased. Trump’s policy of increasing duty to decrease imports from China supports this line of thought. New plants are expected to be set up in the U.S. as is clear fromTrump’s policy of reducing corporate taxes and environmental regulations for manufacturing companies. U.S. is also expected to export its manufactured goods to other countries as is evident from Trump’s manifesto of re-negotiating trade ties with Canada and Mexico.

All in all this might lead to a global trade war as in case with what happened in the crude oil industry. China is the world’s largest exporter of manufactured goods just like Saudi Arabia for crude oil. China is even suffering from overcapacity for many chemicals and manufactured goods. U.S. is the largest export market of China as was the case for crude oil with Saudi Arabia. If U.S. gradually decreases its import, while increasing its in-house production and export, prices of downstream chemicals as well as manufactured goods are expected to see sharp fall in prices due to oversupply as it happened with crude oil.

U.S. export of manufactured goods and chemicals will give rise to another so called battle for market share as is happening for crude oil.

The only possible alternative to the above hypothesis arises if China increases its domestic consumption to the tune that it’s absorbs all the additional exports it had been making to the U.S. But, this seems highly unlikely keeping in mind the current world’s trade dynamics.

However, we must remember that crude oil, petrochemicals and downstream chemicals are a part of cyclical market. Hence, the periods of high demand and low demand are inevitable. During periods of high demand and less supply we witness high prices for commodities. While during periods of low demand and high supply, we witness low prices for commodities. And in case of interconnected commodities such as crude oil and downstream petrochemical industry, the fall in prices of petrochemical products will lead to increase in their demand, thereby increasing the demand of crude oil. With the rise in demand of crude oil over the supply, the prices are going to rise with the world entering another phase of economic growth, with power concentrated in new world economies.