Inching towards a trade war

US and European markets plunged overnight, weighed down by fears of sovereign debt contagion, and signs of growing trade tensions with the world's top exporter, China.

US President Barack Obama pointedly told Senate Democrats overnight that the issue of a weak Chinese currency had to be addressed "to make sure our goods are not artificially inflated in price and their goods are artificially deflated in price”.

Hostility between Washington and Beijing has increased following the US government's recent decision to approve a $US6.4 billion arms deal to Taiwan. But tensions have been mounting long before that (see also Is China exploiting ASEAN? February 5).

The Obama administration has been annoyed at China following its tactics at the Copenhagen climate change conference.

And earlier this week, US senators voted unanimously to condemn the recent cyber-attacks on Google that provoked the search engine company to threaten to quit China.

The Chinese have punched back though. They're outraged by the planned meeting between President Obama and the Dalai Lama, the Tibetan spiritual leader, warning that the meeting was not in the interests of the United States at a time when the country was trying to recover from the financial crisis.

China has thus threatened that any US company involved in the Taiwan arms deal – which includes Boeing, United Technologies and Lockheed Martin Raytheon – will face sanctions.

China is also taking action against what it sees as unfair western protectionism by filing formal complaints with the World Trade Organisation.

The WTO is already investigating the 35 per cent tariff duty the Obama administration imposed on Chinese tyre imports, and the Chinese have just filed a formal complaint against the 16.5 per cent tariff the European Union levies on shoes imported from China.

But the Chinese have introduced trade sanctions of their own. They retaliated to the US tariff on tyre imports by restricting imports of US poultry and auto parts. And there are suggestions that unless the European Union's shoe tariff is abolished, sales of European pharmaceuticals, cars and wine may be restricted in China.

Some believe this increasingly acrimonious mood between China and the west will pass.

A lot of it, they say, is playing to the home crowd. By playing the nationalism card, the Chinese are diverting attention away from domestic problems such as huge income inequality, and corruption, at home.

Similarly, by picking up on unfair Chinese trade tactics, the Americans and the Europeans are being seen to protect their own workers.

There's no doubt there is an element of local theatre to the rhetoric. But there's an increasingly serious undertone.

As the US and Europe grapple with swollen budget deficits and high unemployment levels, there will be a growing temptation to question the merits of globalism and free trade (see Europe at a crossroads, February 4 and Greece's crisis is contagious, February 4).

There was a hint of this at this year's World Economic Forum in Davos.

French President, Nicolas Sarkozy, raised the prospect of a 'carbon frontier tax' which could be imposed on imports from countries that failed to introduce controls on greenhouse gas emissions.

Such a tax would punish developing countries that are reluctant to force their factories to adopt expensive anti-pollution measures.

And Larry Summers, the chief economic adviser in the White House, told his Davos audience that although the US was committed to free trade, there was a case that the argument for free trade might not apply when it came to countries pursuing mercantilist policies.

In his State of the Union speech last week, President Obama set a goal of doubling US exports over the next five years – a move which he says will create two million new jobs.

With Europe facing a protracted period of low growth – and even more so that bond markets have started focusing on mountainous levels of debt in the weaker European countries – the US will start looking more closely at China.

And the Obama administration will increase the pressure on China to let their currency appreciate against the US dollar, both to boost US exports and to make US goods more competitive in the home market.