Trade is likely to be diverted away from uncertain trade partners due to enhanced bilateral trade costs
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AmyLaughinghouse
The announcement of “reciprocal” tariffs by the Trump administration on April 2, 2025, has created a Schrödinger’s cat-like situation — a state of flux, uncertainty and paradox. The subsequent retaliation by China and the EU, the 90-day hiatus to the imposition of above-base 10 per cent tariffs by the US a week later, and the EU holding back on its own retaliatory tariffs are creating enormous uncertainty in trade policy. This matters for exporters not just in China, the EU and the US but in countries across the world.
Country-specific uncertainty unilaterally and asymmetrically affects the production capacity of firms in exporting countries and demand in importing countries, thereby impacting both exports and imports.
Increased uncertainty also has a direct bearing on bilateral trade costs via increases in contractual uncertainty; heightened uncertainties at the border; and/or via regulatory changes that may enhance bilateral transportation costs, all of which are likely to impede trade. For instance, the global freight industry has been witnessing fluctuations in shipping costs, induced by the current trade policy uncertainty.
Hesitant to trade
Drewry’s World Container Index increased 3 per cent to $2,265 per 40 ft container on April 10. Given the uncertainty about future regulations, tariffs and/or agreements, economic agents may also hesitate to trade for now, preferring to adopt a wait-and-watch strategy instead. Corroborating this, exporters to the US are currently hurrying to complete the orders at hand given the 90-day pause in tariffs.
Uncertainty-induced rise in inventory costs for foreign inputs can also lead to a larger reduction in foreign orders relative to domestic orders, resulting in a substitution of imports by domestic production. This explains up to half of the Great Trade Collapse of 2008-09.
Changes in tariff/regulatory regimes can also impact firm-level decision to participate in international trade. Firms may reduce the fixed investment required to enter new markets. Uncertainty in destination markets can thus result in both trade destruction and trade diversion from more to less-uncertain countries. In fact, a paper by Meredith Crowley and co-authors shows that even threats to raise tariffs in the future (“tariff scares”) have adverse effects on entry into new markets even when the threatened import tariff hikes do not materialise.
Uncertainty is also associated with an indirect effect on exporters’ and importers’ overall trade costs vis-à-vis all trading partners. Thus, trade is likely to be diverted away from uncertain trade partners due to enhanced bilateral trade costs; at the same time, trade is also likely to be created between more “secure” trading partners. Supporting this, Brexit-induced uncertainty has been found to divert trade away from the UK and to “create” more trade between the remaining EU member-states.
Finally, episodes of pronounced uncertainty also alter consumer and business expectations, driving changes in exchange rates, which in turn impact trade flows. Illustratively, Brexit has been one of the key factors driving volatility of the British Pound against leading currencies since the past five years. More volatile exchange rates induce higher bilateral trade with trading partners with more stable exchange rates. A rise in trade policy uncertainty can also induce a precautionary increase in mark-ups, resulting in reduced investment and output, especially by exporting firms.
For all these reasons, the current uncertainty in trade policy is not just a huge dampener on firms’ and countries’ propensities to trade and on their volume of trade but also on investment as supply-chains get disrupted and stock markets take a hit.
The writer is Professor, Finance & Economics, SPJIMR, Mumbai, and Visiting Fellow, Centre for Social and Economic Progress, New Delhi. Views are personal
Published on April 22, 2025
