Currency War

The shadow of a currency war is falling over the China-United States trade war, which has now reached a point where it may drive the world economy to the brink of recession. A possible face-off between the yuan and the greenback is bringing back the spectre of the Great Depression of the 1930s

by Gérard Bérubé

On Monday, August 5, the People’s Bank of China set the yuan’s daily reference rate at 6.9225. The Chinese currency promptly fell, crossing the symbolic 7-per-dollar threshold for the first time in 11 years. Analysts have been saying that the move is a political response to Donald Trump’s new threat to impose 10% additional tariffs on hitherto untaxed Chinese imports, starting mid-December. Wall Street stocks plummeted, with investors seeing China’s “competitive devaluation” as the latest weapon in the currently escalating trade war between China and the United States. In Washington, US Treasury Secretary Steven Mnuchin responded by formally accusing China of manipulating its currency, taking care to specify that he was acting “under President Donald Trump’s orders”.

However, at this point the tone is still rhetorical as there is, in fact, no evidence of currency manipulation. As recently as its May 2019 semi-annual report on the subject, the US Treasury concluded that no major US trading partner had manipulated its currency in order to gain an unfair advantage; that no country has crossed that line, not even China. Last year it acknowledged that China was not devaluing the yuan to boost its exports, concluding that none of the major partner countries had met its currency manipulation criteria in 2018, and that direct foreign exchange intervention by the People’s Bank of China (PBOC) had been “limited”.

In July, the International Monetary Fund concluded that China’s external position is “broadly in line with the level consistent with medium-term fundamentals and desirable policies,” an indication the yuan was remaining basically stable around its fair value. This conclusion did nothing to prevent experts from harking back to the defining event of the 1930s tragedy and evoking the possibility of a trade war. At the time, it was the US that began trade hostilities by raising tariffs on over 20,000 imported goods. This move was met by retaliatory tariffs from its trading partners, thereby raising trade barriers around the world. In 1931, Britain abandoned the gold standard, resulting in a 40% drop of the British pound against the US dollar and forcing the United States and Japan to follow suit.

A Warning

According to Germain Belzile, Senior Lecturer in the Department of Applied Economics at Montreal’s HEC business school, “It is widely acknowledged that these measures, aimed at protecting domestic markets, actually worsened the Great Depression.” Belzile views the August 5 step taken by the People’s Bank of China as a warning. In fact, Trump has been consistently calling on the Federal Reserve to make a large interest rate cut then, only four days later, he insisted that he would never devalue the greenback, saying in response to a reporter’s question on the matter “We don’t have to […] We have the safest currency in the world.”

But behind this warning shot, China is taking a more aggressive role in this seemingly never-ending conflict. “Especially given that there is no consensus as to the actual or true value of the Chinese renminbi,” says Belzile, adding that there is also the risk of retaliatory measures being imposed by other trade partners in a tit-for-tat game of trade relations and protectionism.

Dominique Lapointe, an economist with Laurentian Bank Securities does not call the 1.2% devaluation following the PBOC’s move “aggressive”. “It’s a fairly modest drop.” In order to reduce the effect of Trumps’ threatened 10% import tariffs, Lapointe estimates that the bank could have devalued the currency by 6%. Germain Belzile agrees, saying “the tariffs imposed by the United States put upward pressure on the local currency and downward pressure on its counterpart.”

In a paper published shortly after the August 5 currency adjustment, Xinxin Li, a partner at New York-based economic and political advisory firm Observatory Group, quotes a PBOC statement in which it claimed that its actions are a response to unilateralism and protectionism, without specifically naming the United States. According to Li, the bank’s short-term intent was simply to send a warning, not to start or even threaten to start a trade war. However, Li does see the move as indicative of Beijing’s tougher stance. Since early 2018, the renminbi devaluation has followed the imposition of US tariffs but, this time, the Central Bank and the Chinese government have decided to act of their own accord – a sign of just how difficult China-US relations have become.

The yuan will most likely continue to trade in the 7.2-7.5 yuan per US dollar range until the end of 2019, with a new 7.3 yuan-per-dollar benchmark. A restrained response from Beijing to US tactics is to be expected. But if the Trump administration follows through with its tariff threat on September 1, that will “open the door to faster devaluation,” and set off a “chain reaction of competitive devaluations in financial markets,” writes Xinxin Li in his paper. If this were to happen, the Japanese yen and the euro would experience upward pressure while the currencies of emerging countries would suffer.

The US goes to war

Lapointe agrees that China will continue to respond patiently and methodically adding that, if a currency war does break out, it will be initiated by the US. He recalls all those US Treasury reports confirming that no major US trading partner was engaging in currency manipulation. “As recently as last May, and despite the Treasury raising the threshold of the three main evaluation criteria, all major trading partners, including China, successfully passed the test. However, this did not prevent the Treasury Department from going against its own criteria and declaring China a currency manipulator.” This accusation could lead to sanctions being imposed on foreign ownership and financial transactions with the United States. “By adding to the already growing pressure on China, the United States would be opening up a Pandora’s box.”

Belzile shares the same moderate outlook, believing China will try to downplay the spat until the US presidential elections, hoping support for Trump will decline in the meantime. “However, the end result of all this is a great deal of investor uncertainty, and steadily rising odds of a worldwide recession.”

Especially since China has little to gain from playing the currency devaluation game. In 2016, when the PBOC cut its daily yuan reference rate by over 6%, Beijing believed this would increase the currency’s value. “Instead the opposite happened, as the move set off a capital outflow. The Chinese government doesn’t want that to happen again.” Lapointe adds to the list of consequences by mentioning increased inflation and higher import prices for products such as petroleum, which China badly needs. “Look behind the official GDP figures and you’ll see a fragile economy plagued by weak sectors such as manufacturing.” But who knows? “China’s retaliation against American agricultural products is affecting Chinese consumers, but that is a price the government agrees to pay.”

Belzile agrees: “American consumers and companies pay for the government’s tariffs but the US economy is strong enough to withstand the economic impact. Not so China, where 600 million people have moved from rural areas to the country’s many burgeoning cities. Unemployment is growing and automation is resulting in many job losses, particularly in the manufacturing sector.” The HEC lecturer mentions the “tacit agreement” between the government and its people, whereby totalitarianism is accepted – or at least tolerated – in exchange for jobs and a better quality of life. He emphasizes that weakening this “social contract” would definitely lead to political problems for China, although he is careful to add that the US would not be immune from a global recession.

In conclusion, Belzile recalls that, early in his mandate, Trump claimed that “trade wars are good and easy to win”!