New Delhi: The rising fears of the China-US trade war morphing into a currency war have rattled markets across the globe. Last Monday, China’s renminbi breached the symbolic seven-to-the-dollar mark, which prompted the Trump administration to declare China a “currency manipulator”.
As the market sentiment weakened, the People’s Bank of China (PBoC), the country’s central bank, moved quickly to assure the markets that Beijing would not use currency depreciation to offset the costs of the US tariffs. But investors remain sceptical.
Meanwhile, in the US, the White House continues to mount pressure on the Federal Reserve, its central bank, to weaken the US dollar.
With too many contradictory signals, there is a genuine fear that a global currency war might be on the cards. More worryingly, there is no global mechanism to stop countries from entering a competitive devaluation drive, which could wreck the global economy.
Also read: World economy edges closer to a recession as trade dread deepens
Devaluation as export subsidy
The whole idea behind hiking tariffs on foreign goods and services is to protect domestic industries from competition.
When applying such trade barriers becomes hard or ineffective, another way to support domestic industry is by lowering the currency exchange rate, thus making the country’s exports cheaper.
For a long time, the US has accused China of artificially keeping its exchange rate low. This low exchange rate has been responsible for Beijing’s export led-growth model.
But to maintain exchange rates at a certain level, the PBoC needs to make necessary transactions at the foreign exchange markets. This necessity to intervene in the foreign exchange market has forced China to maintain over $3 trillion of foreign exchange reserves. And a third of these foreign reserves are held in US government bonds called ‘treasury bills’ or ‘treasuries’.
Using devaluation to offset tariff costs
Recently, the trade war saw a massive escalation when President Donald Trump announced that the US would hike tariffs on $300 billion of Chinese goods.
As a consequence, the PBoC allowed the exchange rate to depreciate below the one dollar-to-seven renminbi mark. Maintaining the Chinese currency above the seven mark, also known as ‘po qi’ in Mandarin, has become a symbol of China’s control over its currency, and more broadly, the economy. So when the renminbi breached the mark, investors across the world felt China was being forced to offset the tariff costs through currency depreciation.
Meanwhile, the Trump administration perceived it as a sign of Beijing resorting to its old techniques. The US Treasury Department responded by declaring China a “currency manipulator”.
However, Tom Mitchell argues in The Financial Times that since the start of the trade war in 2018, the renminbi has depreciated from 6.4 to 7. At a time when expectations of a China-US trade deal have risen, Chinese authorities have moved to strengthen the exchange rate again. But if the two states fail to reach a deal, the renminbi will depreciate again.
‘Manipulator’ label is meaningless
For a long time, the US and its allies tried to turn the International Monetary Fund into a currency manipulation watchdog, but failed. So, while the US Treasury Department has labelled China a “currency manipulator”, it does not lead to any tangible costs for the Chinese economy.
There is another fundamental flaw in Trump’s approach. The Chinese government is lowering its exchange rate as a response to rising trade pressures, and analysts argue that if the US prefers a more stable renminbi, it should begin by resolving the trade war.
Although China has had a long history of manipulating its currency to support exports, things have changed. As Alan Beattie writes for The Financial Times: “Making the designation during the years of heavy Chinese renminbi intervention would have been intellectually defensible, if practically meaningless. Now it is both incoherent and impotent — indeed, counterproductive.”
Also read: In Trump-Xi fight, both leaders make big bets that may backfire
Pressure on Federal Reserve
Another emerging issue on the US side has been the continued pressure by the Trump administration on the Federal Reserve to weaken the US dollar.
This growing perception about a more overt attack by the White House on the Federal Reserve’s independence is causing panic among investors, as its autonomy is considered necessary for the well-being of not only the US economy but the global economy.
Growing pressure by the Trump administration has forced four former Federal Reserve chiefs to write an op-ed advising against politicising the central bank and its monetary policy.
Complex US-China interdependence
The absence of any mechanism to stop a ‘competitive devaluations’ drive has reminded people of the currency wars of the 1930s and 1980s. Both these phases were detrimental for the global economy.
So, if Trump succeeds in forcing the Federal Reserve to artificially weaken the US dollar, starting a currency war with China, the complex financial relationship between the two countries would affect the future course of action.
Currently, China holds over a $1 trillion of US ‘treasuries’ or ‘treasury bills’ — basically government bonds — which is believed to be its leverage. So if the US begins to devalue its currency, China could respond by dumping the treasuries.
However, economists question this ‘leverage’ on primarily two grounds.
If China dumps US dollars, it is likely to increase the yield on US treasury bills and lower their value, thus effectively reducing the value of China’s foreign exchange reserves. Moreover, there is an acute lack of alternate options where China could invest instead of the US treasuries.
Today, the financial interdependence between the US and China is much greater than it was among major economies in the 1930s or 1980s, and a full-blown currency war might be worse because of this complex interdependence.
Also read: Crack open an iPhone and you’ll see why Trump’s ongoing trade war with China makes no sense
The US dollar is the world’s reserve currency. A store of value for central bankers. America’s twin deficits are financed by the rest of the world. Should the dollar begin to wobble, the US government will find it difficult borrow at 1.5%. President Trump is going against the sane advice of his senior most colleagues and advisers. The decision to levy tariffs on the remaining $ 300 billion of Chinese exports was tweeted even as a meeting with the Treasury Secretary was on and he was urging that this not be done. 2. Some import tariffs have been deferred to December, to afford relief to Christmas shoppers. A 3.1% fall on Wall Street in a single day was another cost Trump recognises. Plus the fear that a recession would harm his reelection prospects. The worst may not come to pass. We can pray that there is still some method to the great man’s madness.