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Effects of the U.S. China Trade War Becoming a Currency War

Posted August 20, 2019


Earlier this month, the U.S. Treasury Department declared China a “currency manipulator” after the yuan fell above the pivotal 7 to the U.S. dollar benchmark. That was viewed by many as a major escalation in the increasingly bitter strife between Washington and Beijing. But what does this mean in practical terms for importers?

Background


Every year, as required by law, the U.S. Treasury issues a report identifying countries that it believes are intervening in some way to fix the price of their currencies in ways that contribute to economic imbalances. There is no fixed criteria for what precisely this designation means, which inherently involves a number of assumptions and judgment calls. It does, however, serve as a basis for opening negotiations with that country and justifies the imposition of punitive sanctions should they be deemed required, even though it’s worth noting that the law lacks any provisions dictating that specific remedies or actions be taken.

Even so, for more than a decade, a bipartisan group of U.S. politicians has urged the U.S. Treasury to designate China a currency manipulator. Indeed, President Trump has been one of the most vocal critics of China in this regard, long accusing the country of manipulating its currency to give it an unfair trade advantage.

The Case for Designating China a “Currency Manipulator”


The rationale, by Trump and others, was that China was running a large balance of payments surplus, including a huge trade surplus as well as massive net investment inflows — a situation that should have caused the yuan to appreciate in value relative to a then oversupplied dollar.

The rise of the yuan would have helped reverse these growing imbalances, making imports to China cheaper, and exports from China more expensive, thus narrowing the trade gap, the hawks argued. What they didn’t realize, however, was that China’s central bank was scooping up all those excess U.S. dollars and adding them to its growing foreign exchange reserves, which topped $4 trillion by 2014.

Critics argued that by intervening in this way, China was effectively keeping its currency artificially low and perpetuating its trade imbalances. In 2005, Sen. Chuck Schumer led a push to label China a “currency manipulator” and slap all Chinese imports with a hefty “countervailing tariff” to counter its “currency advantage.” Among Republicans, while President George W. Bush had some measure of success getting China to move off a longstanding peg, it did little to stop foreign exchange reserves and trade surpluses continuing to grow; a situation that led Mitt Romney to vow that he would declare China a “currency manipulator on Day One” of his term, though he never detailed what actions he would have taken.

Even with this in mind, under both Presidents Bush and Obama, Treasury refrained from officially designating China as a “currency manipulator” for various reasons. In part this was doubtless owing to them being mindful of the diplomatic furor that would have ensued had they done so, together with a shared aversion to being drawn into a pitched battle involving tariffs, something which both opposed on principle (though not always in practice).

It was also unclear whether any punitive U.S. surtax imposed on the basis of alleged “currency manipulation” would hold up if challenged at the World Trade Organization. Unlike Trump, who routinely denounces the institution which he believes treats the United States “very unfairly”, such a rejection, prior administrations feared, would undermine rather than enhance America’s leverage in shaping the future direction of global trade.

These Are Not the “Currency Manipulators” You're Looking For...


While debate over Chinese “currency manipulation” raged in D.C., unusual things started happening in 2014... China's foreign exchange reserves peaked and suddenly began to decline at an unprecedented rate. With more dollars now flowing out of China than in, the central bank found itself countering the heavy downward pressure on the yuan by selling, rather than buying, the huge number of U.S. dollars it held (typically in U.S. Treasuries).

Speculation around the implications of this triggered a sharp sell-off, cut short, ironically, by China intervening to prop up its currency and drawing down about $1 trillion of its $4 trillion in foreign exchange reserves in the process. As well as imposing capital controls that made it hard for people to move money out of China, this enabled Beijing to eventually staunch the net outflow of money and the draw on its reserves. The move also allowed the yuan to gradually depreciate to around 6.9 to the dollar — just short of 7:1, which had been seen as an important measure of stability.

Aside from anything else, what all this demonstrated was that old notions about “currency manipulation” in the familiar beltway debate had been upended, yet few politicians in Washington had realized the ground had shifted fundamentally. Instead, they carried on with the same complaints, charging that China was keeping its currency weak and viewing any drop in the Yuan as evidence of Beijing’s malfeasance.

A Mismatch Between Rhetoric & Reality


It seems hard to believe that Secretary Stephen Mnuchin wasn’t quickly alerted to the radical mismatch that existed between the inflammatory rhetoric on the Hill and the sober reality that China, if anything, was intervening to support the yuan and keep it falling below 7:1. As part of recent trade negotiations, in which Mnuchin appears at times to be heavily involved with, it had been widely understood by the U.S. up to now that China had intended to continue this policy.

Trump’s Section 301 tariffs on China – and the continual threat of more to come – have placed renewed downward market pressure on the yuan. Last year, the currency fell over 5% against the dollar, once again just shy of the 7:1 threshold. Therefore, when Trump announced at the beginning of August that he would be moving ahead with a new round of tariff hikes, all Beijing had to do was not interfere to allow the yuan to depreciate and finally break the 7:1 barrier.

Of course, the domestic monetary policy of the world’s second largest economy is incredibly complex and, as such, a great many things influence the upwards or downwards market pressure on its currency, including renewed monetary easing in both China and Europe; something Washington has complained about as of late. But given the Federal Reserve had retracted back into an easing mode, at the president’s strong urging, no less, these complaints are now largely moot.

The latest depreciation of China’s yuan was sharp and abrupt reaction clearly made in response to the threat of new U.S. tariffs. President Trump and his economic advisers may be angered and frustrated that Beijing did nothing to stop it from devaluing, but it didn’t precipitate the drop either.

What Does It All Mean?


Labeling China a currency manipulator on this basis is a highly dubious move, but what does it mean in practical terms? In fact, the designation has very little direct consequence, besides heightening the rhetoric on each side. It could be used as the basis for additional tariffs, but there are already plenty of other reasons for doing that if Trump wants to pursue that course. The Fed could ease more in order to weaken the dollar as Trump has repeatedly said he wants, or as he tweeted recently: “We should MATCH, or continue being the dummies who sit back and politely watch as other countries continue to play their games – as they have for many years!”

Following that course of action however, would affect every other country, not just China, and could therefore have widespread unintended consequences. One possibility, albeit not a likely one, is that the U.S. Treasury could intervene itself in currency markets to buy up yuan with dollars to artificially boost its price, though purchasing billions in yuan-denominated Chinese financial assets, in the midst of a trade war with Beijing, may be a move too brazen even for Trump.

Bottom line is that the implications of exactly what the U.S. designating China a “currency manipulator” means other than to needlessly ratchet up tensions between the two sides and make the likelihood of reaching a deal even more remote, are not entirely clear. More so, that is, than was already the case with an administration still aggressively touting the “billions and billions” that are “pouring into the coffers of the USA,” while also perpetuating the erroneous belief that China is bearing all the cost of the tariffs — the exact opposite of reality.

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