07 Dec 2018
With US President Donald Trump accusing China of manipulating its exchange rate to gain the upper hand on trade, we consider the likelihood of an all-out currency war between the rival superpowers.
The trade war between the United States and China is intensifying.
On September 24, the two countries hit each other with their biggest round of tariffs yet: Washington slapped ten per cent levies on $200 billion of Chinese imports, spanning thousands of products; China retaliated immediately with new taxes of between five and ten per cent on $60 billion of US goods, including meat, chemicals, clothes and auto parts.1
The moves marked a significant escalation in the growing conflict between the world's top two economies. US President Donald Trump's tariffs now apply to over $250 billion of Chinese exports, roughly half the annual total. Having placed levies mostly on industrial goods earlier in the year, Trump’s latest tariffs include thousands of products bought by US consumers, including furniture, electronic devices and even baseball gloves.
There seems every prospect of the fight intensifying. Not only is the size of the US levy set to increase at the end of the year to 25 per cent, Trump has threatened tariffs on a further $267 billion of Chinese products.2 That would mean virtually all China's annual goods exports to the US being subject to tariffs, with the US having imported $527 billion worth of goods from China in the year to the end of June.3 China, which is running out of new US products to target in response as it imports barely a quarter of that amount – $135 billion – has failed to spell out what, if any, further steps it is considering.4
China’s options
Renowned foreign exchange expert Jens Nordvig, founder and chief executive of Exante Data, which provides data and analysis to the financial industry, believes an obvious option open to Beijing is to subsidise key industries to limit the damage. Indeed, he believes this has already started to happen.
Nordvig, a former head of foreign exchange research at Nomura, says Beijing has other avenues open to it, including halting the export of various items such as rare earths or high-tech components; boycotting various US goods as it has done before with Japanese products; and reducing its holdings of US government bonds, worth almost $1.2 trillion. Given the extent to which relations with Washington have soured, he sees a significant risk that it will deploy some of these other weapons.
Perhaps most worrying of all, there has been speculation Beijing may be seeking to maintain the competitiveness of its exports by deliberately weakening its currency, the renminbi. That could potentially open an altogether more chaotic front in the conflict with Washington. After hitting its highest level against the US dollar in nearly three years on April 11, by October 8 the renminbi had fallen nearly ten per cent – it lost 3.3 per cent of its value in June alone, the worst one-month decline since China established its foreign exchange market in 1994. The fall has left it hovering just above its lowest level in a decade.
The move has not gone unnoticed in Washington. Trump, who on the campaign trail declared China a ”currency manipulator“, complained on July 19 the renminbi was “dropping like a rock”.5 On October 9, US Treasury Secretary Steven Mnuchin warned China not to engage in competitive devaluations of its currency.6
The renminbi’s fall: intervention or market forces?
However, while some commentators question whether the fall has been deliberately engineered by China, the evidence suggests otherwise, according to Joubeen Hurren, fixed income portfolio manager at Aviva Investors.
He argues that although it would be natural to assume China is letting its currency fall to make its exports more competitive and neutralise the bite from US tariffs, it seems more likely market forces have been behind the currency’s weakness, with the economy having slowed in part due to Chinese authorities’ efforts to rein in credit creation.
“If you look at where the exchange rate fixes have been taking place relative to the previous day’s close, the PBoC (People’s Bank of China) has been fixing it stronger. It has actually been attempting to prevent it dropping too fast,” Hurren says.
Others concur. Harvard University professor Jeffrey Frankel describes Trump’s accusations that China is manipulating its currency downwards as “absurd”. “Since 2014, China has spent $1 trillion in reserves trying to stop its currency depreciating. That is a heavier intervention in the foreign exchange market than any country has made in history,” he says.
Nordvik also sees “no evidence” the PBoC has been selling the yuan “according to the most reliable metrics we have”.
Having abandoned a policy of fixing the exchange rate in 2005, China has allowed the renminbi to float in a narrow margin around a rate determined with reference to a basket of world currencies. Its value against the dollar is permitted to fluctuate in a band around a daily reference rate. That band has gradually grown looser, from plus or minus 0.3 per cent in 2005 to plus or minus two per cent since March 2014.
While acknowledging Chinese officials have an interest in not saying anything that could inflame tensions further, Hurren says recent events reinforce his view that the trade spat is not morphing into a currency war.
Chinese Premier Li Keqiang, during a speech at a World Economic Forum event in the northern Chinese city of Tianjin on September 19, said China “will never go down the road of relying on yuan depreciation to stimulate exports”.7
Hurren says it is important to recognise that at the same time as the renminbi has been coming under pressure – due also to the anticipated effect of Trump’s tariffs – the dollar has been underpinned by a strengthening US economy and rising US interest rates. He points out the renminbi is far from alone in losing value against a resurgent dollar, with various other emerging market currencies having been hit even harder as the withdrawal of US monetary stimulus and rising trade tensions cause a flight of foreign capital.
Furthermore, complaints from the US – and for that matter a number of other countries – that China keeps the value of the renminbi artificially low, boosting its exports and trade surplus at the expense of trading partners, are nothing new.
Although the US Treasury has repeatedly stopped short of labelling China a ‘currency manipulator’ in its twice-yearly reports to Congress, it has consistently pressured Beijing to allow its currency to appreciate at a faster pace and fluctuate more freely in line with market forces.
The International Monetary Fund (IMF), the World Bank and many economists have also argued for faster appreciation and a more flexible exchange-rate policy. Partly in response to these pressures, but more because of domestic considerations, China has allowed the renminbi to rise by around 20 per cent against the dollar since July 2005. Yet the pace of appreciation has not appeased the US and other countries, whose manufacturing sectors continue to face stiff competition from cheaper Chinese goods.
The magic number seven
While there may be little evidence China has been trying to weaken its currency to date, it is still too soon to rule a devaluation out.
“We need to see what happens to the renminbi in the final months of the year. If China respond to this further escalation (of tensions) by letting it fall below seven (to the US dollar), that would be significant,” says Nordvig.
By contrast, Hurren would be wary of reading too much into such a move. While Beijing has historically been prepared to abandon long-term objectives to ensure economic growth hits its target, and a weaker currency would help to offset any negative impact of US tariffs, there seems little need for it to go down that route for the time being.
That, somewhat ironically, is because Trump’s domestic economic policies are likely to severely compromise the effectiveness of the tariffs in cutting the US current account deficit. Partly fuelled by swingeing tax cuts, US growth has been accelerating rapidly in recent months. With the economy already operating at close to full capacity, imports are being sucked in at a record pace, including from China. It is unclear tariffs will be able to stem the flow by much until the economy begins to cool.
According to data from the US Commerce Department, the US deficit on trade in goods and services totalled $338 billion on a seasonally-adjusted basis in the first seven months of 2018, seven per cent higher than the prior year, as imports climbed more than eight per cent to a record $1.8 trillion. A breakdown revealed the all-important bilateral deficit on trade in goods with China climbed nine per cent to $223 billion; imports rose by a similar margin to $297 billion.8
If US tariffs do eventually depress China’s growth rate by a half a percentage point or more, as some analysts are forecasting, it may suit the PBoC if the renminbi were to depreciate a little bit further. But Hurren believes even if the tariffs were to have such a material impact on the Chinese economy, it is more likely Beijing would look to support activity primarily via fiscal policy, and other types of monetary policy measures, rather than a weaker exchange rate.
Beijing’s eyes fixed on long-term goals
In any case, for now, with tariffs having failed to curb US demand for Chinese goods, Beijing is unlikely to be diverted from its long-term goals: rebalancing the economy from investment towards consumption; reducing high debt-to- GDP levels; liberalising its capital markets; and potentially having a fully-floating currency.
Many commentators have suggested the trade war between the US and China is an inevitable consequence of the latter’s emergence over the past two decades as a genuine economic superpower. And that is encouraging it to challenge the global economic architecture built from the ruins of World War II and the US’ dominant role within it.
For instance, Steve Bannon, Trump’s firebrand former chief strategist, who in 2017 said there was “no doubt” the two nations were heading to war within the next decade over islands in the South China Sea, claims the US has been fighting an economic conflict with China for decades.9
“A hundred years from now, this is what they’ll remember – what we did to confront China on its rise to world domination,” he told The New York Times last September.10
Indeed, in 2017, Chinese President Xi Jinping admitted China’s long-term strategy was to supersede the United States as the most powerful and influential nation on earth within 30 years.11
Reserve currency vs currency reserves
According to James McAlevey, global head of rates at Aviva Investors, it is understandable why some people are paying such close attention to the renminbi at present given the size of China’s trade surplus and its past efforts to depress the value of its currency.
However, he argues it is important to keep in mind that China’s desire to see the renminbi replace the dollar as the world’s premier reserve currency is a central plank of its goal to oust the US as the world’s hegemon.
“Who wants to hold reserves in a currency that’s likely to be devalued ten per cent every time they’re caught in a trade spat? We think China’s playing a very long game here. It all comes down to the battle for supremacy between the US and China, one of which has the global reserve currency and the other the most reserves,” he says.
According to the IMF, the renminbi accounted for just 1.7 per cent of global central banks’ holdings of foreign exchange reserves at the end of September.12 However, McAlevey, who points out that represents a 100 per cent increase in the space of 12 months, believes the renminbi’s share of global reserves will inevitably climb further as China loosens its capital controls, once its domestic financial markets are sufficiently large and liquid and once the renminbi is freely traded. Should China – the biggest foreign owner of US government bonds – scale back its buying of Treasuries in the coming years as it looks to diversify its foreign exchange reserves, any attempt to weaken the currency now would be counterproductive.
Phoney currency war
All of this is not to deny currencies are being used by various countries as a tool to maintain their slice of the global economic pie. For instance, McAlevey says that to some extent the world has been engaged in a phoney currency war ever since the financial crisis, as central banks around the world slashed interest rates to zero and beyond to try to reflate their economies. One of the unstated aims of this policy was to boost exports via weaker exchange rates.
Other countries have been intervening more directly. According to Joseph Gagnon and Tessa Morrison of the Peterson Institute for International Economics, a Washington-based economic think tank, between 2015 and 2017 seven non-resource exporting countries – Hong Kong, Israel, Macau, Singapore, Switzerland, Taiwan and Thailand – bought excessive amounts of foreign currencies to pin down the value of their own to maintain large current account surpluses.13 For example, the IMF estimates Switzerland alone purchased $171 billion in 2016 and 2017.14
Many of these countries have huge current account surpluses. According to the IMF, Singapore had a surplus of 18.8 per cent of GDP in 2017. In Taiwan it was 14.5 per cent and in Thailand 10.6 per cent.15 Collectively these countries are important and these surpluses are deficits for other nations.
Crack down on currency manipulation
With Trump having so far been focused on tariffs, currencies have largely gone under the radar. However, that could be set to change. In March it was announced Washington had reached agreement with South Korea – a country which has been accused of manipulating its currency in the past – on a revised free-trade pact. The deal contained a side agreement calling for a crackdown on currency manipulation and steps to bolster transparency in foreign exchange practices.16
Although Brad Setser of the US Council on Foreign Relations described it as a “bad deal” and the level of disclosure required of Korea “underwhelming”,17 Gagnon and Morrison believe the side agreement could have “broad implications” for future US trade policy.18
ECB governing council member Ewald Nowotny recently warned there could be an accidental currency war if the global trade battle escalates further. Perhaps mindful that a succession of devaluations and so-called beggar-thy-neighbour policies preceded the Great Depression of the 1930s, he said the situation could escalate and potentially have a more serious effect than a trade spat.19
However, while some countries will no doubt continue to look for ways to use their currency as a means of defending their economic interests, it is far from clear the escalating trade war between the US and China will lead to a currency war between the two nations that matter most.
As Hurren says: “While devaluing the renminbi might be a tempting riposte to Trump’s tariffs, it would not be doing much more than sticking a plaster over a short-term problem when all their focus is on the long-term prize.”
1. ‘China Strikes $60 Billion of US Goods in Growing Trade War,’ Bloomberg, 17 September 2018
2. ‘Trump says he's ready to hit China with another $267 billion in tariffs,’ CNBC, 7 September 2018
3. Source: United States Census Bureau
4. Ibid.
5. ‘US President says Chinese currency “dropping like a rock”,’ CNBC, 19 July 2018
6. ‘Mnuchin warns China on currency devaluations,’ Financial Times, 9 October 2018
7. ‘China says won't weaken currency to boost exports, as U.S. tariffs mount,’ Reuters, 19 September 2018
8. Source: United States Census Bureau
9. ‘We're going to war in the South China Sea ... no doubt,’ The Guardian, 2 February 2017
10. ‘Next Stop for the Steve Bannon Insurgency: China,’ The New York Times, 8 September 2018
11. ‘China reveals plan to become world’s biggest superpower within 30 years,’ The Independent, 21 October 2017
12. Source: International Monetary Fund. Currency Composition of Official Reserves (COFER) report published 28 September 2018
13. Currency Manipulation Update for 2015-17. Peterson Institute Report by Gagnon J. and Morrison T., 3 April 2018
14. Source: International Monetary Fund, Currency Composition of Official Foreign Exchange Reserves
15. Ibid.
16. ‘US, South Korea to revise trade pact with currency side-deal, autos concessions,’ Reuters, 27 March 2018
17. ‘A bad deal on currency (with Korea),’ Council on Foreign Relations. Blog Post by Setser B, 18 May 2018
18. Op. cit.
19. ‘ECB’s Nowotny cautions over dangers of unintended currency war,’ Financial Times, 9 July 2018