US-China trade war risks becoming a currency war — with greater damage

Leaders of the world’s most advanced economies — Canada, France, Germany, Italy, Japan, the United Kingdom and the United States, known as the Group of 7 (G-7) — met in France last month, with the world markets on edge and economies slumping.

Divisions major and minor exist between the U.S. and many of its fellow G-7 partners. Several members — notably, Italy at the moment — are in domestic political tumult; Britain is struggling to extricate itself from the European Union. Russia, as always, casts a dark shadow over all. And China, with its Belt and Road initiative, is an economic challenger for some and an important partner for others.

One formidable challenge on the minds of G-7 leaders was the escalating U.S.-China trade war and its fallout on world markets and slowing global economy. It ratcheted up again, with President Trump’s announcement of new U.S. tariffs on $300 billion worth of Chinese goods — some imposed this month and the rest planned for December — and China’s announcement in response of new tariffs on $75 billion worth of U.S. goods. (China plans to hold back on part of that as a gesture to help restart the talks, which have not been rescheduled.)  

To the trade war’s disruption we now can add the possibility of even greater disruption from a potential currency war. We aren’t there yet; we can avoid it. But to do so, we must understand this is not just about numbers. There are deeper issues — mistrust, misunderstanding, conflicting political pressures.   

On Aug. 5, China’s currency, the renminbi (RMB), fell below what markets consider the “psychologically significant” level of 7 RMB to the dollar. The drop, less than 2 percent, was hardly enough to trigger the enormous market reaction that followed. President Trump accused China of currency “manipulation” — lowering the value of the RMB against the dollar to neutralize the impact of his tariffs. However, with tariffs on nearly half of Chinese imports already at 25 percent, the 2 percent drop would have little impact. 

President Trump pressed the Federal Reserve to counter by pushing down the dollar’s value and pushing up the RMB. Actually, the Treasury, not the Fed, has authority over such actions but did not institute measures to do that.  

Taken together, these actions raise fear of a series of competitive devaluations — a currency war. 

China’s policies

In the past, China’s central bank had intervened in currency markets to lower the value of the RMB enough to make Chinese exports cheaper (and thus more attractive to foreign buyers) and imports more expensive (and thus less attractive to Chinese consumers).

For several years, however, China actually has propped up its currency to make it stronger, not weaker. This time, China held back on such intervention; it cut down on purchases of RMB that had supported its value, and the currency fell in response to market pressure. These market forces likely were triggered by the expectation of U.S. tariffs shrinking Chinese exports: Markets generally respond to a weakening trade balance by selling a country’s currency. 

There likely also were political signals involved in this decision. China’s leaders regarded President Trump’s earlier warning that he would impose new tariffs as violating the “truce” he reached with President Xi Jinping during June’s G-20 Summit. They assumed that would preclude such measures.  

For Xi, facing internal pressure to demonstrate strength, a response likely was imperative. Allowing the central bank to stand aside while the RMB dropped was one way to signal a negative reaction. Because Chinese authorities do not want a sharp currency drop, the slide was controlled. But it was, nonetheless, a signal that additional U.S. tariffs could increase market pressure on the currency — and, perhaps, a willingness to allow the RMB to fall further. In fact, the currency has fallen by roughly another 2 percent since early August.

U.S. policies 

There are three U.S. criteria to brand a country a currency manipulator; China fulfills only one. The Treasury’s charge that Beijing was guilty of manipulation because its central bank did not buy RMB in the markets to support it, despite having “plenty of cash on hand,” is not a criterion. 

And U.S. law requires only that, even if a country is found to be a manipulator, the Treasury work with it and the International Monetary Fund (IMF) to ensure “that [it] regularly and promptly adjusts the rate of exchange.” A key problem for the U.S. is that the IMF has stated publicly that the RMB is not undervalued.   

There are, however, other possible ramifications. 

The administration might further raise tariffs, based on a previously proposed policy by the Commerce Department to impose countervailing duties — normally used to offset direct trade subsidies — against China, on grounds that a lower RMB constitutes a subsidy. Commerce in May released a draft proposal to add currency devaluation as one justification for countervailing duties — a justification that has never been used by any country. China could bring a case against the U.S. since that move would run afoul of World Trade Organization rules. 

The U.S. might seek an international agreement to push up the Chinese currency’s value and push down the dollar’s. This has been done before; in September 1985, the U.S., France, Germany, Japan and Britain produced the Plaza Accord that sharply reduced the dollar’s value, particularly against the Japanese yen. 

That old playbook is unlikely to work today, however. There are benefits to engaging other nations, but cooperation with key allies and other major powers — with most of whom the U.S. is engaged in trade (e.g., tariffs and threats of tariffs) or currency disputes — would be an enormous stretch, as would persuading China to agree to a large currency realignment.

The U.S. could decide to try this alone. Treasury has money to influence currency values in its Exchange Stabilization Fund, but only about $100 billion. The Fed has far more available, but may be reluctant to join in. China’s reserves are around $3 trillion — so its unlikely the U.S. would win this battle.

Moreover, such an effort would trigger a full-scale currency war and probably escalate the trade war. In such unstable times, international investors often flock to the safest assets — U.S. Treasury bonds — so the dollar could actually rise or, at least, drop very little. 

Almost certainly, President Trump will intensify pressure on the Fed to lower U.S. interest rates a lot more, assuming that this would discourage purchases of dollar bonds because of their shrinking return — and that this would cause the dollar to depreciate. Even without pressure, the Fed is likely to lower interest rates largely because the trade war is beginning to slow U.S. growth. But this will be a gradual process and do little to resolve Sino-U.S. trade imbalances. 

What’s next

So far, recent currency-related events have not had much economic impact beyond market volatility. And labeling China a currency manipulator has not produced any direct adverse economic action. 

But there is a precarious balance here, and the cycle of escalation could emerge at any time.  

There are no easy answers. What started as a conflict over tariffs and trade deficits has spread to conflicts over investment, advanced technology exports and imports, intellectual property, trade secrets and, now, currencies. An all-out currency war could become the worst of these, at least in the short term, because it would disrupt virtually all global stock and bond markets as well as trade, and impact mortgages, 401(k) retirement plans, etc. Many other currencies could drop sharply.

Averting this requires an effort to avoid both competitive depreciation and cascading charges and reprisals. Both nations might include in their discussions at least a few other major international financial powers to help produce a compromise that is consistent with international norms and rules — and because they share an interest in a rational, market-calming outcome.  

Robert D. Hormats, vice chairman of Kissinger Associates, was undersecretary of State for Economic Growth, Energy and the Environment, 2009-13; assistant secretary of State, 1981-82; and a former ambassador and deputy U.S. trade representative, 1979-81. As senior economics adviser to three White House national security advisers from 1969 to 1977, he helped to oversee the U.S. opening to China. He is a former vice chairman of Goldman Sachs (International). Follow him on Twitter @BobHormats.