Report

Is the Trade War About to Become a Currency War?

Some experts figure Beijing might risk further driving down the renminbi against the dollar.

A panda sleeping at the Shenyang Forest Wild Zoological Garden in northeastern China on Dec. 30, 2017. (AFP/Getty Images)
A panda sleeping at the Shenyang Forest Wild Zoological Garden in northeastern China on Dec. 30, 2017. (AFP/Getty Images)

Long before he became U.S. president, Donald Trump railed against what he called China’s manipulation of its currency for economic advantage, even when that wasn’t quite true. Now, thanks to Trump’s escalating trade war, China is increasingly tempted to let its currency further slide in value—precisely what the president and the rest of his administration have warned Beijing not to do.

China so far has responded to the Trump administration’s trade war, especially tariffs on $250 billion worth of Chinese imports, with tariffs of its own on U.S. goods, especially agricultural products. But China is running out of tit for tat responses, as it imports much less from the United States than it exports, leaving Beijing looking at other ways to get back at Washington such as throwing up fresh barriers to U.S. businesses and undermining U.S. foreign-policy goals.

But there are still powerful—if risky—economic arrows left in China’s quiver. Over the spring and summer, Beijing found one way to take much of the sting out of U.S. tariffs, by letting its currency slide by about 9 percent against the dollar to the lowest level in several years, making its own exports that much cheaper and largely offsetting the impact of U.S. duties.

For the value of the Chinese renminbi—also known as the yuan—to fall that far, that fast, was a conscious decision, because Beijing still largely controls the value of its currency and could have intervened to stop the slide. And some China trade experts are betting that China’s rulers are now dug in enough against Trump that they could soon let the currency slide again.

“It was a signal to Washington that we don’t like what you are doing, and if you keep slapping on tariffs, our currency is going to weaken significantly, and you’re going to have a currency war on top of a trade war,” Robin Brooks, the chief economist at the Institute of International Finance, the global association for the financial industry, said of this summer’s dive.

In some ways, the earlier move to weaken the renminbi was an easy decision, since the currency had steadily gained in value the prior year, giving it some room to fall without causing serious damage.

But China’s currency is now being pushed downward due to a host of factors. As the United States raises interest rates, it makes Chinese rates relatively less appealing, pushing down the renminbi. Chinese central bankers are also trying to inject more cash into the banking system, essentially pursuing the kind of “looser” monetary policy meant to shore up growth that also tends to push down currencies.

Now, with Trump’s tariffs set to escalate even further, there are fears that China could just let the renminbi fall as it did this summer, essentially unleashing a currency devaluation that would further ramp up bilateral tensions.

In late September, the United States levied 10 percent tariffs on a whopping $200 billion worth of Chinese goods, and the tariff is scheduled to rise to 25 percent in January. Trump has also threatened additional tariffs on $267 billion worth of Chinese products, adding up to essentially everything the country ships to the United States. Those escalating U.S. actions, and especially the likelihood that tariffs will jump to 25 percent next year, are giving trade hawks in China a fresh hearing, Brooks said.

“The expectation is that as tariffs go up to 25 percent, the hawks will be more vocal,” he said.

Moreover, despite Trump’s confident assessment at the United Nations General Assembly meetings last week that “we are winning on every level,” Beijing shows no signs of backing down. “China will not be blackmailed or yield to pressure,” Chinese Foreign Minister Wang Yi said at the same gathering in New York.

But further devaluation would be a risky play for China, which stepped in to stabilize the renminbi in late summer right above a critical psychological threshold of about 7 to the U.S. dollar. If Beijing decides to let the currency slide further in value, it’s not clear when or where it would stop, which could spook Chinese savers and domestic stock markets and undermine the Chinese leadership’s sense of control.

“The challenge for China is that any further move [downward] would be perceived as a shift in policy, and it’s not clear where the limits might be,” said Brad Setser, a former economic official in the Obama administration now at the Council on Foreign Relations.

“They’re more constrained than they were a few months ago, because it would be a much more consequential decision,” he said. “Then again, if the U.S. ends up with tariffs of 25 percent on the majority of its trade with China, that’s also quite significant.”

For China, letting its currency fall in value would serve a couple of different objectives. Depending on how much it slides, it would offset most of the upcoming U.S. tariffs, making Chinese exports about as competitive as they were before the trade war began. That’s an important consideration now that the damage from U.S. tariffs is starting to percolate through the Chinese economy.

But there’s another reason that a falling renminbi might appeal to policymakers in Beijing: It could spook global stock markets, including in the United States. When China devalued the renminbi in the summer of 2015, stock markets around the world shuddered. Given the importance of buoyant stock prices to Trump’s perception of his economic stewardship, such a move could get his attention, Brooks said.

“If the trade hawks in Beijing prevail, they may argue, first of all we need to weaken the currency to offset tariffs, and, second, if we can unsettle the stock market, maybe we can weaken the resolve of the U.S. president,” he said.

But there are plenty of risks to such an action. China suffered massive capital flight during the currency depreciation of 2015 to 2016, as Chinese investors sought to move out of renminbi-denominated assets. Allowing the renminbi to fall further in value could spark another huge capital outflow. Then again, after that episode, Beijing put some restrictions in place to limit capital flight, which might make devaluation more tempting.

The big question remains: Are Chinese policymakers more afraid that the trade war will poleax the economy, or that a cheaper renminbi will lead to another exodus of Chinese capital?

“We don’t know to what extent 2015 so scarred them that they are no longer willing to look at depreciation as a tool, or whether they concluded that they have the available tools to limit capital flight, so they can with some difficulty manage a depreciation,” Setser said.

A cheaper Chinese currency wouldn’t just have impacts at home. It would likely push other emerging-market currencies further down as well, which would make their debt burdens that much harder to bear (even if it would erode some of China’s export advantage). A cheaper renminbi and a flood of Chinese imports would also further anger Japan and the European Union, which have sought to join the Trump administration in a unified response to China’s trading practices in general.

With all the forces pushing down the renminbi, including the trade war, U.S. rate hikes, and more domestic economic stimulus, the only way Beijing can likely avoid further devaluation is by stepping in and actively propping up the currency, as it did in 2015 to 2016 by spending more than $1 trillion in foreign-currency reserves.

That might make U.S. officials in Washington happy, but it would represent an odd about-face for an administration that’s been so vocal about the need for Beijing to stop manipulating its currency.

“The irony for the administration is that in the near term, the United States wants China to continue to manage its exchange rate,” Setser said.

Keith Johnson is Foreign Policy’s global geoeconomics correspondent. @KFJ_FP

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