The Currency Manipulation Game Is Afoot – but That’s Better Than a Trade War

The trade war between the United States and China is heating up again, with U.S. President Donald Trump abruptly announcing plans to impose a 10-per-cent tariff on the US$300-billion worth of imports from China that he had so far left untouched. The Chinese authorities then allowed their currency, the renminbi, to fall below the symbolic threshold of seven yuan for every U.S. dollar. The Trump administration promptly responded by naming China a “currency manipulator” – the first time the U.S. had done that to any country in 25 years. Pundits declared a currency war, and investors immediately sent global stock markets lower.

The U.S. assertion that the recent depreciation of the renminbi amounts to currency manipulation is not true. It would be more correct to say that the Chinese authorities gave in to market pressure – the immediate source of which was none other than Mr. Trump’s announcement of the new tariffs.

Economic theory says that tariffs do not improve a country’s trade balance in the way its proponents think they do. When an exchange rate is market-determined, it automatically moves to offset the tariff. Intuitively, if tariffs discourage U.S. consumers from buying imported Chinese goods, then demand for renminbi weakens, and the currency’s price falls.

The task of evaluating whether the United States’ trading partners manipulate their currencies lies with the U.S. Treasury Department, which uses three criteria. Two of the three coincide with internationally agreed yardsticks for manipulation under the Articles of Agreement of the International Monetary Fund: Persistent one-sided intervention by the country to push down the value of its currency, and a large current-account surplus. Neither of these applies to China today.

There was a time when China did act to keep the renminbi substantially undervalued. From 2004 to mid-2014, and particularly in 2004-08, the Chinese authorities intervened heavily to slow down the currency’s market-driven appreciation. Over these ten years, however, the renminbi still appreciated by 30 per cent against the dollar, peaking in 2014.

Then the wind changed, and market sentiment turned against the renminbi. For the past five years, contrary to what Mr. Trump and some other U.S. politicians often claim, the Chinese authorities have intervened to slow down the depreciation of the currency.

The Chinese authorities’ recent decision to let the renminbi break the seven-yuan barrier may well have been a deliberate response to Mr. Trump’s latest tariff offensive. At the same time, however, China remains concerned that its currency might slide too far too fast and destabilize financial markets.

Mr. Trump, meanwhile, is a master at accusing others of transgressions that he has committed or is considering. While accusing China of currency manipulation, he wants to do the same with the dollar. Not content with publicly pressuring the U.S. Federal Reserve to cut interest rates, Mr. Trump has explicitly attempted to talk down the currency. Clearly, he sees the world as a game of competitive depreciation.

If the U.S. were now to engage in a pure currency war against China, it would find itself outmatched, because the U.S. Treasury has only a fraction of the firepower available to the Chinese authorities for foreign-exchange intervention. Furthermore, no matter how crazy U.S. policy gets, investors continue to respond to an uptick in global uncertainty by piling into dollars, the world’s number-one safe-haven currency. Paradoxically, therefore, Trumpian volatility can send the dollar up rather than down.

More generally, major governments have so far abided by a 2013 agreement to refrain from competitive depreciation, in the core sense of explicitly talking down currencies or intervening in foreign-exchange markets.

But if currency wars are defined much more broadly to include central banks’ decisions to ease monetary policy with the side effect of depreciating their currencies, then the windmills at which Mr. Trump is quixotically tilting may not be wholly imaginary. For example, the Bank of England responded to the Brexit referendum with a monetary stimulus that depreciated the pound. More recently, the European Central Bank signaled a further easing of monetary policy in response to slower eurozone growth.

Fears of currency wars (or competitive depreciation) have always gone hand in hand with the desire to avoid trade wars. Both concerns are rooted in the “beggar-thy-neighbour” policies of the Great Depression when countries tried to gain a competitive advantage vis-à-vis their trading partners in a collectively futile exercise.

In truth, however, currency wars are less damaging than trade wars. Whereas a currency war is likely to result in looser global monetary policy, an all-out trade war could derail the global economy and financial markets.

The real significance of the U.S. decision to label China a currency manipulator, therefore, is that it represents a further escalation of the two countries’ avoidable trade war. And, sadly, Fed interest-rate cuts may give U.S. politicians the impression that monetary policy can repair the damage caused by their own trade-policy mistakes.