Trade war with China risks becoming a currency war
It turns out that trade wars aren’t so easy to win. Would a currency war be any different, or more importantly, any less dangerous?
Earlier this month, China fired a shot across the bow of foreign exchange markets by allowing the onshore value of it currency, the renminbi, to weaken below the symbolically important sevento-the-dollar level. Though the weakening was small in percentage terms, its message was unmistakable, coming only four days after the Trump administration threatened to impose a 10% tariff on an additional $300 billion of Chinese exports, a warning that also caused China to suspend purchases of American agricultural goods.
The tit-for-tat between the world’s two largest economies was viewed as a possible preview of more damaging skirmishes to come, and thus triggered a selloff in stocks and a massive rally in safe-haven bonds that shows only tentative signs of abating. That selloff continued Friday following the latest tariffs imposed by China on U.S. products.
Trump’s recent tweet that the dollar is the “highest … in U.S. history” is false. Even after a 36% rise since July 2011, the real tradeweighted value is actually 3% below the level when he took office and 20% below its 1985 peak.
Boring — until it isn’t
Currencies are the tectonic plates of the global financial system, grinding away at a snail’s pace below the surface of world commerce. Discussions of foreign exchange rates will generally clear a room, at least until those plates slip and asset prices quake.
To prevent such upheavals, the United Nations in July 1944 convened a conference at Bretton Woods, New Hampshire, to forge a post-World War II monetary system based on cooperation and interdependence. The goal of the 44nation participants was to enshrine exchange rate stability and thereby head off the competitive devaluations that contributed to the inflations, deflations, trade wars and recessions that followed World War I.
A quarter-century of relative stability ended in 1971 when President Richard Nixon, faced with an untenable balance of payments shortfall, effectively terminated Bretton Woods, setting in motion a resurgence of inflation and economic instability that continued for over a decade.
In 1985, policymakers from the major developed economies cooperated to bring down the high-flying U.S. dollar, but implementing the so-called Plaza Accords eventually played a role in the 1987 stock market crash. A few years later, currency volatility in Asia also shook global financial markets, as did China’s decision to devalue the renminbi by 3% in 2015.
Race to the bottom?
One way for a country to offset the effect of tariffs is to allow its currency to weaken by an equivalent amount. Which is why a trade war could metastasize into a currency war.
Aside from China’s warning shot this month, that seems not to be happening — so far.
Foreign currencies are weak because growth overseas is weak, causing central banks in Europe and Japan to lower benchmark interest rates, as Trump demanded the Federal Reserve do as well.
Notably, Trump’s recent tweet that the dollar is the “highest … in U.S. history” is false. Even after a 36% rise since July 2011, the real trade-weighted value of the U.S. currency is actually 3% below the level when he took office and 20% below its 1985 peak.
In fact, the dollar is now almost exactly in the middle of its trading range of the last 46 years. And despite its recent 2% decline, China’s currency is still up about 15% since 2005.
Risky business
There are several ways that a fullblown currency war might erupt in coming months.
The U.S. Treasury could draw upon its $100 billion Exchange Stabilization Fund to intervene in the offshore renminbi market, where the Chinese currency floats freely. China could respond by using its $3 trillion of reserves to buy dollars — thus driving up the greenback’s value, or sell a portion of its $1 trillion of U.S. Treasury securities, thereby pushing up U.S. bond yields.
Each of those moves carry enormous risks.
By weakening the onshore renminbi further, China could ignite inflation and trigger capital flight. By intervening to push down China’s offshore currency, the U.S. would be setting a dangerous precedent while lacking the financial firepower to make much of a difference anyway.
With the trade war already damaging growth prospects nearly everywhere, there’s a nagging sense that a slow-motion train wreck is underway, and it is only a matter of time before ego-driven miscalculations in a post-truth world send the global economy skidding off the tracks.
Bad beginnings have a way of causing bad endings.