The US Treasury Department announced late on Aug 5 that it had determined for the first time since 1994 that China was manipulating its currency. It’s considered a step to begin a currency war.
A currency war surface when policy makers are accused of deliberately driving down exchange rates — or fixing them too low — to gain a competitive advantage. A weaker currency means a country’s exports can be sold more cheaply overseas, providing a jump-start to the economy at home.
The story started since Aug 1, when US President Donald Trump tweeted that he will impose 10 per cent tariffs on the remaining US$300 billion of Chinese imports from Sep 1. This is considered a move to force Beijing more truthful in negotiations, beacause they had given up what had achieved in May.
It didn't take long for China to retaliate against Trump's trade war escalation. China’s state-run agricultural firms have now stopped buying American farm goods, and are waiting to see how talks progress. It’s an official cancellation what the 2 countries had agreed in the Jul 31 negotiation. Protecting US farmers is a prioritization of President Trump in the US-China trade war. As Aug 6, China soybean imports plunged to 2004 level.
Editorials in state-run newspapers suggested Xi will reject any deal that either retains punitive tariffs or forces China to make concessions on issues like state-run enterprises that could weaken the party’s grip on power.
“By linking today’s devaluation with the renewed tariff threat, the PBOC “has effectively weaponized the exchange rate,” said Julian Evans-Pritchard at Capital Economics in Singapore. “The fact that they have now stopped defending 7 against the dollar suggests that they have all but abandoned hopes for a trade deal.”
Almost at once, President Trump tweeted: “China dropped the price of their currency to an almost a historic low. It’s called “currency manipulation.” Are you listening Federal Reserve? This is a major violation which will greatly weaken China over time!”
An effective but dangerous weapon
In a trade war, the rivals have two most inportant weapons: tariff and exchange rate. Up to now, both US and China have used the first one - tariff. The US has imposed 25 per cent tariffs on US$250 billion of Chinese imports, while China has imposed the same tariffs on US$170 billion of imports from US.
The problem is that the US has a lot of "ammunition" for this weapon, because the amount of Chinese goods exported to the US is estimated at US$550 billion. However, China has used "all the bullets", because of US exports to China is only US$170 billion.
Thus, when President Trump continues to use the tariff weapon, though as small as 10%, it’s enough to make the Chinese feel desperated. Now, they have just one weapon left - the exchage rate. According to the experts, the RMB 2.5% depreciation is a surplus to offset the 25% US tariff. As of Aug 6, the yuan has fallen by 1.6% compared to the previous 2 days.
This will force people to withdraw money from banks to switch to haven assets, such as foreign currency (USD), gold or real estate. At a more dangerous level, it could lead to large-scale foreign currency bleeding, people massively move their domestic currency into foreign currency and send it to foreign banks for shelter.
In China, for decades, the government didn’t allow RMB to float. In fact, according to experts, the yuan has been overvalued over the past years. Routinely, Beijing moves to keep RMB strong "artificially", and launches cash-control policies to to prevent capital withdrawal or flowing.
Therefore, once the state decides to float RMB, the currency may immediately collapse. Then, Chinese state-owned enterprises (SOE) could be bankrupt beacause their debt would suddenly bulge out. It is well known that the debt of Chinese SOE and banks is very large and Chinese banks are in a "worse" health condition than American ones.
Although Beijing has recently taken many measures to prevent the transfer of money abroad, "fearful cash flow" always finds a way out. This happened in 2015, when the yuan also experienced a sharp devaluation. At that time, capital flows from China rushed to global markets, prompting Beijing to urgently seek to stabilize the exchange rate of the yuan.
Will everyone loose?
However, experts always keep the view that a trade war, as well as a currency war, is always a "losing" battle. As seen, trade war will increase tariffs, leading to increased prices of goods and services, while the currencies of the participating countries will depreciate as a result of using exchange rate weapon, leading to double inflation. And all the burdens are on the shoulders of the people and businesses.
Historically, there have been currency wars, such as the currency war in the 1930s, when countries abandoned the gold standard. At that time, the UK devalued Pound to 25%, then many other countries followed. After the Second World War, the Bretton Woods System was established to prevent a currency war. However, this system was canceled in 1973. And soon after, a currency war took place until 1987. During this period, the US economy experienced three crisis in 1974, 1979 and 1980. So we can see, currency war does not bring the desired results such as increasing exports and jobs. Instead, it brings deflation or severe inflation, recession and even crisis.
In the case of the US and China, because these two countries are now major trading partners of most other economies, when one of them uses exchange rate weapon, other countries are forced to adjust their currency exchange rates to not lose too much competitiveness to their partners. Thus, countries will be caught up in a spiral of currency devaluation that has no end.
Because the US and China are both members of the World Trade Organization (WTO), in order to use tariff weapons, they must behave according to its laws. Before imposing tariff on Chinese goods for the first time, US had conducted many investigations and studies.
Based on those studies, the White House accused Beijing of violating WTO laws, such as subsidizing domestic companies through the state-owned enterprise system, forcing foreign companies to illegally transfer technology when investing in China, supporting domestic companies to steal US technology using hackers, spies and harmful hardwares…
Despite being the second largest economy in the world, China is still far behind the US both in size and quality.
At first, Beijing agreed to change, but abruptly canceled the agreement in May, leading to the following round of tariff increases. Observers said that Beijing would rather be taxed than adjust those two things, because they are the backbone for the Chinese-style market economy. If broken, there is a risk that China's political system will collapse as well. They don’t want to fall into the Soviet’s fault.
China has used its last weapon (exchange rate), while the US still has "surplus ammunition" for the first commercial weapon (tariff). If nothing changes, the US will impose 10 per cent tariffs on US$300 billion of Chinese imports from Sep 1. This tariff still has room to increase, to 25% or more. With Beijing devaluating RMB and the United States has officially accused China of being a currency manipulator, it is likely that Washington will step forward to sue China at the International Monetary Fund (cause RMB is 1 of the 5 currencies that SDR is based on) or at WTO to expand sanctions on China.