The U.S. trade war with China reached a new phase on Aug. 5 after the U.S. labeled China a currency manipulator. That followed a surprise move by the Chinese government to let the yuan break through the long-standing 7-to-1 exchange rate for the first time in 11 years. Tensions eased slightly when China’s central bank fixed the exchange rate a bit higher than the lowest point the yuan hit, but global financial markets remained rattled.
Recent events in the trade dispute have been fast-moving. On Aug. 1 President Trump announced new tariffs on China – 10% on an additional $300 billion in goods — saying China had not bought large amounts of U.S. farm products as promised. Four days later, China devalued the yuan, and the U.S. currency manipulation charge followed. Then on Aug. 6, China said it may increase tariffs on U.S. farm products. But Wharton Dean Geoffrey Garrett explains why U.S.-China dispute is unlikely to become a full-on currency war, in this opinion piece.
Global markets were spooked yesterday by the Chinese Renminbi crossing the psychologically important barrier of 7 RMB to the greenback—sparking speculation that the current trade war will metastasize into a currency war between the world’s two biggest economies. The fact that the Trump administration responded immediately by officially labeling China a “currency manipulator,” for the first time in 25 years, is only grist for the mill.
The logic is straightforward. A weaker Chinese currency cushions the blow to Chinese exports of American tariffs. But greater Chinese exports to America would increase America’s trade deficit within China, creating incentives for the Trump administration to retaliate with a tit-for-tat weakening of the dollar.
Despite this logic, there are three powerful reasons why the trade war won’t become a currency war. In increasing order of importance they are:
1. Donald Trump loves showing America’s strength—and to many, there is no better signal of strength than a strong U.S. dollar.
What’s more, when the global economy wobbles, investors turn to the U.S. dollar as a port in the storm.
2. The Trump administration cannot unilaterally manipulate the dollar, even if it wants to.
This is true on multiple levels. The dollar floats on global foreign exchange markets without the capital controls that allow a country like China to manage the value of its currency. The single most direct way to weaken the currency is for the central bank to lower interest rates. In the U.S. that is the domain of the Federal Reserve. To Trump’s chagrin, the Fed remains independent of the White House, and its charter asks it to balance the risks of unemployment and inflation, not the exchange rate. And the Fed told the financial markets just last week not to expect further cuts to interest rates.
3. The Chinese government cannot afford the risk of an RMB in free fall.
All the charges by America in the past decade that China is a currency manipulator belie the fact that for more than a decade after 2005, the Chinese currency actually appreciated considerably against the U.S. dollar. This no doubt reduced China’s exports to America, but to China it was worth the price. The specter of mass capital flight has been an existential fear of the Chinese government since the Asian financial crisis in the late 1990s. China then saw the devastating effects of capital flight and vowed that it would never happen in China. With the slowdown of the Chinese economy giving itchy feet to holders of RMB, the last thing China’s government wants is to turn market nervousness into a full-on rush for the exits.
There is no doubt that allowing the RMB to cross 7:1 against the dollar was Xi Jinping’s shot-across-the-bow response to Trump’s threat of imposing tariffs on all Chinese imports on September 1. Just don’t expect the single shot to become an ongoing fusillade.
(This article originally appeared on LinkedIn.)