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China's currency depreciation should set off alarm bells

July 10, 2018

Editor’s note: China’s currency depreciation of 6% is a tariff on $130B of US exports to China (2017 trade numbers) and a subsidy of 6% on $506B goods exports to the US. Compare this to the 25% tariffs on only $50B of imports from China which the administration just put into effect. Their “aggregate tariff” is $7.8B ($130B x 6%).  Our aggregate tariff is $8.5B ($34B x .25). Roughly equal until you figure that there is an added $30.4B ($506B exports x  6%) subsidy to their exports to us. Related impacts are: Chinese consumption suppression, forced savings, increased capital exports to the US. America needs to get into the exchange rate management game. 

The recent sharp Chinese currency depreciation should be setting off alarm bells for the global economy.

[DESMOND LACHMAN | July 9, 2018 | The Hill]

Not only does that movement likely presage further currency depreciation in China, the world’s second-largest economy, but it also increases the likelihood that China and the United States might be drifting inexorably toward both a currency and a trade war. 

Since March, the Chinese currency has depreciated by some 6 percent, taking it to the sensitive level of 6.7 renminbi to the dollar. It has done so in the context of a weakening Chinese economy, a generalized strengthening of the U.S. dollar and the implementation of an "America First" trade policy. 

There are at least two reasons to think that the Chinese will be forced to continue allowing their currency to depreciate against the U.S. dollar. The first is that they will need to use currency depreciation as the means to provide some support to the Chinese economy by incentivizing its export sector.

This is especially the case at a time when domestic policy efforts are being made to rein in China’s massive credit and housing market bubbles and as the Chinese economy gets hit by an increase in U.S. import tariffs.  

As China’s credit and housing market bubbles burst, the Chinese economy must be expected to weaken markedly. This would seem to be particularly the case considering that the Chinese credit bubble over the past eight years has been far larger than that which the United States experienced in the run up to its 2007–2008 housing bust.

In those circumstances, the last thing that the Chinese economy needs is to be hit by yet another shock in the form of increased U.S. trade protection.

A second reason to think that the Chinese authorities will allow their currency to depreciate against the dollar is that if they did not do so, their currency would appreciate along with the U.S. dollar against the currencies of all of its other trade partners.

This is especially the case at a time that the expansive budget policy of the Trump administration at this late stage in the U.S. economic cycle is putting strong upward pressure on both U.S. interest rates and on the U.S. dollar. 

The reason to fear that additional Chinese currency depreciation will lead China and the U.S. further down the road to a full-blown currency and trade war is that China and the U.S. will have different views as to future Chinese currency depreciation.

For their part, the Chinese authorities are likely to view currency depreciation as a perfectly justifiable policy move for them to allow considering the prospective marked weakening of the Chinese economy.

After all, they might argue that this is precisely what the world’s major countries have been doing since the 2008–2009 Great Recession when their respective economies weakened. 

At various intervals over the past decade, the Federal Reserve, the Bank of Japan, the European Central Bank and the Bank of England have all responded to weakening in their economies by massive money printing that has had the effect of causing their respective currencies to depreciate.

The Chinese authorities might very well ask why they should be prevented from allowing their currency to depreciate now that its economy is weakening when this has been the accepted practice for the advanced industrialized countries. 

For its part, the Trump administration is likely to view Chinese currency depreciation as yet another means by which China is gaming the international trading system.

Far from viewing currency depreciation as a means to support a weakening economy, the Trump administration will view such depreciation as a Chinese return to its old ways of unfairly manipulating its currency for competitive advantage and for generating trade surpluses at the United States' expense.

Sadly, all of this holds out the prospect for an intensification of a U.S. currency and trade war. With both sides likely to feel strongly justified in their divergent views on China’s currency depreciation, it also does not bode well for an early resolution of trade tensions between China and the U.S. 

Needless to add, any intensification in U.S.-Chinese currency and trade frictions could cast a dark cloud over the global economy. As Napoleon might have put it, when the world’s two largest economies engage in a currency and trade war, the rest of the world economy will shudder. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.


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