Is the Trade Conflict Triggering a Currency War?

The relative prices in world trade adjust via the global monetary system. A stable U.S. dollar functions as a reserve and transaction currency for the world markets. U.S. President Donald Trump is now abandoning the basic principles of American monetary policy by openly championing a weak dollar and directly attacking the independence of the U.S. Federal Reserve. A cycle of devaluation threatens to weaken the world economy.

The exchange rate determines the prices and thereby the supply and demand of goods and services in international trade. A certain degree of flexibility of exchange rates helps markets to efficiently determine prices. However, strong exchange rate fluctuations mean higher hedging and transaction costs for business.

The external value of a currency is the result of market expectations, and central bank policies. Interest rate hikes strengthen a currency, while interest rate cuts tend to lead to devaluations. In the short-term, an economy can offer its products at lower prices internationally by devaluing its own currency, similar to giving a discount. At the same time, international purchasing power is declining, raising the costs for imports. On one hand, this increases the willingness of domestic consumers to replace imports with domestic products. On the other hand, inflation is increasing as some products are now imported at higher prices – for example, crude oil. Importers and creditors therefore favour a strong currency, while exporters and debtors tend to prefer a weak currency.

However, this desired improvement in export competitiveness will only be successful if individual countries devalue their currencies by lowering interest rates. If all economic areas simultaneously lower interest rates, the exchange rates remain unaffected as the differences in interest rates between the economic areas are decisive rather than merely their levels. Since the gain in market share is not due to such key factors as productivity or quality and is at the expense of trading partners, this is also referred to as a “beggar-thy-neighbour” policy.

The accusation that China artificially devalues its own currency in order to make its products cheaper for foreign buyers and to unfairly increase sales has prevailed for some time. Even under President Trump’s predecessors, China’s monetary policy was a thorn in the side of the United States. According to the U.S. definition, currency manipulation is the deliberate effort by a country to influence the exchange rates between its currency and the U.S. dollar in order to gain an “unfair competitive advantage in international trade.” The last time China was officially listed as a currency manipulator by the Department of the Treasury was from 1992 to 1994.

However, under President Trump, the currency conflict between the United States and China escalated further. In response to U.S. tariff increases, China had, according to U.S. sources, stopped supporting its currency with dollar sales in early August 2019, which caused it to depreciate above the seven renminbi/dollar mark. China had thus stopped its revaluing interventions in the currency markets and allowed the market to react to the U.S. special tariffs. The IMF had acquitted China of accusations of currency manipulation as recently as July 2018 following an investigation.

In early August 2019, the Trump administration classified China as a currency manipulator. This happened outside of the usual processes for such a classification. China meets only one of the official criteria. This classification functions predominantly as a political signal. (An article on the legal background can be found here.)

Strengthening Trade Defense Instruments

In late May 2019, the Department of Commerce (DOC) published a Notice for Proposed Rulemaking: Modification of Regulations Regarding Benefit and Specificity in Countervailing Duty Proceedings. Under the Tariff Act of 1930, the executive can impose tariffs when foreign governments provide their companies with an unfair competitive advantage through subsidies. The DOC proposed that the undervaluation of a currency and unfair exchange rates should be regarded as government subsidization. In early February 2020, the DOC published the final regulation. In the U.S. public debate, the EU and Germany are also accused of currency manipulation: Germany is listed on a corresponding monitoring list by U.S. authorities.

Phase One-Deal

In the course of the negotiations of the Phase One Deal between the United States and China, the situation finally improved in mid-January 2020 with regard to currency issues. In mid-January 2020, the U.S. Treasury reversed its decision to classify China as a currency manipulator. According to Secretary of the Treasury Steven Mnuchin, China had made enforceable commitments to avoid devaluation competitions and at the same time to promote transparency and accountability. It remains to be seen whether this ceasefire will hold.

Outlook

The expansion of the trade conflict to monetary policy increases uncertainty for the world economy. Companies must be prepared for noticeable shifts and greater fluctuations in exchange rates. The costs of hedging against these fluctuations will continue to rise. In the long-term, an erosion of the independence of the Federal Reserve could threaten to end the dollar’s position as the world’s reserve and transaction currency.