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, central bank policies, and economic developments (such as growth rates). 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.

Accusation of Currency Manipulation

In the U.S.-China trade war, 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. In fact, in response to increased U.S. tariffs, China stopped supporting its currency by selling U.S. dollars. As a consequence, the yuan devalued below the seven yuan per dollar mark. In other words, China halted its interventions in the currency markets, allowing a natural market reaction to U.S. tariffs. After an investigation in July 2019, the International Monetary Fund (IMF) acquitted China of currency manipulation. The BDI furthermore does not support the accusation that China is currently artificially depreciating the renminbi.

However, in early August, the U.S. administration classified China as a currency manipulator, just as Trump had promised during his election campaign. 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 and will likely lead to an inconclusive formal dialogue process between the two countries at the IMF. (An article on the legal background can be found here.)

On 28 May 2019, the Department of Commerce (DOC) published a Notice for Proposed Rulemaking. 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 now proposes that the undervaluation of a currency and unfair exchange rates should be regarded as government subsidization. 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.

Trump Departs from the Principle of a Strong Dollar

At the same time, President Trump is blatantly pressuring the Federal Reserve to lower interest rates. The principles expressed by previous U.S. administrations to support a strong dollar and an independent Fed no longer seem to apply. There now stands a risk of an international devaluation race that no one can win.

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.