Following U.S. President Donald Trump’s announcement of more tariffs on Chinese products, Beijing took the rare measure of devaluing its currency. The yuan slipped to 7.0136 on Friday after falling to 7.0039 on Thursday. This week marked the first time since 2008 that the Chinese yuan crossed the threshold of seven per dollar, an event that inspired global markets to slide downward. The People’s Bank of China (PBOC) sets a midpoint each day before the markets open and allow the currency to be traded against the dollar within two percent of that specified value.
Since the beginning of the trade war between Beijing and Washington, the yuan has fallen 11 percent compared to the dollar, although it is still up 3.7 percent since 2008. As it is the second-largest economy in the world and holds nearly 25-percent of the U.S. national debt, any action from China on the value of its currency is sure to come under intense scrutiny. This week, however, the effect was magnified in light of the ongoing trade war. Consequently, the U.S. Treasury Department labeled China a “currency manipulator.” How these two events – the devaluation and subsequent accusation of currency manipulation – impact global trade remains to be seen, but there are some likely scenarios which may play out.
China’s currency is traditionally strictly managed as are all aspects of the Chinese economy including foreign investment and trade. Historically, the yuan is also a very stable currency and seldomly experiences great fluctuations. This week’s devaluation of a less than two-tenths of a yuan caused minor pandemonium, a sign of its rarity. The PBOC undoubtably decided to let the yuan slide due to the prolonged trade war and in doing so, will likely influence its trading partners.
Firstly, the currency devaluation was interpreted by other governments as a sign that the U.S. – China trade war will not end anytime soon. Therefore, other nations have rushed to protect their own economies, mainly by lowering interest rates. Banks in India, New Zealand, and Thailand all took this action on Wednesday.
Secondly, a weaker yuan makes Chinese exports more attractive for its trade partners. Trump has often accused Beijing of intentionally keeping the currency weak to the dollar in order to gain an unfair economic advantage, but many economists have argued that it has actually been priced properly in recent years and, given the current trade war, should start to weaken.
Perhaps most importantly for Beijing, the currency devaluation will help offset the negative effects of tariffs. Because goods from China will now in theory be slightly cheaper, the 25-percent tariffs begin to lose their effect. As the currency slides lower, so does the amount levied against imported products. With cheaper products, the dollar has more buying power in China, making Chinese products once again attractive to U.S. importers, even with the tariffs. This puts pressure on American manufacturers to cut their prices in order to win business which would otherwise go to Beijing.
Almost immediately after the PBOC began devaluing the yuan, the U.S. Treasury Department designated it as a currency manipulator for the first time in nearly 30 years.
“This is a major violation which will greatly weaken China over time,” Trump tweeted. According to a Treasury Department statement, it is currently working with the International Monetary Fund (IMF) to resolve the issue, and it presumably hopes to see some sort of punishment against Beijing.
A former head of the China IMF thinks that this is unlikely to happen, however, and that the U.S. is in the wrong.
“This is an extraordinary action of hostility against a major trading partner, with little economic basis and again driven mostly by presidential whims,” said Eswar Prasad, who is also a Cornell University economist.
The labeling of China as currency manipulator could pave the way for further action from the U.S. government. During his campaign for president, Trump often accused China of manipulating its currency and now he finally has that officially declared by his government and can use it as leverage for securing more sanctions or protectionist strategies for U.S. goods. The label also gives Trump something he can bargain with by telling Beijing diplomats that he will get the classification removed if they make economic concessions on their end.
Just the Beginning
This week was possibly just the beginning of China’s new strategy on its currency. It could continue to let it slide, possibly approaching even 8 yuan per dollar. According to the PBOC, the drop was due to “trade protectionism” and given the unending nature of the trade war, its foreseeable that more protectionism might be necessary in the coming weeks and months ahead. The U.S. stock market just experienced its worst week of the year, a sign that global trade issues are beginning to sting. While Trump came into office with a rather strong economy from his predecessor and experienced even more growth under his tenure, economists have been warning about another possible recession. China might be the tipping point towards that eventuality.