/stories/2019/08/us-and-china-continue-to-spar-over-currency-and-tariffs

US and China continue to spar over currency and tariffs

China's yuan fell further Tuesday against the U.S. dollar. Photo: Kin Cheung/Associated Press

By UM News

China's yuan fell further Tuesday against the U.S. dollar. Photo: Kin Cheung/Associated Press

US and China continue to spar over currency and tariffs

By UM News
A move by China to devalue its currency disrupted global financial markets on Monday.

Wall Street tumbled to its worst showing of the year Monday following a move by China to devalue its currency to make Chinese exports cheaper for U.S. consumers and blunt the impact of a new round of tariffs proposed by the Trump administration.

After the Dow Jones industrial average plunged 767 points, the U.S. Treasury accused China of being a “currency manipulator,” and the rhetoric between the two countries ratcheted up throughout the day and threatened to cause continued disruption of global markets.

But the tumult from Monday appeared to subside a bit Tuesday morning, as the Chinese government announced some moves to stabilize its national currency, the yuan.

Paulo LemePaulo Leme, a lecturer in finance at the University of Miami Business School, fielded some questions about Monday’s activities. He is a former executive with several financial firms, and served for nine years as a senior economist at the International Monetary Fund.

Why would China devalue its currency?

A country devalues its currency either because it has a balance of payments crisis (running out of international reserves) or to nudge competitiveness slightly. The former is usually accompanied by a large depreciation (say 20 percent, 30 percent or more), called an overshooting. The price of the scarce asset (say the U.S. dollar) rises relative to the domestic currency. The latter can improve competitiveness because a devaluation is equivalent to an import tariff plus an export subsidy at the same rate of the devaluation. The tariff reduces imports and protects the domestic industry against foreign exporters and the subsidy boosts exports.

What does it mean for the U.S. to label China a “currency manipulator,” and what, if any, recourse does the U.S. have to challenge this?

In practice, nothing. Calling China a currency manipulator allows the U.S. Treasury to intervene in the foreign exchange market, if it so desired, and file a complaint against China at the International Monetary Fund, which is inconsequential. With daily foreign exchange market trading of $6 trillion, there is little the U.S. Treasury can do in the foreign exchange market market but to watch. In sum, the real consequence of this bravado is to further escalate tensions between the U.S. and China, distancing them further from a growth-friendly resolution to the trade war. This raises significantly downside risks to US and global growth and markets.

Is devaluation an effective tool to use to safeguard that country’s economy?

No, unless the devaluation is used to help the country re-emerge out of an external payments crisis. The devaluation generates a trade surplus, restores confidence and capital inflows and helps the economy grow and rebuild its reserves. A small and opportunistic devaluation in response to the escalation of the trade war will be quickly washed out either by higher domestic inflation or competitive devaluations elsewhere, washing out the real impact of the measure.

What does it mean to the U.S. and global markets?

For the U.S., it erodes good will and reduces the chance of a concerted effort to reverse the trade war. As such, over the long-run, protectionism will hurt the U.S. economy, reducing growth in the U.S. and raising the price level. For global markets, it raises volatility in financial markets and triggers a flight to safety (markets de-risk). Investors reduce positions in riskier assets (explaining the sharp drop in equities) and increase cash and Treasury bills. In turn, this depresses yields in the long-end of the U.S. yield curve and high-grade corporate bonds. Finally, capital flows toward U.S. assets will likely strengthen the U.S. dollar.

Is there a past model where this kind of devaluation has worked?

Devaluations work when they are the result of a balance of payments crisis and are backed by sound economic policies that reinforce confidence and reforms that boost productivity and competitiveness. The danger of China's devaluation lies in the intensification of the trade war and competitive devaluations. This was the great lesson of the 1930s: protectionism plus devaluations is a lose-lose proposition, potentially throwing the world economy into a recession.

Worse than China's devaluation itself was having the U.S. Federal Reserve cutting interest rates in a futile attempt to offset the negative shock on growth resulting from a new round of higher import duties in the United States days after the Federal Open Market Committee meeting. Neither a looser monetary policy in the United States, nor a devaluation in China will work, being no substitute for international cooperation and a freer trade system.