Currency War?

On August 5, China allowed its currency, the yuan, to depreciate against the U.S. dollar. It wasn’t a particularly large move, a little more than 1.5%, but it breached 7 yuan per $ -- a level seen as “psychologically important.” More importantly, the move ignited concerns of a possible currency war and the Treasury Department responded by formally declaring China to be a currency manipulator. The irony here is that U.S. trade policy has put downward pressure on the yuan and China has been working to prevent the currency from weakening further. This seems unlikely to develop into a currency war – that is, unless we see the two major economies of the world facture apart completely.

First, a little background. During the Asian financial crisis of 1997, country after country saw their currency come under pressure. Global investors’ efforts to pull money out pushed the currency lower, creating more incentive to pull money out, generating a downward spiral. IMF bailouts helped to stabilize the situation, but these came with a cost, typically higher interest rates to keep the currency from appreciating – and higher interest rates were a negative for growth. The lesson for these countries was that you should build up enough reserves to be able to defend the currency when under pressure. That happened country by country, but increasing reserves was a much bigger deal for China given the size of its economy.

To be clear, there is an important distinction between routine currency market intervention (selling yuan to buy U.S. dollars) to stabilize the exchange rate and outright manipulation to keep your currency weak in order to fuel export growth. China’s trade surplus ballooned to 10% of its GDP in 2007, partly reflecting a changing economy (greater efficiencies in production and distribution), but also because the currency was artificially weak. The country’s forex reserves surged to $2 trillion by 2009 and then doubled again (to $4 trillion) by 2014.

China maintained a peg to the U.S. dollar until 2005, when it shifted its reference to a basket of currencies (of which the U.S. dollar is the largest share). Despite China’s efforts to weaken its currency, the yuan appreciated against the dollar until 2013. Since then, the forces have shifted. In recent years, China has run down its reserves (to $3.1 trillion in July), to keep its currency from weakening. It has also put in place capital controls to limit outflows (which further weaken the currency).

Scott Brown
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