A Currency Crash Course for Politicians
US President Donald Trump has imposed duties on a range of Chinese goods because he thinks that China is still holding down the renminbi's exchange rate to boost its exports. But China no longer needs to sell its goods at below-cost prices, and it has been unloading its dollar-denominated foreign-exchange reserves since 2014.
MUMBAI – One major impetus behind US President Donald Trump’s protectionist policies is his belief that China has artificially weakened its currency in order to dump goods in the United States. Trump harped on this issue often during his presidential campaign. But now that he is taking action to reduce America’s bilateral trade deficit with China, there could be grave consequences for the world economy.
Trump is making a mistake. And yet his views about China’s currency should not come as a surprise, given that exchange-rate management is one of the most complex areas of economic policymaking.
I learned this the hard way while serving as an adviser to the Indian government from 2009 to 2012. After Standard & Poor’s downgraded US long-term sovereign credit from AAA to AA+ on August 5, 2011, I was surprised to see the dollar begin to strengthen. It took me a while to understand what was happening.
Investors were worried that the downgrade could cause global turbulence and began to pull their money out of emerging markets. In earlier times, investors would then have parked some of their money in strong European economies. But, because most of those countries had handed over monetary policy to the European Central Bank and could no longer print their own money, there was a heightened risk of default.
By contrast, the US had its own currency and central bank, allowing it to make good on its debt under almost any circumstances. And investors were also reassured by the fact that the world’s second most powerful economy, China, had a vested interest in a relatively strong, stable dollar, owing to the fact that a large portion of its massive stock of foreign-exchange reserves was held in dollars. Hence, the paradox: though the source of the problem was the US, money went rushing to the US, strengthening the dollar.
I have had a keen interest in exchange-rate management ever since that episode. In May 2013, when I was Chief Economist at the World Bank, my colleague Aristomene Varoudakis and I published a study examining different exchange-rate policies across a wide range of countries. We found that almost all countries occasionally buy and sell on foreign-exchange markets in order to increase or boost the value of their own currency. In most cases, this is not done directly, but rather by commercial banks acting at central banks’ behest.
China, for its part, has pursued an interesting exchange-rate policy over the decades. Through the 1980s and 1990s, there is no doubt that China kept its currency artificially undervalued so that it could sell more goods internationally. From the mid-1990s to 2005, the renminbi was virtually pegged to the US dollar in nominal terms, and the dollar did experience real appreciation. The logic was simple: by buying dollars, China could cause the relative value of the dollar to rise, which meant that the value of the renminbi would fall. Accordingly, the People’s Bank of China accumulated enormous dollar reserves during this time.
As it happens, Switzerland pursued a similar – albeit shorter-lived – strategy after the 2008 global financial crisis, and particularly after September 2011. During that time, the Swiss National Bank managed to hold down the Swiss franc’s value while accumulating a huge volume of foreign-exchange reserves.
Is this a good strategy? In China’s case, it certainly allowed domestically based firms to export more, but only because they were selling at below-cost prices, thus incurring losses. This approach makes sense if one is selling habit-forming goods, because you can raise prices and make up for earlier losses once the customer has become dependent on the product. Hence, if you were starting a newspaper in the print era, it was generally wise to underprice it until you had built up a large base of loyal readers.
Like certain products, buying from a country can also be habit-forming. Once you have mastered all of the rules and regulations, as well as the culture and politics, of a trading partner, you have an interest in continuing to do business with that country.
With the US and many other nations now hooked on buying from China, Chinese policymakers no longer need to maintain an undervalued currency. And, indeed, China has been spending down its foreign-exchange reserves since mid-2014. Though the renminbi was once kept artificially weak, there are now many economists who believe that it is actually overvalued. That, after all, is what one would expect for the seller of an addictive good.
In this context, Trump’s tariff war comes far too late, and will prove utterly self-defeating. But let’s assume that Trump is right – that China is still selling its products to US consumers at a loss. In that case, my advice to him is simple. He should send a thank-you note to Chinese President Xi Jinping.
China’s Currency Catch-22
As the Trump administration ratchets up tariffs on Chinese goods, many observers have begun to wonder if China will respond with a strategic currency devaluation to boost the competitiveness of its exports. But, despite despite possessing a powerful financial and monetary arsenal, Chinese policymakers have no good options.
LONDON – Officials at the People’s Bank of China (PBOC) have long insisted that “China won’t weaponize the renminbi.” And yet, implicit in their promise not to manipulate the currency for strategic ends is their ability to do so if they so desired.
China’s monetary policy has come to the fore now that US President Donald Trump has imposed import tariffs on a range of Chinese goods. Many are wondering if China will respond to Trump’s trade war by threatening a currency war. If it does, the world should call its bluff.
To be sure, with more than $3 trillion in foreign reserves and an established – albeit not entirely successful – system to manage its exchange rate, China has enough financial and monetary leverage to bring the US economy to its knees. But having the weapons it needs does not mean that China can afford to use them.
In June, the renminbi had its worst month on record, dropping 3.7% against the dollar. Analysts are divided about the cause. Some view it as the result of a slowdown in economic growth, coupled with market concerns about the introduction of US tariffs and dollar appreciation on the back of rising US interest rates. Others suspect that Chinese monetary authorities intervened to weaken the renminbi, in order to offset the impact of US policies.
The Chinese government has a long history of intervening to ensure that the renminbi’s exchange rate aligns with its economic goals. But, since 2016, when the renminbi was included in the basket of currencies that determines the value of the International Monetary Fund’s Special Drawing Rights (SDR), the exchange rate has been determined mainly by market forces.
Still, despite PBOC Governor Yi Gang’s insistence that China’s exchange rate reflects demand and supply (with a basket of currencies as a reference), monetary authorities have the power to intervene when necessary. And though such interventions have been less frequent than in the past, they have continued to muddle market signals.
In the context of today’s trade war, however, an “engineered” competitive devaluation of the renminbi, even if technically possible, would not be in China’s best interest. Unlike in the past – and despite the Trump administration’s view of China as an unreformed currency manipulator – a weak renminbi has more costs than benefits for China.
For starters, by increasing import prices and bolstering export sectors, a weaker renminbi would undermine the Chinese government’s goal of shifting away from export-led growth and toward a model based on higher domestic consumption. Moreover, a weaker renminbi could invite renewed US complaints about currency manipulation.
Finally, and more crucially, a weak renminbi at the same time that dollar-denominated assets become more attractive could cause China to suffer capital flight. In this scenario, Chinese monetary authorities might be forced to reverse course and prop up the renminbi. By then, such an intervention would have to be large, implying a significant decrease in the country’s official reserves, as happened in 2015 and 2016.
Complicating matters further, China’s monetary authorities are already struggling to maintain financial stability under conditions of slowing economic growth, a total debt-to-GDP ratio of around 250%, and monetary-policy normalization on the part of the US Federal Reserve.
China thus finds itself between a rock and a hard place. To discourage new lending and reduce the risk of capital outflows, the PBOC should tighten monetary policy. But counteracting the negative impact on growth resulting from rising US interest rates and tariffs calls for more monetary accommodation.
So far, China’s answer to this conundrum has been to relax capital requirements in order to create more liquidity in the banking system. But if Chinese savers expect the renminbi to depreciate further, this measure could be offset by capital outflows – even with the capital controls the government currently has in place.
Looking ahead, Yi may have to resort to more than verbal assurances to support the exchange rate. That could mean that China and the Fed will end up selling – or at least not rolling over – US Treasury bonds at the same time. In the event, US interest rates could go through the roof, implying serious risks for global financial stability. So, while a weak renminbi is worse for China than it is for the US, a PBOC intervention to strengthen the currency could undermine the Fed’s policy normalization, and financial stability generally.
China’s lack of a fully liquid and convertible currency means that there will always be a fundamental divergence of exchange-rate regimes across the international monetary system. And this divergence will continue to produce distortions that intensify the global effects of new US monetary-policy trajectories.
The solution to this problem is straightforward: eliminate the distortions. China should float the renminbi so that its exchange rate becomes truly market-determined, even as it continues to manage capital flows. A “managed” approach of this kind would help China strengthen its financial system and develop the renminbi as a major international currency.
Unfortunately, China seems as beholden to its current exchange-rate regime as the Trump administration is to its trade policy. The US and China’s irreconcilable approaches are not good for anyone. We all should be concerned about what may come next.
Trump May Kill the Global Recovery
In a sharp departure from this time last year, the global economy is now being buffeted by growing concerns over US President Donald Trump's trade war, fragile emerging markets, a slowdown in Europe, and other risks. It is safe to say that the period of low volatility and synchronized global growth is behind us.
NEW YORK – How does the current global economic outlook compare to that of a year ago? In 2017, the world economy was undergoing a synchronized expansion, with growth accelerating in both advanced economies and emerging markets. Moreover, despite stronger growth, inflation was tame – if not falling – even in economies like the United States, where goods and labor markets were tightening.
Stronger growth with inflation still below target allowed unconventional monetary policies either to remain in full force, as in the eurozone and Japan, or to be rolled back very gradually, as in the US. The combination of strong growth, low inflation, and easy money implied that market volatility was low. And with the yields on government bonds also very low, investors’ animal spirits were running high, boosting the price of many risky assets.
While US and global equities were delivering high returns, political and geopolitical risks were kept largely under control. Markets gave US President Donald Trump the benefit of the doubt during his first year in office; and investors celebrated his tax cuts and deregulatory policies. Many commentators even argued that the decade of the “new mediocre” and “secular stagnation” was giving way to a new “goldilocks” phase of steady, stronger growth.
Fast-forward to 2018, and the picture looks very different. Though the world economy is still experiencing a lukewarm expansion, growth is no longer synchronized. Economic growth in the eurozone, the United Kingdom, Japan, and a number of fragile emerging markets is slowing. And while the US and Chinese economies are still expanding, the former is being driven by unsustainable fiscal stimulus.
Worse still, the significant share of global growth driven by “Chimerica” (China and America) is now being threatened by an escalating trade war. The Trump administration has imposed import tariffs on steel, aluminum, and a wide range of Chinese goods (with many more to come), and it is considering additional levies on automobiles from Europe and the rest of the world. And currently the renegotiation of NAFTA is stalled. Thus, the risk of a full-scale trade war is rising.
Meanwhile, with the US economy near full employment, fiscal-stimulus policies, together with rising oil and commodity prices, are stoking domestic inflation. As a result, the US Federal Reserve must raise interest rates faster than expected, while also unwinding its balance sheet. And, unlike in 2017, the US dollar is now strengthening, which will lead to an even larger US trade deficit and more protectionist policies as Trump, assuming he remains true to form, blames other countries.
At the same time, the prospect of higher inflation has led even the European Central Bank to consider gradually ending unconventional monetary policies, implying less monetary accommodation at the global level. The combination of a stronger dollar, higher interest rates, and less liquidity does not bode well for emerging markets.
Likewise, slower growth, higher inflation, and less monetary-policy accommodation will temper investor sentiment as financial conditions tighten and volatility increases. Despite strong corporate earnings – which have been goosed by the US tax cuts – US and global equity markets have drifted sideways in recent months. Since February, equity markets have been buffeted by fears of rising inflation and import tariffs, and by the backlash against big tech. There are also growing concerns over emerging markets such as Turkey, Argentina, Brazil, and Mexico, and over the threat posed by populist governments in Italy and other European countries.
The danger now is that a negative feedback loop between economies and markets will take hold. The slowdown in some economies could lead to even tighter financial conditions in equity, bond, and credit markets, which could further limit growth.
Since 2010, economic slowdowns, risk-off episodes, and market corrections have heightened the risks of stag-deflation (slow growth and low inflation); but major central banks came to the rescue with unconventional monetary policies as both growth and inflation were falling. Yet for the first time in a decade, the biggest risks are now stagflationary (slower growth and higher inflation). These risks include the negative supply shock that could come from a trade war; higher oil prices, owing to politically motivated supply constraints; and inflationary domestic policies in the US.
Thus, unlike the short risk-off periods in 2015 and 2016, which lasted just two months, investors have now been in risk-off mode since February, and markets are still moving sideways or downward. But this time the Fed and other central banks are starting or continuing to tighten monetary policies, and, with inflation rising, cannot come to the markets’ rescue this time.
Another big difference in 2018 is that Trump’s policies are creating further uncertainty. In addition to launching a trade war, Trump is also actively undermining the global economic and geostrategic order that the US created after World War II.
Moreover, while the Trump administration’s modest growth-boosting policies are already behind us, the effects of policies that could hamper growth have yet to be fully felt. Trump’s favored fiscal and trade policies will crowd out private investment, reduce foreign direct investment in the US, and produce larger external deficits. His draconian approach to immigration will diminish the supply of labor needed to support an aging society. His environmental policies will make it harder for the US to compete in the green economy of the future. And his bullying of the private sector will make firms hesitant to hire or invest in the US.
Over time, growth-enhancing US policies will be swamped by growth-reducing measures. Even if the US economy exceeds potential growth over the next year, the effects of fiscal stimulus will fade by the second half of 2019, and the Fed will overshoot its long-term equilibrium policy rate as it tries to control inflation; thus, achieving a soft landing will become harder. By then, and with protectionism rising, frothy global markets will probably have become even bumpier, owing to the serious risk of a growth stall – or even a downturn – in 2020. With the era of low volatility now behind us, it would seem that the current risk-off era is here to stay.
Will Trump Launch a Currency War, Too?
Last month, Donald Trump personally announced a series of import tariffs and other measures to restrict the flow of Chinese goods and capital into the United States. Clearly, Trump views China as a significant economic threat, so it may be only a matter of time before he sets his sights on the renminbi as well.
SANTA BARBARA – In recent weeks, the Trump administration has rolled out a series of trade and investment measures that put China squarely in its crosshairs. Clearly, Trump and his advisers view China as America’s chief “economic enemy.” The question now is whether they will follow up with an attack on the renminbi, China’s increasingly popular currency.
So far, the US has imposed sweeping import tariffs of 25% on steel and 10% on aluminum, which Trump personally announced early last month. Since then, the administration has carved out exemptions for certain US allies, while using the tariffs as a bargaining chip to extract concessions from others.
China, for its part, is not a major supplier of steel or aluminum to the United States. But Chinese overcapacity has been putting downward pressure on steel and aluminum prices globally, to the detriment of US producers. So, the Trump administration’s aim is to force China to reduce its own output sharply.
Even more dramatically, the Trump administration has unveiled plans to impose import tariffs on a wide range of Chinese goods, valued at up to $60 billion. It is also tightening restrictions on corporate acquisitions and investments by foreign firms; and it has signaled its intention to challenge China’s forced technology transfers at the World Trade Organization.
Moreover, the administration is moving to bar Chinese companies from investing in sensitive US sectors such as semiconductors and 5G wireless-communications technologies. Trump has already blocked a $117 billion bid by Broadcom – a Singapore-based firm with close ties to China – to acquire the US tech giant Qualcomm.
Similarly, the Trump-appointed commissioner of the Federal Communications Commission, Ajit Pai, has agreed to treat Huawei, China’s top telecommunications equipment maker, as a national security risk. And, under a proposed new rule, firms with that classification will no longer be able to supply equipment to companies building Internet infrastructure in the US.
To date, the Trump administration has not taken any direct action against the renminbi. But if it views Chinese exports and investments as a threat, it may be only a matter of time before it targets the Chinese currency, too.
Since the 2008 global financial crisis, China’s government has gone to great lengths to promote the renminbi’s international standing. It has eased regulations so that more trade-related transactions may be settled in renminbi, thus bypassing traditional invoicing currencies like the US dollar. It has established a network of renminbi clearing banks that spans financial centers around the world. It has cultivated active markets for renminbi deposits and renminbi-denominated bonds in Hong Kong and elsewhere. And it has reached currency-swap agreements with dozens of foreign central banks, in the hope that the renminbi will become a new global reserve asset.
Meanwhile, China achieved a major milestone in 2015, when the International Monetary Fund agreed to include the renminbi in the basket of currencies that determines the value of its synthetic reserve asset, the Special Drawing Right (SDR). Previously, that privileged status had been granted only to the US dollar, the British pound, the Japanese yen, and the euro. Inclusion in the SDR currency basket thus provided a major boost to the renminbi’s international standing, and encouraged China to go even further in promoting the currency. Most recently, China launched a new exchange for renminbi-denominated crude oil futures, which some observers see as a direct challenge to the dollar.
As part of its increasingly ambitious bid for global influence, China aims to develop a currency that could be worthy of a global superpower. The US has long benefited from the dollar’s dominant position in financial markets and central-bank reserves, and China now wants to reap similar rewards. If the renminbi’s rise comes at the expense of the dollar, that’s too bad.
Before Trump, US policy for maintaining the dollar’s primacy was largely passive, if not conciliatory. Even when it was clear that China was promoting the renminbi as an alternative to the dollar, the Obama administration did little to defend the greenback. In fact, the US actually supported the renminbi’s entry into the SDR basket, despite widespread doubts about the currency’s qualifications, because it wanted to encourage China to become a more reliable stakeholder in the existing monetary system.
But then came Donald Trump, and all bets were off. Although its international standing has risen, China’s currency is still a long way from major-league status. Trump, the self-proclaimed dealmaker, presumably knows this, and will be tempted to exploit the renminbi’s vulnerabilities.
For example, if China chooses to resist Trump’s demands for concessions on trade, the US could prohibit the renminbi’s use in invoicing or settlements by US businesses transacting with Chinese partners. It could discourage, or establish new barriers to, investments in renminbi-denominated assets. Or it could offer swap agreements on favorable terms to any central bank that is prepared to abandon its agreement with China. The list of possible punitive actions is long.
Of course, a currency war alongside a trade war would be dangerous, and possibly disastrous. At a minimum, financial markets could be destabilized, and international lending could be disrupted. Unfortunately, a man who thinks that “trade wars are good, and easy to win” is unlikely to be deterred by these possibilities. We can only hope that cooler heads will prevail.