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September 28, 2018

Will Trade War with China Escalate Into a Currency War?


Over the past week, the trade war between The US and China has continued to escalate, with new trade tariffs introduced that will affect billions of dollars of products in the global marketplace. One of the biggest concerns among economists is that the trade war will develop into a full-blown currency war. How likely is this to happen, and what do investors need to do to protect themselves and their money in these turbulent times?

What is a currency war?

Phrases like “currency war” are popular in the media, as the sensationalist wording is great for selling newspapers. But what does the term really mean? In short, a currency war happens when one country’s central bank intentionally sets out to devalue its currency in order to stimulate the economy. President Trump has already spoken out on more than one occasion, accusing not just China but also Russia and even the EU of doing exactly this, although there seems little logic in them actually doing so. 

Devaluing a currency makes the products manufactured cheaper for international markets, and therefore boosts sales. However, it has an equal and opposite effect on imports, leading to a rise in inflation and piling the pain on consumers. Given China’s well-publicised strategy of seeking to compete on global markets on the basis of quality, as opposed to the “pile them high, sell them cheap” strategies of years gone by, it is hard to see that there would be any logic in the nation intentionally triggering a currency war. 


What is really happening?

The US dollar is high, and the Chinese yuan keeps falling, these facts are beyond dispute. However, it is the drivers behind the trends that need to be examined. Currency valuations reflect how investors perceive a particular market relative to others. Movements are seldom a pure result of internal factors within that market. As anyone well versed in forex will tell you (but also one of the very first things you are taught when you’re first dabbling in this exchange), currencies need to be viewed in pairs. Essentially, shifts in price are a reflection of comparative values in that currency pair, so both sides of the coin need to be assessed.



In the case of the yuan, it seems far more probable that if any government is to carry the responsibility for its current weakness, President Trump would be better advised to look in the mirror. It might be politically expeditious to blame it on internal manipulation, but those economists who prefer to follow Occam’s razor point to a simpler solution. The steel tariffs that set all these wheels in motion coincided with the yuan’s first significant drop in value in the second half of June. It could be argued that the weakness in the yuan is a simple and inevitable consequence of those trade tariffs. 


Did it fall or was it pushed?

The fact that the yuan has dropped significantly in value does have some positive consequences for the Chinese economy, and in some aspects, it blunts the effects of the trade tariffs. This is why the Chinese central bank has not taken any overt action to counter the effects of currency devaluation.

However, there is a big difference between watching it happen and causing it through internal manipulation. A report published by the US Treasury provides a detailed definition of currency manipulation, and the simple fact is that what has been observed in China does not meet it. Ultimately, economists on both sides of the Atlantic agree that the devaluation in the yuan is an inevitable market reaction to broader economic factors, the largest of which are the US trade tariffs.


The graph above shows historical exchange rates between the Chinese Yuan Renminbi (CNY) and the US Dollar (USD) between 4/1/2018 and 9/26/2018 (source: exchange-rates.org)

How should investors react?

Of course, all the economists in the world might agree on the above point, but the likelihood is that President Trump will not be convinced. For private investors, however, it is important to have a clear vision of the why as well as the what when it comes to currency valuations in order to make the right decisions. 

In times of trouble, investors typically search for a safe haven. In the pre-EU days, currencies like the German Mark would have strengthened. Today, however, the EU has problems of its own, and sterling is being avoided due to the spectre of Brexit hanging over it. The Japanese yen has therefore seen some strengthening, but the safest currency of them all is the US dollar. 

This is another way in which the trade sanctions have ultimately backfired on the Trump administration, driving the value of the US dollar ever higher, while the Chinese yuan, the Euro and other key currencies continue to stutter. 


A currency war, in its formal definition, still seems less than likely. However, the current Forex trends look set to continue. By ignoring the hype and understanding the true drivers, investors can be in the best position to react.  


The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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