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.
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