All Financial Wisdom

USA vs China: From Commercial War to Currency War

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After the first movements of a trade war between United States and China, China is studying its potential impact to see if a gradual depreciation of its currency, the yuan, could be forthcoming.

Ironically, while Trump attacked China in the election campaign to keep its currency artificially weak, the yuan has gained around 9% against the dollar since he took office and has remained stable in recent weeks despite the escalation of the commercial tensions between the two economies.

What China is proposing is to use its currency as a tool in future trade negotiations with the United States, while also examining what would happen if China carried out the devaluation of the yuan to offset the impact of any trade agreement.

Therefore, this does not mean that China embarks on a devaluation, but, for now, it is studying this possibility, which will depend, to a large extent, on the future of US protectionism.

What consequences would the devaluation of the yuan have?

All countries have been tempted to devalue the currency to help cushion their economies from time to time. That said, China’s devaluations could pose a problem for the global economy. Given that China is the world’s largest exporter and is the second largest economy, any change made by such a large entity in the macroeconomic outlook tends to have notable repercussions.

With the cheapening of Chinese products, it is possible that the commercial income of many small and medium economies driven by Chinese exports will be reduced. And if these countries are indebted and heavily dependent on exports, their economies could suffer a severe impact.

For example, Vietnam, Bangladesh and Indonesia depend heavily on their exports of footwear and textiles, so they could be in serious trouble if China’s devaluations make their products cheaper in the global market.

It also has to be mentioned that a weaker yuan is likely to trigger a massive exodus of funds from China that resembles the one that occurred between 2014 and 2017, when the currency weakened by 13%, from 6.05 to 6.94 against to the dollar. This is the last thing Beijing wants to see now, since it has made financial risk control its top priority.

 

Although, as we have said, the yuan has strengthened more than 9% against the dollar since December 2017 and foreign exchange reserves have since resisted a downward trend, the pressure of the flight of capital continues to be present in if a devaluation error occurs.

We must also bear in mind that many Chinese companies have part of their debt denominated in dollars, so if we saw a devaluation of the yuan, it would hinder their efforts to pay down their debt.

Calibrating the power of China

A commercial war, can lead to a currency war and China has an ace up its sleeve…it owns 20% of US public debt. The total value of these values ​​is about 1.2 trillion dollars.

In short, China is lending money to the United States to buy its products and helping the economic progress of the Chinese economy. This, in turn, is increasing the trade deficit between the United States and China,

If such a large debt holder decided to reduce their purchases, the demand for treasury bonds could fall and investors could demand higher returns for their investments in US treasury bonds. In other words, for the American Treasury it would be more expensive to refinance debt maturities.

If China decides to use this weapon of economic destruction, it could not only affect the United States but lead to another global financial crisis. Bond prices in the United States and around the world would plummet due to this bailout. The interest costs for the companies would increase and would have an impact on the equity markets.

 

China has commitments that must be met

Chinese President Xi Jinping had maintained the government’s commitment to reform China’s economy in a more market-oriented direction since he took office for the first time more than four years ago. This made the People’s Bank of China’s assertion that the devaluation was the result of the measures taken to allow the market to be more instrumental in determining the value of the yuan more credible.

The objective was to give markets a greater role in determining the renminbi’s exchange rate, with the objective of allowing a deeper monetary reform.

At that time, the measure was also consistent with China’s “slow but steady” reforms aimed at consolidating in the financial markets. And in fact, currency devaluation was one of the many monetary policy tools that it employed in 2015, including cuts in interest rates and stricter regulation of the financial market.

There was another reason: China’s determination to be included in the basket of reserve currencies of the Special Drawing Rights (SDRs) of the International Monetary Fund (IMF), which is an international reserve asset that IMF members can use to buy national currency in the currency markets in order to maintain exchange rates.

The IMF re-evaluates the currency composition of its SDR basket every five years, the last time being in 2010. At that time, the yuan was rejected on the basis that it was not “freely usable.” But the devaluation, supported by the claim that it was made in the name of market-oriented reforms, was well received by the IMF, and the yuan became part of the SDR at the end of the year.

Within the basket, the Chinese renminbi has a weight of 10.92%, which is higher than the weight of the Japanese yen and the pound, at 8.33% and 8.09%, respectively. The interest rate on IMF loans depends on the SDR interest rate. As exchange rates and interest rates are interrelated, the cost of IMF loans for its 188 member countries will depend in part on China’s interest rates and exchange rates.

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