China’s renminbi move shows they are hunkering down, ready for a long trade war

The trade war is ramping up and has spread into a potential currency war. The U.S. has declared China a “currency manipulator,” while China showed it could crash equity markets by allowing its currency to depreciate. How will this end? Who knows, but it doesn’t look good for anyone.

The Trump administration is intent on changing the trade relationship with China. There is little doubt the Chinese have used all the tools at their disposal to gain an upper hand. And it has worked.

In 2018, China sold nearly $540 billion of goods to the U.S., but bought only $120 billion in return. Clearly, the trade balance is out of whack.

To rectify the situation, the administration started negotiations on a new trade agreement. But at the same time, it employed the U.S. economic muscle by imposing tariffs on about 40% of the Chinese exports to the U.S.

When the latest round of talks stalled, the president indicated that he would levy tariffs on most of the remaining Chinese products. His actions triggered a response, and what began as a trade battle appears headed toward full-scale war.

The Chinese indicated that they were suspending purchases of U.S. farm products and letting their currency depreciate. The administration indicated that it would place tariffs on the rest of China’s exports to the U.S. and labeled the Chinese “currency manipulators.”

Why does currency manipulation matter? Because the value of a currency determines the cost of imports and exports.

For example, if the Chinese yuan (renminbi) is valued at six to the dollar, something that costs 6 yuan in China would cost an American importer $1. If the yuan weakens so a dollar buys 12 yuan, that same product would cost the American importer only 50 cents.

In short, by devaluing the currency, the Chinese made their goods cheaper for U.S. importers to purchase and therefore more competitive. It also made our exports to China more expensive, because a Chinese company would have to use more yuan to buy the same number of dollars.

Which brings us to the currency war. The Chinese allowed their currency to depreciate to a level not seen in more than a decade and outside the range they set for the yuan. By devaluing its currency and making its goods cheaper, China could offset, at least partially, the tax that American importers pay for the tariffs.

Why did the Chinese take an action they knew would cause a strong reaction? It part, it was in retaliation for the U.S. extending tariffs to almost all Chinese goods.

But the Chinese currency action also sent a warning. If the U.S. imposed additional tariffs, China could offset them by allowing its currency to fall further.

The markets understood the message. The Chinese were hunkering down and ready for a long, possibly bloody war. The last thing the world economy needs is a drawn out trade war between the two largest economies, so not surprisingly, the equity markets tanked.

But the bullets didn’t stop being fired. The U.S. labeled China “currency manipulators.” That triggers possibilities for the U.S. to further attack the Chinese, though in reality, it is likely more bark than bite.

It is interesting that the accusation that the Chinese are manipulating their currency comes at a strange time. When an economy weakens, it is normal for its currency to follow suit. Actually, the yuan might fall further without intervention.

Regardless, the world economy has entered a very dangerous phase. We have new tariffs being imposed, currency wars that are flaring, and economies that are faltering.

In the middle of all this is the Federal Reserve.

The Fed cut interest rates largely because it was concerned that international issues (really, the trade war with China) would cause U.S. growth to slow.

But by reducing rates, the Fed has enabled further trade bullets to be fired. If the administration expects that the Fed will cut rates to offset the negative impact of its trade policies, it will continue with those policies.

The Fed has blundered, even if it was trying to do the right thing. By linking trade and interest rate cuts, it may have precipitated a vicious cycle of more trade battles, slower world growth, faltering equity markets, additional rate cuts, and so on.

Where this not-so-merry-go-round stops is anyone’s guess. There are two immovable objects: Trump and the Chinese. Neither is willing to lose face by giving in.

Unfortunately, unless the U.S. and/or China backs down, the cycle of trade and currency battles will likely worsen. And the end to that is almost certainly a recession.