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Are Trade Wars Spiraling Into A Currency War?

President Donald Trump delivers remarks on trade at Granite City Works Steel Coil Warehouse, Thursday, July 26, 2018, Granite City, Ill. (AP Photo/Evan Vucci)

President Trump recently tweeted that currency manipulation was rampant across the rest of the world. He blames the U.S. Federal Reserve for raising interest rates and strengthening the dollar. He also accuses China and Europe of manipulating their currencies, making U.S. exports less competitive.

In reality, the U.S. dollar’s strength is primarily driven by fiscal stimulus, mainly the tax cuts, that was poured onto an already strong economy.

This wouldn’t be the first time a trade war has morphed into a currency war. But pitting currencies against each other is a dangerous tactic that has historically reduced aggregate trade and growth.

Renminbi Depreciation

Trump was most critical of the renminbi, saying it had “dropped like a rock.”

It’s true that the Chinese currency has depreciated approximately 8% against the dollar over the last three months. And a weaker currency makes Chinese exports more competitive and neutralizes some of the bite from U.S. tariffs. It would be natural to assume that China is managing its currency lower, but at this point, it seems more likely that market forces are behind the currency’s weakness.

China’s growth is starting to slow as its government squeezes housing speculation and clamps down on credit growth. Inflation is hovering well below target. With trade tensions rising, the Government has cut taxes and increased infrastructure spending in an effort to stoke demand.

CNY/USD FX RateBloomberg

A key deterrent to currency manipulation is the risk of capital flight. China’s disastrous attempts in 2015 and 2016 to steer the currency is still fresh. Back then, the People’s Bank of China (PBOC) adjusted the renminbi’s rate fixing mechanism against the dollar. This led to market confusion, resulting in equities and other risky assets tumbling. As the PBOC tried to restore confidence, it was forced to sell $1 trillion of forex reserves to support the renminbi. It has yet to rebuild those reserves.

For now, Chinese officials seem comfortable allowing markets to set the exchange rate rather than acutely managing it.

Currency Wars Are Not The Answer

While the Trump Administration expresses alarm at currency depreciation, this is likely the first in what may be a series of surprises. Strong growth drives U.S. demand. This will undoubtedly increase imports, with a competitive dollar taking the edge off any incoming tariffs. Conversely, U.S. exports will struggle as they lose competitiveness in target markets. The net effect is an expanding trade deficit.

Ironically, a quick solution to shrinking the U.S. trade deficit is an economic downturn. In 2009, as the great recession dented consumer demand, U.S. imports dropped by 26% from a year earlier. Exports also dipped, but not as dramatically, reducing the annual trade deficit by 40% compared to 2008. Clearly, no one would root for a recession to shrink the trade deficit.

As an advanced economy, the U.S. has more of a competitive advantage in providing high-end services rather than producing low-cost goods. On a global basis, the U.S. runs a trade deficit in goods but a surplus in services. So efforts to globally expand U.S. services should receive as much attention as negotiating fair terms for goods.

The real challenge for the Trump Administration’s trade agenda is that the U.S. fiscal boost, slowing growth outside the U.S., a strengthening dollar and tariffs are unlikely to shrink the U.S. trade deficit. Working with allies to equalize and lower existing tariffs, and then with their support address intellectual property concerns with China, may yield more sustainable results.

This material contains opinions of the author, but not necessarily those of Sun Life Financial or its subsidiaries.

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