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Amidst slowing global trade and intensifying trade disputes and tariff actions, the prospects of competitive currency devaluations (aka: “currency wars”) to shore up export competitiveness becomes more probable. Whether last week’s devaluation of the Chinese currency, the renminbi (RMB), beyond the 7-to-1 US dollar (USD) exchange rate constitutes a move in this direction remains to be seen.
As The Conference Board China Center has previously opined, the economic downsides of devaluation on the Chinese side are significant. Therefore, we question whether China’s central bank, the People’s Bank of China (PBoC), would permit a sustained devaluation.
Nevertheless, given China’s huge role in global trade, competitive devaluation of the RMB—perhaps even perceptions of it—would necessarily prompt exchange rate adjustments for most currencies worldwide, including the USD. Members should thus carefully consider the following exchange rate related exposures and develop contingency plans accordingly. Key exposures to consider are six-fold:
Debt exposure: Does your company rely on one currency to service debt that is denominated in another? If so, the cost of servicing this debt could be impacted.
Supplier exposure: If your supply chain runs across international borders, whether on the first tier or beyond, the price of your intermediate inputs may be impacted.
Customer exposure: If your company sells goods or services across borders, the prices your customers pay in their local currency may be impacted.
Balance sheet exposure: The value of assets and liabilities on your balance sheet may be impacted by currency gyrations.
Price competitiveness exposure: Even if your company’s goods or services are not directly impacted by currency fluctuations, the goods and services of your competitors may be. This could impact your company’s price competitiveness.
Global equity markets plummeted last Monday, August 5 on news that China’s currency had broken through the 7-to-1 barrier overnight, dropping to 7.05 RMB to the US dollar. This movement came as a shock to financial markets as it appeared that China’s central bank was unwilling to defend the Renminbi against increased downward market pressures. It also signaled that the weapons being wielded in the ongoing economic dispute between the US and China may be expanding in scope beyond tariffs to include competitive currency devaluations as well.
If true, this escalation may constitute the launch of a currency war in addition to the ongoing trade war. This development could result in an extended period of turbulence in currency markets that create even greater uncertainty for companies doing business globally.
While financial markets seem to have absorbed last Monday's exchange rate adjustment and stabilized, the RMB has remained beyond 7 to the US dollar ever since. There is no certainty, therefore, that this episode is over and that further devaluations will not occur. For most of 2019, the RMB/USD exchange rate had hovered between 6.7 and 6.9, despite protracted US-China trade tensions, slowing economic growth at home and abroad, and USD strength (all factors that should have been undermining the RMB’s value). This stability was achieved via Chinese intervention—China’s central bankers were, in essence, manipulating China’s currency to maintain a stable rate, arguably on the artificially high side.
Last week, however, the PBoC loosened its grip on the RMB’s leash and let market forces drive the value of the currency past the psychologically important 7-to-1 threshold—a rate that hadn’t been breached since the Global Financial Crisis.
The timing of the PBoC’s actions is important. August 6’s RMB devaluation followed a threat from the White House to implement additional tariffs on $300 bln worth of Chinese imports, which was itself motivated by the lackluster outcome of recently concluded US-China trade negotiations in Shanghai. These new tariffs, if imposed, would join an existing set of duties on $250 bln worth of Chinese goods that have been rolled out over the last year and, importantly, would expand America’s tariff covered to include every good that China sends to the US.
Unlike previous tariff volleys in which China had been able to respond with retaliatory duties on American imports to China, Beijing has now run out of US goods to correspondingly tax. By depreciating the RMB, whether through direct market intervention (which China is known to be capable of) or inaction (allowing the market to move the RMB in a predetermined direction—which was the case here), China is undermining the effectiveness of the US tariffs on its goods and augmenting the impact of its tariffs on US goods. While the depreciation was measured, it sent a clear message to Washington: China is prepared to use its currency to respond to US tariffs.
The White House responded to the RMB’s fall by officially labeling China a "currency manipulator." This US Treasury Department designation is largely a formality, but it does potentially expand the set of penalties that the US can wield against China. Technically, the US government is required, as a next step, to seek assistance from the IMF to engage the offending country to address the currency manipulation. Whether this will be successful is questionable, however, because some of the official criteria used to confirm a manipulation offence may not be applicable in this case. Regardless, the US may elect to raise additional duties on China to "cancel out" the benefit to Chinese exports that results from RMB devaluation.
Another potential US response is to weaken the value of the US dollar. The White House is likely to strengthen its case that the US Federal Reserve should lower interest rates beyond last week’s 25 basis point cut. Doing so would further reduce yields on US debt, making them less attractive to foreign buyers and, thereby, reduce demand for the USD on global markets while simultaneously increasing the USD supply. This chain of events would broadly depreciate the value of the USD against other currencies, including the RMB.
If trade tensions linger and US economic growth weakens over the coming quarters, the Administration could also respond by accelerating fiscal spending. The recent budget agreement in Congress creates room to stimulate the economy, for example, by redirecting funding to infrastructure spending for which there is likely broad Congressional support. Higher fiscal spending is most likely to exert downward pressure on the dollar due to greater demand for foreign goods and services, especially if other economies in Europe and Asia respond less aggressively and slow even more.
A final but dangerous route to weakening the USD could potentially come from direct US government intervention in currency markets by letting the US Treasury sell more dollars abroad. In the past, the Federal Reserve has supported this kind of currency intervention through their own actions, but there may be more reluctance to do so this time if the primary motive is a competitive devaluation in a currency war rather than a way to support the stability of the US economy (the Fed’s mandate). Alternatively, the Fed could counter sales by the Treasury via their own purchases of USD, which would become an important source of internal conflict with unclear consequences.
Even if any of the above dollar devaluation strategies are engaged over the coming months, the overall impact will also depend on China’s actions. Was the RMB depreciation earlier this week a one-off event, or is China willing to weaken the RMB further, even if that hurts China’s own economy? Would China be willing to go a step further by weaponizing its more than $1 trillion in US securities? A rapid sell off of China’s US treasury holdings would likely damage both economies, but given the current instability in the relationship even rumors of this could shake markets (as we have seen this week) and make business executives reluctant to make investment decisions.
In the coming months, global executives could find themselves trying to navigate an international currency market wherein both the USD and the RMB are competing in a ‘how low can you go’ devaluation game. US interest rates and Chinese forex reserves, including China’s holdings of US treasuries, would likely be the primary ordnance in this currency war. However, the fallout would likely spread elsewhere and is difficult to fully predict.
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