Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate on August 9th.
The US-China trade war heated up in the first week of August. On August 1, Donald Trump abruptly announced plans to impose a 10 % tariff on the remaining $300 billion of imports from China that he had not already hit with earlier tariffs. The Chinese authorities then allowed their currency, the renminbi (RMB), to fall in value below the highly visible line of 7.0 RMB/$. The US Administration promptly reacted on August 5 by naming China a “currency manipulator” — the first time any country had been given that designation in 25 years. Pundits declared a currency war, while investors responded by immediately sending stock markets down.
The accusation that depreciation of the RMB is manipulation of the currency to gain unfair competitive advantage is not true. It would be more correct to say that the Chinese authorities gave in to market pressure – that there had been more sellers of RMB than buyers in the foreign exchange market – and that the immediate source of that market pressure was none other than Trump’s announcement of the new tariffs.
Textbook theory says that tariffs do not succeed in improving the trade balance in the way that their proponents think they do. When the exchange rate is market-determined, it automatically moves to offset the tariff. Intuitively, if tariffs stop American consumers from buying Chinese goods, then the demand for RMB on the foreign exchange market goes down. So the price of the RMB goes down.
The criteria for judging currency manipulation
The US Congress in 1988 gave the Treasury the task of evaluating whether trading partners manipulate their currencies. It laid out three specific criteria that Treasury was instructed to use to make this judgment. (Congress slightly modified the rules in 2015.) Two out of the three tests coincide with internationally agreed criteria for manipulation, under the Articles of Agreement of the International Monetary Fund: persistent one-sided intervention by the country to push down the value of its currency and a large current account surplus. China is not violating either of the two criteria.
The third criterion specified by Congress – a large bilateral trade imbalance with the US – makes no sense in economic terms and accordingly has no role in international agreements. The US runs bilateral trade deficits with most trading partners. (This is simply because its total trade deficit is large and getting larger, which was in turn the predictable consequence of Trump actions to pump up the US budget deficit, a familiar pattern known as the twin deficits. The third criterion under international agreements is an assessment of the level of the exchange rate. (The RMB was undervalued by most tests during 2004-2008, but probably overvalued by 2014.) With the subsequent decline during 2014-2019, an IMF report on July 24 judged the value of the Chinese currency to be at the level “warranted by fundamentals and desirable policies.” In any case, even under the US procedures, the single criterion of a bilateral trade deficit is not supposed to be enough to get a country named a manipulator.
For 30 years, the US Treasury fulfilled its mandate from Congress in a professional way, regardless of who was in the White House. The abrupt decision to name China a currency manipulation this month despite not meeting the criteria represents yet another case of Trump heedlessly running roughshod over established norms, professional expertise, the long-term credibility of US institutions, and even the plain meaning of the law.
To be sure, there was a time, particularly 2004-2008, when China acted to keep its currency substantially undervalued. From 2004 to mid-2014, the Chinese authorities intervened heavily to slow down the market-driven appreciation of their currency. Gradually over the decade, the currency did appreciate nonetheless, by 30% against the dollar altogether.
Then the direction of the wind shifted. For the past five years, the Chinese authorities have intervened to slow down the depreciation of the RMB contrary to oft-repeated charges from Trump and some other American politicians. The value of the currency peaked in mid-2014. Then market pressure turned against it, initially due to a slowing Chinese economy and an easing of its monetary policy. The People’s Bank of China in 2015 and 2016 spent $1 trillion in foreign exchange reserves, out of a total accumulated stash of $4 trillion, in an effort to prop up the RMB. This is by far the largest intervention in history to support the value of a currency. Beyond PBoC intervention, China also used other tools to dampen the depreciation. As Mark Sobel explains, “it jawboned the markets not to sell renminbi; it squeezed short positions; there was undoubtedly administrative guidance to the markets; it intensified capital outflow controls; and there was probably some modest intervention by Chinese state proxies to support the currency.”
It is fair to interpret Beijing’s August 4 decision to let the exchange rate break the 7.0 barrier as a deliberate response by Chinese leaders to Trump’s latest tariff offensive. But there is more to it. China has been concerned that the RMB’s slide would go too far too fast, destabilizing financial markets. The decision to let it go was a reluctant recognition of market realities. Trump’s tariffs have been increasingly important among those market realities. They, not manipulation, are the fundamental cause of the recent exchange rate move.
Trump is a master of the old trick of accusing others of transgressions that he himself has committed or is thinking of committing. He wants to manipulate the dollar. He has gone beyond public pressuring of the US Federal Reserve to cut interest rates, itself a violation of longstanding domestic norms. He has explicitly used the language of talking down the dollar not just a departure from 30 years of a “strong dollar” formulation of US policy, but also a violation of more recent informal international agreements. Clearly, he sees the world as a game of competitive depreciation. (Some Democratic presidential candidates as well have indicated a desire to weaken the dollar by actively managing the exchange rate.)
The White House said last month that it had even considered the possibility of intervening directly in the foreign exchange market to push down the value of the dollar – buying foreign currencies in exchange for dollars. (Trump on July 26: “I could do that in two seconds if I wanted.”)
It seems unlikely. The last time the US engaged in an effort to depreciate the dollar against other currencies, the Plaza Accord of 1985, it worked only because it was part of a G-7 cooperative effort to correct an agreed misalignment. The shared motivation was to head off protectionism in Congress, whereas Trump wants dollar depreciation precisely in order to bolster his tariffs.
The circumstances are very different today. If the US were to engage in a pure currency war against China, it would find itself out-gunned. The size of the US Treasury war chest for foreign exchange intervention (known as the Exchange Stabilization Fund) is a small fraction (about 1/30th) of the ammunition held by the Chinese authorities in the form of foreign assets. Furthermore, no matter how crazy US policy gets, global financial markets continue to respond to any upsurge in global risk perceptions by piling into US dollars, the safe-haven currency. Paradoxically, Trumpian volatility can send the dollar up, rather than down.
Major governments have abided by an informal 2013 agreement to refrain from competitive depreciation, in the core definition of explicitly talking down currencies or intervening in foreign exchange markets. To be fair, however, the windmills at which Trump is quixotically tilting may not be wholly imaginary, if currency wars are defined much more broadly as decisions by central banks to ease monetary policy with the predictable side effect of depreciating their currencies. The Bank of England responded to the Brexit referendum with monetary stimulus that depreciated the pound. More recently, the European Central Bank has responded to a slowing in European growth by signaling an easier monetary path than had been expected last year.
Fears of currency wars (or competitive depreciation) have always been described in terms parallel to the desire to avoid trade wars. Both are rooted in the “beggar thy neighbor” policies of the Great Depression, when each country would try to gain competitive advantage vis-à-vis its trading partners, in a collectively futile exercise. The cooperative post-war international system set up at Bretton Woods in 1944 was designed to avoid a repetition of the errors of the 1930s: the plan was to avoid competitive devaluations by pegging exchange rates and to bring down tariffs by multilateral negotiations and enforcement.
In truth, currency wars are less damaging than trade wars. Thus the importance of international coordination is less clear-cut in the former case. A currency war can result in global monetary policy that is a bit easier all around. But an all-out trade war could truly derail the global economy and its financial markets. The significance of the US reaction to the RMB crossing the 7.0 line is that it represents another step in the escalation of the doomed US-China trade war. And the risk from Fed cuts in interest rates is that they would give politicians the impression that monetary policy can repair the effects of their own trade policy mistakes.
This post written by Jeffrey Frankel.