Unlucky Number Seven: The Exchange Rate and the State of U.S.-China Talks
August 6, 2019On Monday, the Chinese renminbi (RMB) fell below the psychologically significant level of seven RMB to the U.S. dollar for the first time in more than a decade. The decision by China to allow a weaker RMB, followed by the U.S. designation of China as a currency manipulator, are the latest and most immediately consequential actions in the U.S.-China trade war to date. Actions on currency have ushered in a new stage in the U.S.-China trade war that risks spinning out of control absent a concerted effort to get negotiations back on track.
Q1: What has been the role of currency in U.S.-China trade talks?
A1: Currency has long been a battle ground in the U.S.-China trade relationship. Back in the early 1990s, when China had a dual exchange rate regime, the U.S. Department of Treasury labeled China a currency manipulator in its Report to Congress on Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States. Two decades later, Mitt Romney, the Republican nominee for president, announced he would label China a currency manipulator on “day one” of his presidency, a warning repeated by then-candidate Donald Trump in 2016. Notwithstanding the threat, the Trump Treasury had—until this week—declined to label China a currency manipulator, estimating that China had intervened in the foreign exchange market to prop up the value of the RMB, a view supported by market analysts and the International Monetary Fund (IMF). That assessment changed on Monday evening when Treasury issued a press release announcing that “Secretary Mnuchin, under the auspices of President Trump, has today determined that China is a Currency Manipulator.”
What the Treasury designation means in practice remains to be seen. The press release noted that Secretary Mnuchin will engage with the IMF “to eliminate the unfair competitive advantage created by China’s latest actions,” referencing Monday’s RMB depreciation. But the case against China may be hard to make: the IMF’s most recent External Sector Report (ESR), an annual report that analyzes global external developments, including exchange rates, concludes that China’s external position was broadly in line with “fundamentals and desirable policies.” The ESR also notes China’s record capital outflows in 2015 and 2016, which in turn were set off by RMB devaluation. Back then, the People’s Bank of China (PBOC), China’s central bank, stepped in to defend the currency, spending hundreds of billions in foreign reserves in the process.
Q2: Why did China allow RMB depreciation on Monday?
A2: It was widely reported that the PBOC had been supporting the RMB to “avoid derailing trade negotiations with the United States.” Trump’s decision to levy a new round of tariffs on $300 billion of Chinese imports effective September 1 appears to have prompted Chinese officials to rethink that approach. Considering the presidential tweet announcing the new round of tariffs came on August 1, just one day after his press secretary released a statement characterizing the most recent round of talks as “constructive,” the decision to impose new tariffs came from the very top. China’s willingness to allow the currency to depreciate was likely intended to remind the president of the downsides of escalating actions while negotiations are ongoing. If that was the idea, it didn’t have the desired effect as evidenced by the currency manipulator designation. Now that escalatory actions have been taken at the most senior levels of both governments, it’s not clear how either side stands down.
Q3: What is the impact of RMB depreciation?
A3: The initial move by the PBOC on Monday was not about export competitiveness (nor is the Treasury designation about exchange rate misalignment). Other things being equal, a weaker RMB would make Chinese exports cheaper; however, currency movements may not be passed through to final prices and may well be more than offset by higher tariffs (depending on the magnitude of any further depreciation and tariffs), at least for exports to the United States.
The more immediate impacts are already being felt in financial markets in the form of repricing risk—putting downward pressure on valuations and increasing volatility. (The S&P 500 index dropped nearly 3 percent on August 5.) The danger now, for China, the United States, and the rest of the world, is that market forces overwhelm the official sector’s ability to respond. Many commentators have recalled the difficulty China faced in 2015-2016 to contain capital outflows sparked by currency devaluation. The situation is arguably more manageable now for China since it has tighter controls in place, but outflow pressures could easily reemerge as market participants both inside and outside China fully price-in the possibility that no deal will be reached. In addition, in contrast to the 2015-2016 episode where Chinese and U.S. interests to stop further RMB depreciation were generally aligned, the current episode can be characterized as one in which both sides are using currency to gain advantage in the negotiations, roiling global financial markets in the process.
Q4: How will currency shape the administration’s handling of the trade war with China?
A4: It’s hard to know how Monday’s dramatic currency developments will ultimately shape the outcome of the U.S.-China trade war, let alone broader U.S.-China strategic competition. Ironically, Trump’s move to impose additional tariffs in order to gain negotiating leverage—which in turn prompted China to let the currency decline—may give China the upper hand insofar as market movements put greater pressure on the United States to deescalate. It’s also difficult for anyone outside the government—perhaps even inside the government—to know where narrowly defined trade negotiations sit alongside other strategic objectives with China. Past administrations sought to frame the trade relationship in a coherent context through mechanisms like the Strategic & Economic Dialogue, forcing internal debate of pros and cons of any proposed policy action. For the sake of global financial stability, one can hope the policy process is more deliberative than the one preceding the August 1 tweet.
Stephanie Segal is a senior fellow with the Simon Chair in Political Economy at the Center for Strategic and International Studies in Washington, D.C.
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