Last week, after nearly two decades of threats from U.S. President Donald Trump and his predecessors, the U.S. Treasury formally labeled China a currency manipulator. This followed Trump’s announcement that new 10 percent tariffs on some $300 billion in Chinese goods would kick in on Sept. 1, which sent the Chinese currency crashing to less than 7 yuan to the dollar for the first time since 2008.
The move has been widely characterized as a dramatic escalation in the trade war, expanding the U.S. offensive from tariffs, tech controls and investment to asset prices. But by the United States’ own definition, China hasn’t actually been intentionally weakening its currency. Quite the opposite, in fact. And the label itself won’t do anything to pressure China into major concessions. What it really suggests is that the U.S.-China trade war has entered a new phase – one marked by waiting around for a change in conditions that forces one side or the other to blink.
How China Manages the Yuan
For more than a decade beginning in the early 2000s, Beijing was indeed quite transparently keeping the yuan artificially weak, buying up some $4 trillion in U.S. treasuries in the process to maintain a peg of around 8.2 yuan to the dollar. Given China’s large balance of payments surplus and large net investment inflows, had the yuan been allowed to float relatively freely like the dollar, yen or euro, it’s estimated to have been less than 6 yuan to the dollar. China kept its currency weak to offset some of the stiffening headwinds facing its export sector, which had begun grappling with factors like rising wages that threatened its low-cost export growth model. This accelerated the exodus of U.S. manufacturing jobs while suppressing demand for U.S. goods among Chinese consumers. Naturally, this generated no small amount of political backlash in the U.S., sowing the seeds for the political consensus in the U.S. today that China’s rise has been aided by an unlevel playing field.
Around 2014, however, China switched course and began allowing the yuan to move more in line with market forces. Narrowly speaking, China has continued to “manipulate” the yuan; to avoid wild swings in value, it sets a daily trading band allowing just 2 percent change in either direction. But this doesn’t meet the U.S.’ own criteria for currency manipulation. In fact, by and large, whenever the People’s Bank of China has been forced to intervene to keep the value within the daily trading band, it’s been to strengthen the yuan. The U.S. Treasury has consistently admitted as much, including in its most recent report on the yuan published in May. Between 2014 and 2015 alone, China spent more than $1 trillion of its foreign exchange reserves defending the yuan.
China switched gears for several reasons. For one, it’s been keen to reduce its dependence on exports by boosting domestic consumption (which generally benefits from a stronger yuan) and the private sector (much of which relies on dollar-denominated bonds, which get more expensive to repay when the yuan weakens). For another, a strong, stable yuan is critical to its sweeping reform and financial de-risking efforts. Most important, a range of macroeconomic factors began placing downward pressure on the yuan and raising fears of capital flight. This was underscored in the August 2015 stock market crisis, which was triggered by China’s decision to allow the yuan to fall more than 4 percent – in line with market forces – in two days.
Defending the yuan has become considerably harder – and more expensive – since Trump launched the trade war 18 months ago. In the year before tariffs kicked in, the yuan had strengthened more than 9 percent. Since then, it has dropped around 5.4 percent. This is not artificial.
To be sure, the weak yuan has taken much of the sting out of U.S. tariffs. But China fears an uncontrollable cycle of depreciation (akin to what it experienced in 2015 and what Turkey faced earlier this year) and the risk of a cascading wave of defaults far more than it fears the tariffs. The numbers make this plain: In 2018, China exported some $550 billion in goods to the U.S. By comparison, it’s estimated to now have more than $3 trillion in external debt. If the yuan weakens, the cost of servicing this debt goes up – as does the risk of lenders refusing to roll over loans, putting Chinese firms in a major fix. This dynamic is what sparked the 1997 Asian financial crisis. Moreover, China’s ongoing liquidity crunch is already biting; bond defaults between 2017 and 2018 quadrupled and are on pace to triple yet again this year, according to Bloomberg figures.
Rather, the yuan’s devaluation is a natural result of the tariffs, which have pushed the dollar up against nearly all currencies largely in tandem while reducing dollar flows into China. For most of the past two years, to improve the prospects of a trade deal and guard against capital flight, Beijing has continued defending the yuan. But this is expensive; China’s foreign exchange reserves have dropped to around $3.1 trillion. On Monday, in response to Trump’s announcement of a dramatic expansion of tariffs, China didn’t intervene to weaken the yuan in retaliation. Rather, it merely took a break from propping it up. What the U.S. is demanding now, in other words, is that China manipulate it more forcefully.
So, What’s the Point?
The Trump administration’s goal in slapping China with the manipulator label isn’t exactly clear. To be sure, the U.S. has ample economic reason to want to narrow the gap between the two currencies; it’s hard to imagine the bilateral trade deficit ever disappearing if the yuan remains so much weaker than the dollar. And there’s some support on both sides of the aisle for dramatic efforts to weaken the dollar.
But the label won’t do much to move either currency in the direction the Trump administration wants. The next step outlined by U.S. law doesn’t involve any sanctions – it’s merely a consultation with the International Monetary Fund, which is unlikely to agree with the Trump administration. (Like the U.S. Treasury, the IMF has consistently concluded that China doesn’t meet its criteria for currency manipulation.) This may dash U.S. hopes to build a multinational consortium to force China to strengthen the yuan. International support has proved invaluable to the U.S. in the past, particularly in the 1985 Plaza Accord, when the U.S. persuaded France, Germany, the United Kingdom and Japan to manipulate exchange rates and bring the dollar down as much as 50 percent against the yen and Deutschmark. This time around, with the U.S. lacking a valid case against China and launching trade disputes with most of the allies it would otherwise court on currencies, such a consortium seems far-fetched.
It’s possible the U.S. is just building a case for greater unilateral escalation. Even when Beijing was flagrantly inflating the yuan from 2002 to 2014, past U.S. administrations repeatedly declined to do anything more than threaten the manipulator label, primarily because none were prepared to follow up with punitive measures like tariffs that may not have survived a World Trade Organization challenge. Trump has no such qualms about wielding tariffs or ignoring the WTO. Still, there’s only so much further Trump can go without tanking the U.S. economy once the next round of tariffs starts to kick in in September (to avoid sticker shock during the holiday shopping season, several big-ticket consumer items will be exempted until mid-December) – effectively taxing nearly every Chinese product exported to the U.S. And the White House can continue its economic offensive without the manipulator label, anyway.
Ultimately, for the move to have any teeth, the U.S. would have to make the leap into direct intervention in currency markets, using tools like the Exchange Stabilization Fund to essentially buy up the yuan as it claims China should be. But intervening against the yuan won’t be easy. Unlike the yen and euro, the supply of yuan available to offshore buyers just isn’t very high, meaning the impact of such a move would likely be limited – and, in some ways, it could weaken U.S. leverage by essentially funding China’s development. The U.S. has more capacity to try to weaken the dollar by buying up a range of foreign currencies. But this is expensive and would have an unpredictable impact on already-spooked markets and potentially undermine the U.S. dollar’s invaluable role as the global reserve currency. It would also further expose U.S. consumers to sticker shock after implementation of the next round of tariffs, which cover consumer goods that had thus far been spared, raising the risk of a political backlash that makes waging a trade war of attrition untenable. (After the last round of tariffs kicked in, the U.S. Federal Reserve estimated that the trade war will cost the average U.S. household $831 per year.) On Friday, Trump backtracked on earlier statements and ruled out the possibility of direct intervention against the dollar – for now.
All this illustrates a critical point: The U.S. is running out of ways to pressure Beijing into major trade concessions, and the tools it has left in its arsenal all have major costs attached. Tariffs are approaching the point of diminishing returns, and trade negotiations have stalled. China has proved more resilient to tariffs than many expected, in part because the yuan’s depreciation and tools like tax cuts, diversion of exports to other markets, and transshipments have offset some of the pain, but also because U.S. consumers and firms have eaten much of the costs. Beijing can’t stomach most of the major structural concessions the U.S. is demanding, and it thinks its economy has stabilized enough to hold steady and wait to see if the political and economic risks of sustaining the trade war in an election year – one that may very well coincide with the start of a recession – force the U.S. to back down.
In these conditions, the White House loses leverage if Beijing thinks it can simply run out the clock, so it needs to counter the expectation that it’ll be desperate to strike a deal before November 2020 – and persuade Beijing that the U.S. is the one better positioned to hold the line until China’s immense structural economic and political vulnerabilities force Beijing to back down. (Trump has pointedly begun lowering expectations that a deal will be reached anytime soon.) Blaming yuan manipulation (and, for that matter, the Fed) for the lack of success of Trump’s tariff-centric trade strategy in bringing down the trade deficit, however disingenuous the case, is one way for the White House to try to prevent domestic political constraints from forcing it to bow out of the trade war prematurely. Meanwhile, raising the possibility of a direct U.S. intervention in currency markets, however steep the costs, may give the U.S. some leverage; Beijing would rather not find out if the White House is serious, and it’s reportedly willing to at least agree to a non-depreciation pact. In other words, there’s negotiating leverage to be had from stoking uncertainty – market jitters and conventional economic wisdom be damned.