An interesting twist to the ongoing trade war between the United States and China took place this week as China appears to have thrown down the gauntlet. The United States imposed an extra 10% tariff on the remaining $300 billion of Chinese imports it had yet to tax. Thus, virtually all of the more than $500 billion of Chinese exports to the U.S. would now cost more to import in the Trump administration than they had during Obama's tenure. The Chinese, however, responded in an unexpectedly aggressive manner.
On Monday and Tuesday, China's central bank moved its currency peg to its lowest level against the U.S. dollar in over a decade. In doing so, the Chinese decreased the impact of the Trump administration's tariffs and signaled they would be willing to take more steps to counter its impact.
This kicks off the currency manipulation phase of the trade wars. China has in the past used a moving peg or established a band in which it allowed the Yuan to trade, however, as President Trump has ramped up efforts to increase pressure on China, it has allowed the Yuan to devalue against the U.S. dollar in an effort to ensure demand for Chinese goods wouldn't decrease. An impending global trade war and race to devalue currencies will most negatively impact Chinese exporters unless it keeps up and devalues its currency and that's exactly what it did. The U.S. Treasury responded by labeling China a "currency manipulator" which is an act with very few real-world implications.
There are two important directions these actions can take and both will impact the global economy. Firstly, should China continue down this road, devaluing its currency by the amount its goods are tariffed, it will undoubtedly cause a run on the Chinese currency. The off-shore Yuan already trades nearly 1 percentage point lower than the official rate and this is, in my opinion, only the beginning. Should the trade wars intensify and should Beijing continue to devalue its currency, there will be a run on the Yuan. Chinese holders of Yuan will no longer view it as a safe haven to park their wealth and will exchange it for dollars or euros.
The good news for China is that it has amassed a war chest of dollars and euros that it can sell to shore up its own currency should it need to. The bad news war chests don't last, especially in the face of an insatiable demand for a flight to safety. Should the world return to Great Recession levels of volatility no central bank will be immune from these runs on their currency. China needs to very carefully plan its next moves or else the miracle economic expansion it has experienced in the last 25 years will come to an end.
China has always bet that it could build up consumer consumption before this day would come. It had hoped that it wouldn't be an export-dependent economy and be at the mercy of foreign countries' politicians but that day has not yet arrived and Beijing is well aware of this fact. Look for emerging markets to continue to benefit from this volatility and decrease in financing costs.
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