The Trump test and the yuan
US President’s insistence that China is devaluating the renminbi makes a currency war between the two countries likely
Donald Trump’s rhetoric during his campaign shows that he is seeking to turn back on established US policy towards China. Tough talk by Secretary of State Rex Tillerson and White House spokesman Sean Spicer signals a more hawkish and unprofessional approach to the territorial disputes in the South China Sea.
If the new administration carries through with its threats and pushes China into a corner, the consequences are unforeseeable and potentially disastrous.
China won’t bow to the Trump administration’s bullying. But it doesn’t want a US – China military clash. Mitigating the danger of a confrontation while protecting its fundamental interests is a daunting challenge indeed for the Chinese government.
A “trade war” between China and the United States is a more real and imminent threat than military confrontation.
While no one knows if Trump himself truly wishes to provoke a military clash in the South China Sea, it is certain that to fulfil his campaign promises, Trump will have to implement a range of protectionist measures.
To impose a 45% import tax on Chinese products, as Trump has suggested, implies that many US imports will become 45% more expensive for American buyers.
Certainly, China’s exports will be affected, but it is hard to say who would be the bigger loser in this trade war.
It is very likely that a trade war will first take the form of a currency war. Trump has claimed that the worst of China’s sins is the wanton manipulation of its currency, robbing Americans of billions of dollars of capital and millions of jobs. Anyone with basic training in economics knows that this accusation is garbage.
Whether China “resisted upward movement of its currency by artificially keeping the yuan’s exchange rate weak” from 2003 to 2014 is a matter for debate.
But as economist Fred Bergsten points out, “over the past two years … China has experienced large outflows of private capital that have driven its exchange rate down and … sparked market fears of disorderly yuan devaluations”.
Yet the political reality is closer to the reverse of Trump’s claim. “The Chinese have intervened heavily on the opposite side of the market,” writes Bergsten. “Instead of buying dollars to keep the [yuan] weak, they have sold large amounts of dollars to prevent it from sliding further.”
In fact, over the past two years, China has spent US$1 trillion of its hard-earned foreign exchange reserves propping up the yuan — an amount larger than the total resources of the IMF and all the money spent during the Asian financial crisis of 1997-98.
Trump vowed to instruct the Secretary of the Treasury to label China a currency manipulator on his first day in office. This promise was not honored.
But if Trump does decide to follow through, the People’s Bank of China (PBOC) can respond immediately by leaving the foreign exchange market entirely, and let the market to decide where the yuan should sit. Why should China continue to promote US competitiveness at its own expense without getting anything in return?
The US Federal Reserve’s exit from quantitative easing will lead to a stronger dollar, while Trump will probably be hoping for a weaker dollar to bolster US exports.
From the US point of view, the only way to weaken the dollar while interest rates in the United States are rising is to force other countries to appreciate their currencies.
China has no intention of devaluing the yuan for trade purposes. It has no intention of bowing to US pressure to appreciate the yuan artificially either. The only solution lies in concerted action in the foreign exchange market by major trading nations. A new Plaza Accord — the 1985 agreement to devalue the US dollar against the yen and deutsche mark — may be necessary.
For the China, the true problem is that the People’s Bank of China is striving to achieve several conflicting goals: stabilising the exchange rate, preserving foreign reserves, maintaining an independent monetary policy and honouring its international commitments to free flows of funds on current and capital accounts.
But it is impossible to achieve these four goals at the same time. Something has to be given up.
Initially, the PBOC did not hesitate to use foreign exchange reserves to prop up the yuan exchange rate. Chinese economists supplied two less-than-consistent arguments to support this policy.
First, they argued that the very purpose of holding foreign exchange reserves is to use them to maintain the stability of exchange rate — there should be no concern about the loss of foreign exchange reserves in defending the yuan.
Second, they put forward that Chinese people should be happy about the depletion of foreign exchange reserves, because the depletion means that wealth is being transferred from the PBOC to the private sector. The advocates of this view coined the process as “storing the foreign exchanges in the people.”
Alarmed by the astonishing speed of foreign exchange reserve depletion, the PBOC turned resolutely to capital controls in the second half of 2016. “We are all supporters of capital control now” summed it up, although until recently, the opposite was true.
China is bound to face more challenges in 2017. If China wishes to achieve exchange rate stability and contain the losses in foreign exchange reserves at the same time, unless something happens that leads to a sudden disappearance of the devaluation pressure, it has to tighten capital controls even further.
At the moment, China’s capital controls have already been very tight. Any further tightening may mean backtracking on many of its commitments to residents and non-residents on cross-border capital flows. This will substantially damage its international credibility.
Fundamentally, the yuan should not be a weak currency due to its large current account surplus, but current devaluation pressure on the currency will not disappear easily.
Even with the world’s largest foreign exchange reserves, China cannot afford to continue to conduct one-way intervention in the foreign exchange market. This persistent one-way intervention is a huge waste. In my view, the least important goal of the four is stabilizing the yuan exchange rate.
Many in China are worried that if the PBOC relinquishes control of the yuan exchange rate, a vicious cycle of devaluation could spin out of control. This is highly unlikely.
Is there any precedent in global economic history of a currency falling excessively and persistently in a country with the largest trade surplus and fastest growth rate in the world? China still has the largest foreign exchange reserves and a strong ability to implement capital controls.
If the PBOC stops intervention, the yuan will fall. But due to its strong fundamentals, the fall will be limited and after a relatively short period of time it will rebound in line with its fundamentals. If the PBoC fears that a further depreciation could lead to a financial crisis, it could set a secret “bottom line.” If the PBoC feels that the devaluation has fallen below the bottom line, it can step in and easily stop a further devaluation.
In short, 2017 will be a year of uncertainty and full of challenges. Among them, two stand out: Trump and the yuan. But China should be able to face these challenges full of confidence.
Yu Yongding is a Senior Fellow at the Chinese Academy of Social Sciences and former member of the monetary policy committee of the People’s Bank of China.
This article appeared in the most recent edition of the East Asia Forum Quarterly, Toward Asian integration.