The currency shift: US-China trade dispute takes an alarming turn

The US-China trade dispute took a dangerous turn this week.

For the first time in 25 years, the US Treasury Department labeled China as a currency manipulator.

The designation came on August 5, the same day China allowed its currency, the yuan, to drop to its weakest level in more than a decade. On top of that, Beijing announced that Chinese companies have stopped purchasing American farm products.

This all occurred just days after President Donald Trump said he would impose a new 10% tariff on $300 billion worth of Chinese products, including many consumer goods, as of September 1.

To say a lot is going on between the US and China would be something of an understatement. So, it’s understandable if you’re confused about the latest round of back and forth between the two countries.

Here’s a breakdown of what’s happened and what may come next.

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Yuan devaluation

According to the New York Times, the People’s Bank of China, the country’s central bank, said the currency decline was because of Trump’s “unilateralism and trade protectionism measures and the imposition of increased tariffs on China.”

Beijing let the yuan weaken past the psychologically important value of seven to the dollar for the first time since the 2008 financial crisis.

So, what’s the advantage of a weaker currency? The short answer is it can make exports cheaper to sell to international markets, thereby maintaining the attractiveness of Chinese goods by helping to offset the costs of the incoming tariffs. The move can also be a disadvantage for American exporters that compete with China.

That’s not to say that there aren’t any drawbacks to devaluing the currency. The devaluation could lead to a drop in foreign investment and hinder financial markets, which could further damage China’s already slowing economy.

The last time Beijing allowed its currency to weaken, back in 2015, almost $680 billion in capital left the country as a result.

“The fact that [China has] now stopped defending 7.00 against the dollar suggests that they have all but abandoned hopes for a trade deal with the US,” Julian Evans-Pritchard, senior China economist with Capital Economics, wrote in a note to clients.

Currency manipulator declaration

Almost immediately after the yuan’s devaluation became known, Trump responded on Twitter, calling the move a “major violation that will greatly weaken China over time.

In a statement, the US Treasury Department officially named China a currency manipulator.

“In recent days, China has taken concrete steps to devalue its currency, while maintaining substantial foreign exchange reserves despite active use of such tools in the past,” the department wrote in its announcement. “The context of these actions and the implausibility of China’s market stability rationale confirms that the purpose of China’s currency devaluation is to gain an unfair competitive advantage in international trade.”

This isn’t the first time the US has given China that designation. It was labeled a currency manipulator back in 1994 under President Bill Clinton. And in its statement, the Treasury said China had “a long history of facilitating an undervalued currency.”

While the designation is considered to be largely symbolic, it will heighten tensions between the US and China and further fuel uncertainty that has already weakened the global economy.

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Did China manipulate its currency?

It’s widely agreed that China did manipulate its currency from approximately 2003 to 2013. But there’s debate surrounding whether the yuan’s recent devaluation is due to direct manipulation.

Twice a year, the Treasury Department puts out a review of currency practices by the US’s major trading partners. The Treasury’s latest report, in May, placed China on its “monitoring list” but noted that the country met only one of the three criteria for currency manipulation under the Trade Facilitation and Trade Enforcement Act of 2015.

The only criteria met, as noted in the Treasury report, was that China’s “extremely large, persistent, and growing bilateral trade surplus” with the US had reached its threshold.

What’s more, a report released by the International Monetary Fund (IMF) in July found that China’s currency practices were “broadly in line with fundamentals and desirable policies.”

According to the Treasury Department, the designation was applied under the Omnibus Trade and Competitiveness Act of 1988, which requires the Treasury secretary to “consider whether countries manipulate the rate of exchange between their currency and the United States dollar.”

Is a currency war on the horizon?

The big question now hinges on whether the US-China trade spat could morph into a full-blown currency war. Currency wars are when countries begin a cycle of devaluations, which have significant implications for both consumers and businesses.

It’s a precarious path to go down that would be difficult for either country to get back from without severe economic repercussions.

As noted earlier, a weaker currency is advantageous for exports. But the flip side is that it makes imports more expensive, leading to inflation and a decline in spending, which could stunt economic growth.

In July, Larry Kudlow, the White House’s top economic adviser, told CNBC that the administration had “ruled out any currency intervention.” But Trump refuted that claim, telling reporters, “I didn’t say I’m not going to do something.

Trump has made it well-known that he’s in favor of weakening the US dollar, and with the latest turn of events, the potential for such a move is rising.

To weaken the dollar, the administration could terminate the strong dollar policy introduced in 1995, which Bank of America analysts claim could cause the “overvalued” US dollar to fall by as much as 10%.

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What now?

Under the 1988 law used to apply the currency manipulator label, the US can either negotiate directly with China or take the matter to the IMF.

But given the unsuccessful negotiation process between the US and China, it’s no surprise that the Treasury Department already indicated that Treasury Secretary Steven Mnuchin will involve the IMF.

Once Mnuchin addresses the IMF, the international body’s board members will review the situation and determine whether China is contravening international law. That review process will produce a summary of the board’s opinion.

But there are no real economic penalties that come from the IMF review, which raises the question of what it will take to end the increasingly dangerous cycle of retaliation measures that the two countries are locked into.

The latest round of tit-for-tat between the US and China doesn’t just raise the question about when a trade deal will be reached, but whether one is even possible.

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