I. Now, a currency war (Source - The Hindu)

• Why has the U.S. accused China of deliberately weakening the yuan?


• What does it mean for the global economy?

The story so far: The United States has designated China as a currency manipulator. The move came immediately after the People’s Bank of China (PBoC), the Chinese central bank, let the yuan weaken past the psychologically significant CNY7 (CNY or the yuan is the basic unit of the renminbi, China’s official currency) to the dollar mark. The yuan, it is important to note, was last at this level against the dollar more than 10 years ago in April 2008. The present devaluation of the currency has gained significance in light of the ongoing trade war between the U.S. and China both countries have slapped high tariffs on goods worth billions imported into their countries from the other side.

What does the move imply for China?

The tag of a currency manipulator per se does not mean any penal action against China. But it could be used by the United States as an excuse to justify other retaliatory sanctions against the country. The U.S. could also drag China to the International Monetary Fund (IMF) although the IMF does not have the teeth to punish China.

Why has the U.S. taken this stand?

The U.S. believes that China has been deliberately weakening its currency (the yuan) in order to boost exports to the U.S. The Trump Administration, which has been trying to discourage the import of Chinese goods into the U.S. by imposing high tariffs since early last year, thinks that the inflow of Chinese goods will affect the business of local U.S. manufacturers.

While the tag of a currency manipulator that has been slapped on China is largely symbolic, it sends across the signal that economic ties between the U.S. and China are set to worsen further. It is also worth noting that the PBoC exerts far more direct control over the exchange rate of its currency by intervening in the forex market. Other central banks such as the U.S. Federal Reserve for instance, usually employ general monetary policy tools, which they use to regulate the money supply in the overall economy, to weaken or strengthen the exchange rate of their currencies.

Although the U.S. accuses China of deliberately weakening the yuan, many analysts believe that while the PBoC may have intervened in the forex market in the past by deliberately selling yuans to weaken the currency against the dollar, it is no longer the case. Instead, they believe that the PBoC today may, in fact, be selling dollars in the forex market to prop up the value of the yuan against the dollar as the market tries to push the yuan down.

Why is China letting the yuan weaken against the dollar?

Devaluing the currency is a common ploy employed by economies that face a slowdown in order to help boost demand for their goods. A currency is devalued (or weakened) using the central bank to increase the supply of the currency in the forex market.

This allows more units of the currency to be purchased using fewer units of various other foreign currencies. In the case of the yuan, increasing its supply will allow more units of it to be purchased in exchange for fewer U.S. dollars. This is a way of transferring more of the purchasing power to buy Chinese goods away from the hands of the local Chinese and into the hands of Americans. The Chinese believe this will help boost the value of China’s exports and also kick start growth. Since the Chinese economy has been witnessing a general slowdown, with growth dropping to a 27year low of 6.2% in July, it is no surprise that China has decided to depend more heavily on exports as a way to boost demand for its goods.

What does this mean for the global economy?

If the U.S. weakens the dollar to retaliate against China’s yuan devaluation, it will enter a currency war. The U.S. President, Donald Trump, on Thursday, in fact, signalled his desire for a weaker dollar by blaming the U.S. Fed for keeping the dollar too strong with its tight monetary policy.

The last time the world was engaged in an allout currency war was during the Great Depression of the 1930s, when countries facing a domestic slowdown tried to boost their economies by devaluing their currencies in a retaliatory fashion. This caused terrible uncertainty for businesses. Combined with high tariffs, this led to a steep fall in international trade. An allout currency war would have similar effects today. Currency devaluation will also not undo any of the negative effects of the high tariffs that have already been slapped by the U.S. and Chinese administrations. Tariffs, which are really taxes by another name, will remain and discourage production.

Conclusion:

Currency devaluation may temporarily boost exports by transferring more purchasing power to the hands of foreigners, but it will not boost domestic production. Eventually, as in the past, such competitive devaluations can cause the size of global trade to shrink.

Hope you enjoyed reading this edition.

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