Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

The danger of Trump’s currency war

It is never easy to establish if a country is manipulating its currency to boost exports

After having initiated a trade war by unilaterally imposing tariffs with the idea of reducing the US’ trade deficit, President Donald Trump has once again shifted his attention to currency. Trump believes that China and the European Union, among others, are manipulating their currencies to gain a competitive advantage over the US. “China, the European Union and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollars gets stronger and stronger with each passing day—taking away our big competitive edge. As usual, not a level playing field...", he tweeted last week.

This raises two important questions: First, are China and the EU actually manipulating their currencies to gain competitiveness and, second, can Trump do anything about it? Last week, he also aired his dissatisfaction regarding the Federal Reserve’s policies.

Admittedly, it is never easy to establish if a country is manipulating its currency to boost exports. The yuan has depreciated by over 5% since the beginning of June and some people may be tempted to believe that China is doing this to undo the damage being done by Trump’s tariffs. But is it really devaluing its currency? As noted above, there is no easy answer. It is possible that the currency has fallen due to slowing growth and monetary easing. For instance, in a note issued earlier this month, Morgan Stanley said: “…the daily CNY fixing rate has been pointing to the strong side compared to our FX team’s model estimate since June 15, indicating that the PBoC is fixing against the weakness. Meanwhile, the lesson from August 2015 suggests that an active material depreciation of the CNY could hurt market confidence and endanger China’s financial stability." A sharp depreciation in the yuan is not necessarily in China’s interest at this stage, as it could lead to capital flight and become self-fulfilling.

Further, the dollar is strengthening because of rate hikes and normalization of the Fed balance sheet. The Fed is expected to hike rates twice more this year, followed by three times next year. This has resulted in significant monetary policy divergence, even in the developed world, which is playing out in the currency market. The European Central Bank will end its asset purchase programme later this year but is unlikely to raise interest rates until the summer of 2019. The Bank of Japan continues to manage the yield curve. However, these central banks are only following in the Fed’s footsteps to support their economies through monetary accommodation. Such policies, though, have implications for capital flows and currency markets. The ultra-loose monetary policy and quantitative easing by the Fed in the aftermath of the financial crisis also resulted in a large inflow of capital in emerging market economies, which led to currency appreciation and loss of competitiveness. The reversal is also making things difficult for a number of emerging market economies.

Trump’s fiscal policy is also partly responsible for the dollar strength. Fiscal stimulus at this stage of the business cycle—when the economy is growing at a healthy pace, inflation is picking up, and the unemployment rate is low—always has a danger of being counterproductive.

So, what can Trump do about the dollar? First, he can always fine tune his fiscal policy and not push demand, which can be inflationary and force the Fed to raise rates at a much faster pace. This would further strengthen the dollar. Second, Trump might want to push the Fed to delay the policy normalization process. This is a risky proposition, and it is unlikely that the Fed would agree. A delay by the Fed in policy normalization will affect its credibility and raise the risk of higher inflation, which could become difficult to handle at a later stage. Third, he can work with other countries (maybe at the G-20 level) to find a way out of the current global monetary non-system. This is highly unlikely, as Trump has shown very little respect for existing international institutions.

Therefore, the risk is that he will again resort to tariffs and end up escalating the trade war, which will hurt the global economy and increase uncertainty. However, an increase in the level of uncertainty in the global economy will result in capital moving to the US, which will lead to appreciation in the dollar.

The rise in the level of uncertainty and trade tensions will affect developing economies like India. The Indian rupee is at an all-time low and has fallen over 8% since the beginning of the year. Although this is not a cause for concern at the moment, as the rupee was overvalued in real terms and the Reserve Bank of India has sufficient reserves to tame volatility, rising trade tension could derail the global economic recovery, which will affect India both in terms of output growth and capital flows.

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