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On August 5th, the Chinese government devalued the
renminbi, allowing it to become weaker than 7 yuan to the dollar
for first time since the global financial crisis. The global
reaction was swift and dramatic. Markets across the world swooned
and the White House officially labelled China a "currency
manipulator." On August 6th, the Chinese government
sought to reassure markets by holding firm to the new, lower
exchange rate and making clear that it is not embarking on a round
of "competitive devaluations." Markets rebounded, regaining some of
the lost ground.
While the outlook is fraught with even more risks as a result of
the escalating trade and currency war, a lot will depend on what
the US and Chinese governments do next. The August 5thdevaluation should be viewed as
a warning shot to the Trump administration and not a fundamental
change in China's currency policy. Above all, Chinese officials
value financial and exchange rate stability. They have the
tools ($3 trillion plus in foreign exchange reserves, capital
controls and other administrative means) to achieve this. While
some have worried the People's Bank of China might sell off a large
portion of its US Treasury holdings (a little over $1 trillion),
this would likely hurt China more than the US. It would mean an
appreciation of the renminbi, which is the last thing the
government wants, at a time when growth is weakening.
There is more uncertainty about what the Trump administration
might do next. It could raise tariffs even more, but this would
hurt US growth as well as China's. It could intervene directly in
forex markets, but the combined Federal Reserve and US Treasury
exchange stabilization funds are only around $200 billion, and pale
in comparison with the daily turnover of $5 trillion in
foreign exchange markets. In the extreme, it could re-impose
capital controls, which along with other developed economies, it
has agreed not to use since the 1970s. This could have an extremely
destabilizing impact on financial markets, and is, therefore,
unlikely to happen. Finally, it could browbeat the Fed to lower
interest rates even more, a move that has massive risks of its
own.
Bottom line: China's recent devaluation is relatively small
in the whole scheme of things. If it stops there, and neither the
US nor China take any other actions that would give markets a fit,
then this episode will probably blow over. On the other hand, if
this is the beginning of a new and dangerous phase of the trade
war, then all bets are off, and the ensuing financial fire storm
could push the US and global economies into recession.
Learn more foreign exchange manipulation how governments can
intervene in currency markets with our primer on the topic.