Will Trump Break the Yuan?

It’s time for everyone to admit that the trade war between the United States and China is not going anywhere anytime soon. With China due to celebrate the 70th anniversary of the proclamation of the People’s Republic on Oct. 1, nothing is going to give on the Chinese side for at least another month. Meanwhile, the United States has already slapped tariffs on just about everything except Christmas ornaments, baby diapers, and “live mushroom spawn,” whatever that is. And even those last few items are scheduled to be taxed starting Dec. 15, after U.S. stores are fully stocked for the holidays.

As the trade war enters a phase of stagnant trench warfare, the real action has shifted to the currency markets. The Chinese yuan is closely pegged to the U.S. dollar, with China’s central bank, the People’s Bank of China, fixing the official rate every day but allowing the currency to float plus or minus 2 percent on offshore markets. These days, that usually means minus. In fact, the yuan has fallen more than 5 percent since trade negotiations broke down at the end of April.

That’s no catastrophe—the Bank of England let the pound fall by more than 10 percent in response to the 2016 Brexit vote—but it is a worrying trend. For 10 years, from 2006 to 2016, China worked hard to strengthen the yuan as part of its successful campaign to have its currency included alongside the dollar, euro, yen, and pound in the International Monetary Fund’s basket of recognized reserve currencies. China had continued to maintain its dollar peg even as the U.S. currency has appreciated over the last decade, making its own exports more expensive in the rest of the world.

Throughout the trade war, China has so far been able to make up for declining exports to the United States by shifting trade toward Europe. This has helped the People’s Bank of China maintain a stable official currency reserve position despite a rapid outflow of U.S. dollars. Over the last 12 months, the bank has sold off around $80 billion of its U.S. dollar reserves, according to foreign holdings data from the U.S. Treasury Department, in a successful effort to slow the inexorable decline of the yuan. These reserves have presumably been replaced with euros, keeping overall reserve levels constant.

The problem for China is that it benchmarks its currency, its international commitments, and even the lending of its Belt and Road Initiative development banks in dollars. It has been unable to break that link, despite two decades of trying. Now, the trade war is making it harder and harder for China to earn the dollars it needs, and the country is increasingly subsidizing exports to Europe to make up the shortfall. That’s a trick that can lift China past its Oct. 1 National Day celebrations, but it can’t work forever. If the euro keeps falling, pushing China to pile on more subsidies, it might not work past Christmas.

As ever with a democracy at war, America’s weak spots are mainly political. The Trump administration’s most powerful opponents aren’t in Beijing but in Washington. For example, the nonpartisan but thoroughly anti-administration Congressional Budget Office is saying that the trade war will cost the average U.S. household $580 by 2020. Read the detailed report, and it turns out that most of that expected loss is attributed to a “projected decrease in real investment” that has nothing to do with households at all. It turns out that the budget office thinks that most of the potential damage caused by the trade war will come from American companies refraining from investing in the United States because of trade war uncertainty. And even that’s nothing but a guess.

As for the direct effects of all of U.S. President Donald Trump’s tariffs, the Congressional Budget Office projects a fall in exports (by about $40 billion) to be offset by an even bigger fall in imports ($80 billion), resulting in an overall improvement in the U.S. trade balance. Meanwhile, the added tariffs should cause tax revenues to rise, helping offset a burgeoning federal deficit. That’s the firmest part of their modeling, because it’s based on decades of historical trade data, but you’ll have to look carefully to find the analysis. It’s buried in a box on page 37 of the report, and you have to calculate the dollar amounts for yourself.

In reality, the Dow Jones Industrial Average moves by at least 1 percent on average at least one day out of every week.

Other critics outside Congress have raised the specter of tariff-induced inflation. Yet the U.S. Federal Reserve has consistently struggled to get inflation up to its 2 percent target rate. If Trump’s tariffs really do raise prices for U.S. consumers, that would actually help the Fed meet its targets. Ironically, in the absence of tariffs, the Fed might have cut interest rates even more aggressively in an effort to spur hikes in consumer prices.

The U.S. media also piles on against Trump’s trade war with every move in the stock market. When stocks fall, it’s “on trade war fears.” When stocks rise, it’s because of “trade war optimism.” In reality, the Dow Jones Industrial Average moves by at least 1 percent on average at least one day out of every week. The Chicago Board Options Exchange VIX index, which measures stock market volatility, has actually been lower in the Trump years than it was during former President Barack Obama’s second term. And overall, stocks are trading near all-time highs, with virtually no change since the trade war turned hot three months ago.

China can survive U.S. tariffs, efforts by manufacturers to shift production to other countries, and even a general economic recession. What China can’t survive—and remain competitive on the world stage—is a currency meltdown. The Trump administration has labeled China a currency manipulator for devaluing its currency to spur exports, but in fact the People’s Bank of China is more concerned with manipulating its currency up than in undercutting U.S. competitiveness with a weak yuan.

As China increasingly sells its exports in depreciating euros, its currency will only get weaker. China’s corporate sector is already experiencing a serious cash crunch, with companies unable to pay their bills because they can’t get their own creditors (including government entities and state-owned firms) to pay on time. China can potentially save its economy from this cash crunch by cutting its currency loose from the dollar, but that would result in a massive loss of face. Yet if China maintains its deteriorating link to the dollar, it could run through its $3 trillion currency reserves much more quickly than anyone realizes.

The fact that China is maintaining a dollar peg while keeping only about one-third of its reserves in dollars is a particular cause for concern. All the policy chatter in the United States is about the supposed “nuclear option,” in which China could dump the dollar. But from the Trump administration’s standpoint (and the Federal Reserve’s), that might actually be a welcome development, as it would drive down the value of the U.S. dollar and spur modest inflation. Much more worrying for the global economy is the possibility that China might have to dump its massive euro holdings in order to maintain an orderly dollar peg. If that happens, it could seriously disrupt the relatively thin euro and yen currency markets.

Barring a crisis of self-confidence on the part of the Trump administration, the end game for the U.S.-Chinese trade war has to involve a much weaker yuan, a stable but low-growth China, and an influx of U.S. investment into currently closed Chinese industries such as finance and telecommunications. The only alternative scenarios are that China will allow a disorderly unwinding of its dollar-focused export machine, or that the Trump administration will blink.

Trump is under a lot of pressure to blink, including pressure from within his own Republican Party. If he holds on until Christmas, he’s likely to claim a big victory for U.S. companies in the new year. But if a week is a long time in politics, four months is an eternity. China will hold firm until Oct. 1, but after that, anything goes.