When US President Donald Trump announced via Twitter on Friday that he was slapping tariffs on an extra US$300 billion of China’s exports, it was widely expected that China’s currency would slide against the US dollar.

What wasn’t expected was that on Monday it would break the seven Chinese renminbi (RMB) to the dollar barrier, a line held by China since 2008.

The RMB/USD exchange rate is tightly managed by the People’s Bank of China. The rate is permitted to move only 2% away from a midpoint fixed by the bank each day.

Although in its official statement the bank attributed the slide mainly to changes in demand and supply, the slide would not have happened had the bank not allowed it. In the past it spent as much as US$107 billion in a single month defending the renminbi.

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It is more reasonable to believe that the devaluation was a deliberate decision taken to offset the effect of the punitive tariffs.

By making China’s exports cheaper in US dollars it will neutralise the effect of Trump’s decision to impose tariffs that would make them more expensive.

But it will have far-reaching implications, so far-reaching as to suggest that Beijing has run out of alternatives.

In part, China is hurting itself…

The exchange rate - the external price of money – affects almost everything, including inflation in China itself, which will receive a boost as imports to China become more expensive.

Chinese inflation is already on the rise due to disruptions in supply of food staples such as pigs.

There isn’t much the People’s Bank of China can do to restrain inflation. Pushing up interest rates might choke the economy given that China’s GDP just posted its smallest quarterly gain since 1992.

It would also make it even more difficult for already heavily indebted state-owned enterprises and local governments to make payments on their debt.

If the Chinese think the currency is going to continue to fall they’ll attempt to take their money out of the country while it still has buying power.

Although the People’s Bank of China has demonstrated its capacity to control capital flight, it has increasingly had to do it using harsh measures that harm legitimate trade and investment.

The devaluation will essentially act as tax on net importers, which in China are households. This means it will work against China’s goal of rebalancing the economy away from investment to private consumption.

…and endangering global recovery

An RMB that breaches seven is also bad news for the global economy. It means weaker demand from China, which will depress global economic growth.

In that way it can be thought of as spreading the cost of US tariffs onto China’s trading partners, which are themselves likely to devalue in something of a currency war. The Australian dollar has fallen through 68 US cents, a low not seen since the global financial crisis.

Asian economies are also likely to devalue, among them South Korea, Vietnam, Thailand and Indonesia. The European Central Bank has also signalled rate cuts and other measures to bring down its exchange rate as has the Bank of Japan.

Other nations will devalue…

The US Fed itself will be under pressure to cut rates further in what the Pacific Investment Management Company has warned could lead to a “full-blown currency war with direct intervention by the US and other major governments/central banks to weaken their currencies”.

On Tuesday Australia’s Reserve Bank signalled its willingness to cut interest rate again, although in our case the drop in the Australian dollar might have made it nervous. It would prefer a controlled rather than unpredictable decline in the dollar.

John Connally Jr, Richard Nixon’s treasury secretary, once said in 1971 that the US dollar was “our currency, but your problem”. He meant that the rest of the world had to live with whatever the US did for its own reasons.

…meaning none of them will win

As the currency of the world’s second largest economy increasingly moves to the centre of global trade, China is able to say much the same thing. But an international currency war could hurt China as well by endangering the still not complete international recovery from the global financial crisis.

The People’s Bank of China has tried to reassure the world that it “has experience, confidence and capacity to maintain renminbi exchange rate at a reasonably stable equilibrium”.

It might do more for confidence if it wound down its control, as have other countries, relying less on manipulating the exchange rate for strategic reasons.

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