Weaker yuan could trigger 'broader currency war'

Business | 7 Aug 2019 5:58 pm

It isn’t the base case for most economists, but the threat that the trade fight between the U.S. and China could turn into a currency battle can not be ruled out, writes William Watts.

“There is little doubt that there has been an escalation in the trade war between the U.S. and China in the past few days. What is in question is whether recent events will trigger a full blown currency war and how far the crossfire will extend,” said Jane Foley, senior FX strategist at Rabobank, in a note.

The U.S. Treasury late Monday formally designated China a “currency manipulator” after Beijing allowed the yuan to trade above 7 per dollar in both the offshore  and mainland market. Analysts noted that, in an ironic twist, the “manipulator’ designation came after China effectively refrained from intervening in the market to shore up the yuan.

That said, Beijing’s decision to allow the yuan to fall through what market participants had long dubbed a “line in the sand” was seen by many analysts as a “warning shot” of the potential for a more aggressive weakening of the yuan after President Donald Trump last week unexpectedly announced 10 percent tariffs on the remaining US$300 billion of imports from China that weren’t yet facing levies.

Currency-related tensions appeared to ease on Tuesday after China fixed the yuan at a higher rate than observers had expected following Monday’s decline. Analysts also noted that the U.S. designation of China as a manipulator appeared largely symbolic, arguing it was done in a way that appeared designed to limit the potential fallout.

Efforts by either country to weaken their currencies in an effort to gain a competitive advantage come with significant risks, economists said, as well as doubts over their likely effectiveness.

“A significant and rapid move lower in the onshore yuan  could send shock waves through the global economy. China is the world’s largest importer of commodities and a considerable consumer of goods produced in the Asian region. A weaker CNY could thus prompt a broader currency war,” Foley said, referring to the trading symbol for the yuan.

Meanwhile, Trump has used verbal intervention in an effort to push down the value of the U.S. dollar — an effort that’s been largely unsuccessful, she noted.

The dollar has remained resilient, despite last week’s quarter-point interest-rate cut by the Federal Reserve and expectations for further cuts over the next year. That’s because other central banks also have adopted more accommodative monetary policies and the dollar’s dominance in the international payments system, Foley said, which can boost demand for the currency during periods when investors are shedding stocks and other risky assets.

“If trade tensions and slowing world growth were to trigger a broader rout in risky assets, the USD is likely to hold firm against a large basket of currencies – though the safe haven [Japanese yen] and [Swiss franc] would likely be the major beneficiaries of these circumstances,” she said.

Meanwhile, Foley and other analysts doubt that efforts by the U.S. to directly intervene in the currency market would be successful given history, as well as an expected reluctance by other countries to cooperate in an effort to weaken the dollar’s value given a shared environment of weak growth and soft inflation.

But analysts are reluctant to rule out such a scenario given the heightening trade tensions, even after White House economic adviser Larry Kudlow last month said intervention wasn’t on the table.

“A full-blown currency war would be hard to wage, as historic US FX interventions against the market have largely proved ineffective, and a sustained CNY depreciation would risk capital flight for China,” said James Watson, senior economist at Oxford Economics, in a Tuesday note. “But with Chinese policy makers looking more assured with a weaker CNY and U.S. policy-making ever more unwavering, the tail risk of a currency war can’t be ruled out.”-MarketWatch

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