President Donald Trump’s tweeted demands for a weaker dollar, and his subsequent designation of China as a “currency manipulator”, have sparked fears that his trade battles are morphing into a currency war. The last time we had a global competitive devaluation was in the 1930s, as the world descended into the Depression. But today, currency values are set in huge global markets rather than against gold. That leaves the US in our opinion currently alone on the battlefield, armed with only the equivalent of a pea shooter.
Naming China as a currency manipulator as previously explained is a dead end. Under US law, the next step is for the Treasury department to consult with the International Monetary Fund (IMF), which just recently gave China’s currency practices a clean bill of health. Even if Steven Mnuchin, US Treasury secretary, were somehow able to prove that china is manipulating its currency, the punishment is more than “expedited negotiations”, hardly the big stick the president of the US is looking to wield. The US could create sanctions in the form of tariffs, but threatening to do what you’re already doing is limited in its power of persuasion.
Mr. Trump has also put Japan, Germany and Italy on the manipulation watch list. Yet as a haven currency, the yen is strengthening because of the trade conflict, not depreciating. And Germany and Italy do not have their own currencies to manipulate. The dollar is currently near an all-time high because the US is growing faster than any other developed economy. Theory suggests cutting interest rates will lower the value of a currency, but since the Federal Reserve reduced its benchmark rate on July 31 the dollar has only strengthened.
A president concerned about a “big currency manipulation game” could engage in direct currency intervention. The Treasury secretary can deploy the exchange stabilization fund, or ESF – which holds roughly 95 billion US-Dollar – to sell dollars and buy foreign-denominated assets. But that amount is peanuts compared with the more than 5 trillion US-Dollar traded on average each day in global foreign exchange markets. The previous three times the US has intervened to affect the dollar’s value; it was joined by G7 allies. This time, it would act alone. Unconvinced that the US government has the fire-power to weaken the dollar, markets would bet against intervention and force the government to burn through all its available funds.
In prior invention, the Fed has matched the Treasury’s contribution, providing a little more ammunition. This time the central bank’s participation is not a foregone conclusion, given the Fed’s concerns about its independence and the impact of a currency war on global financial stability. Even if it did match the ESF, the total amount of funds available would be only about 190 billion dollar. The Fed would be likely to sterilize the intervention, selling Treasury notes to absorb the additional dollars in the market in order to head off the inflationary threat from increasing the money supply. This means short-term interest rates stay the same, so there is little reason to expect exchange rates to move. Some economists argue that intervening to weaken a currency sends a strong signal that monetary policy will ease. But, as the FED has signalled easing, so too have other central banks.
Intervention against the onshore renminbi is even more problematic. The Chinese government controls that market and the US cannot buy a currency that is not for sale. The US could intervene in the offshore renminbi market (based primarily in Hong Kong), but it is not very deep or liquid. Offshore renminbi pressures are sometimes transmitted to the onshore currency by companies that have access to both markets, but the Chinese central bank can sustain a wedge between the values of the two.
The US could buy euros and yen and hope other currencies strengthen visa knock-on effects. But with growth flagging in both Japan and the eurozone, any US currency intervention is in our opinion likely to lead to retaliation.
The global competitive depreciation of the 1930s eventually sparked monetary easing that arguably boasted demand and helped many economies grow their way out of the Depression. Now, rates are already low and there are few signs that the cost of borrowing is a constraint on economic activity.
The US in our opinion cannot unilaterally weaken the dollar. By trying, it could spark a global recession, raise political tensions and upend financial markets as countries try to depreciate their currencies against everyone else’s. Showing up alone on the battlefield with the equivalent of a pea shooter is bad enough. Creating a circular firing squad in the process is even worse.*