Assessing the risk of a currency war
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.