China uses currency as weapon in trade war, rattling markets

By allowing China's currency to breach a level long viewed as a line in the sand, Beijing may be suggesting it is intensifying the trade war with the United States. Photo / 123RF

The trade war between the United States and China entered a more dangerous phase Monday, as Beijing allowed its currency to weaken, Chinese enterprises stopped making new purchases of US farm goods and President Donald Trump's Treasury Department formally labelled China a currency manipulator.

The escalation shook world markets as nervous investors looked for safe places to park their money. Wall Street suffered its worst day of the year, with the S&P 500 closing down nearly 3 per cent. Selling was especially heavy in the trade-sensitive technology, consumer discretionary and industrial sectors. Yields on US Treasurys, which fall as prices rise, dropped as investors sought safety in government-backed bonds. Benchmark indexes in Asia and Europe also fell.

On Sunday, the People's Bank of China, that country's central bank, took steps to limit the effect of Trump's next round of tariffs by letting its currency weaken past the psychologically important point of 7 yuan to the American dollar for the first time in more than a decade. A weaker currency can make goods cheaper to sell abroad, allowing businesses and consumers to help offset the additional tariffs Trump plans to impose September 1. It also harms US exporters that are trying to compete with China.

In an unusually blunt statement, the central bank blamed the currency fall on Trump's "unilateralism and trade protectionism measures and the imposition of increased tariffs on China." Chinese enterprises also halted new purchases of US agricultural goods in response to Trump's decision to impose additional tariffs, according to China's state-run Xinhua News Agency, which called the president's move a "serious violation" of an agreement reached in June with President Xi Jinping of China.

Late Monday, Treasury took the unusual step of labelling China a currency manipulator — the first time it has done so since 1994. In a statement, the Treasury said that Steven Mnuchin, the Treasury Secretary, "will engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China's latest actions."

The action is mostly symbolic, requiring the administration to consult with the International Monetary Fund to try to eliminate the unfair advantage the currency measures have given a country. But China is likely to view the label as a rebuke, further escalating pressures between the countries.

The move will finally fulfill Trump's campaign pledge to designate China as a currency manipulator. As a presidential candidate, Trump was sharply critical of China's currency practices and promised to label China a manipulator if elected.

Until Monday, Trump's Treasury had declined to apply the label to China in the five currency reports it has issued since the president took office. Instead, it has said the United States has deep concerns about China's intervention in its currency.

Economists say that China held down the value of its currency for many years, but it had already ceased that practice by the time Trump came into office. Ultimately, Trump was persuaded by his advisers to hold off on the label. In its most recent currency report, in May, the Treasury Department criticized China's trade and currency practices but still did not conclude that Beijing was improperly devaluing its currency.

The hardened positions underscore the increasingly tough path to resolving the trade dispute, which has begun to inflict damage across the global economy. US and Chinese negotiators met in Shanghai last week, the first face-to-face discussions since trade talks collapsed in May, but made little progress in resolving their differences.

The question now is whether Beijing will allow its currency to weaken further and what Trump may do in response. The two sides have been locked in an intractable tit-for-tat economic war, with China meeting Trump's tariffs with punishment of its own.

The United States has already imposed tariffs on US$250 billion worth of Chinese goods, placed tougher restrictions on Chinese investment, banned some Chinese companies from doing business with US companies and begun restricting visas for Chinese graduate students in sensitive research fields like robotics and aviation. Those moves were aimed at getting China to open its markets to US companies, protect American intellectual property and buy more agricultural products, none of which has happened yet.

On Monday, Trump accused China of manipulating its currency and suggested he would look for ways to retaliate.

"China has always used currency manipulation to steal our businesses and factories, hurt our jobs, depress our workers' wages and harm our farmers' prices. Not anymore!," the president wrote, adding, "It should have been stopped many years ago!"

If China allows its currency to fall even more, countries in East and Southeast Asia that compete in similar industries could face market pressure to devalue their own currencies. Such devaluation spirals can lead to higher inflation, pinched household spending and disruptive shifts of money across borders. They can also lead to more tariffs or other restrictive trade measures.

"It's hugely significant as they are making a clear choice to do this," said Michael Every, head of financial markets research in Asia for Rabobank, referring to China's central bank. "This is going to escalate rapidly and badly."

A significant devaluation could also hurt China itself. Many of its biggest and most indebted companies in sectors like property and heavy industry have borrowed huge amounts overseas in US dollars. A weaker yuan, which is also known as the renminbi, makes paying that debt back more expensive. It could also hurt companies that depend on commodities, such as oil, that are priced in dollars, and could spur wealthy Chinese to take their money out of the country.

For those reasons, devaluations make investors nervous. Four years ago, when China devalued its currency more drastically, a global market rout followed.

Financial markets suffered another slump Monday, with companies exposed to the next round of Trump's tariffs hit particularly hard, including retail and technology stocks. Tech giants Microsoft and Apple dropped more than 3.4 per cent and 5.2 per cent respectively. Selling was heavy in shares of computer chipmakers, which generate significant revenue from sales to technology manufacturers based in mainland China. Retailers like Nike and Best Buy also suffered declines.

The trade war had seemed on the cusp of being resolved in May, when the two sides were close to a deal. But after Beijing rejected some of America's demands in May, talks collapsed and Trump put in place plans to tax another US$300 billion worth of imports.

In June, Trump agreed to hold off on additional tariffs after meeting with Xi in Japan. But last week, Trump said he would impose 10 per cent tariffs on another US$300 billion worth of Chinese goods as punishment for Beijing's failure to make large-scale purchases of US farm products, like soybeans.

On Monday, Beijing indicated those purchases would not be forthcoming anytime soon.

China's official Xinhua News Agency cited the country's economic planner, the National Development and Reform Commission, and the commerce ministry as saying that Chinese companies were suspending purchases of US agricultural products in response to the Trump administration's plans to impose new tariffs on US$300 billion in Chinese exports to the United States.

The report said that China had not ruled out imposing its own tariffs on newly purchased US agricultural imports and that the Chinese companies suspended their purchases.

Zippy Duvall, the president of the American Farm Bureau, called the announcement "a body blow to thousands of farmers and ranchers who are already struggling to get by." US exports to China fell by US$1.3 billion during the first half of the year, and US farmers now stand to lose all of what was a US$9.1 billion market in 2018, Duvall said. That in turn had fallen from a US$19.5 billion market in 2017, before the trade war began.

The escalating trade war already threatens to end what had looked to be a modest global expansion. The US economy still looks relatively strong, but growth in both the service and manufacturing sectors is slowing. The European economy has also been weak, as the trade war weighs on export-dependent economies like Germany and Italy. China's growth has been hit by the trade war, which has compounded some of its homegrown problems. Other countries that depend on China's voracious economic machine, such as Japan, have been harmed as well.

Yi Gang, the central bank's governor, attributed the move in the renminbi, or RMB, to market forces, adding that many currencies had depreciated against the dollar recently.

"I am confident that the RMB will continue to be a strong currency," Yi said in an article published to the social media account of the central bank.

The renminbi weakened by around 1 per cent against the dollar overall, a move that is not necessarily significant on its own. But the fact that Beijing allowed it to breach a level that was long considered symbolic raised questions about whether the move was a deliberate threat from China's top leaders, who would most likely have to give permission to the central bank to let its currency fall to such a level.

"The currency is largely controlled by the PBOC, but the PBOC does not have the independence to decide on its own the level of the renminbi," said Michael Pettis, a professor of finance at the Guanghua School of Management at Peking University, referring to the central bank.

"This was clearly a decision made higher up," Pettis said.

Trump has increasingly looked for ways to counteract China, including considering whether the United States should weaken its own currency. Trump and his advisers discussed intervening in currency markets to artificially weaken the US dollar in late July, but the president decided against the idea.

The president has also been jawboning the Federal Reserve to cut interest rates, including Monday.

"China dropped the price of their currency to an almost a historic low," Trump wrote on Twitter. "It's called 'currency manipulation.' Are you listening Federal Reserve? This is a major violation which will greatly weaken China over time!"

The Fed did cut rates last week for the first time in a decade, a move taken in part to help the US economy weather the effect of Trump's trade war.

But Trump's trade policies are counteracting some of the Fed's efforts to stimulate the economy. The US tariffs on China lower China's growth, weakening its currency and making the American dollar relatively strong. A stronger dollar cuts into inflation in the United States, and might force the Fed to cut interest rates by more than it would otherwise to sustain its desired pace of growth and price gains.

"The dollar has a very mechanical impact in the way the Fed thinks about its main policy lever," said Neil Dutta, head of US economics at Renaissance Macro Research. "By doing nothing, the Fed is de facto sanctioning a tightening in policy. They would need to lower rates just to keep pace."

Dutta thinks the fact that the Chinese yuan is weakening and the trade war is escalating increases the likelihood that the Fed will cut rates by half a percentage point at its next meeting, in September.

Lower rates should weaken the dollar, all else equal, though that is never the central bank's explicit goal. But policy does not occur in a vacuum, and the Fed's recent move to drop its benchmark rate comes as economies from Japan and Australia to Europe shift toward easing monetary policy, potentially by cutting their own interest rates.

Market gyrations spurred by trade concerns have caught Fed policymakers' attention.

"I am certainly monitoring developments very closely," a Fed governor, Lael Brainard, said in Kansas City, Missouri, on Monday when asked about the lurch in markets. "I have said, and I think others have as well, that we're committed to sustaining the expansion."

Written by: Alexandra Stevenson, Ana Swanson and Jeanna Smialek

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