Currency Wars and the Impossible Trinity

For the first time since May 2008, the Chinese currency, the Yuan, was allowed to weaken past 7-to-1 against the dollar. So, is this just another news cycle or does it actually matter? It turns out, this one is kind of a big deal. After President Trump’s punitive move on tariffs late last week - threatening to add 10% tariffs to $300 billion of Chinese imports - this is undoubtedly a bold escalation by the Chinese government. By doing so, the weaker Yuan somewhat undermines the American tariff on Chinese-made products.

The Chinese economy continues to cool off despite the government efforts to boost it via lower interest rates and fiscal policy stimulus. This is not surprising considering global trade has weakened significantly and exports of goods account for 18% of the Chinese economy vs 8% for the U.S. By the U.S. and China playing hardball, they have put their economies and global markets at risk.

Risky Business: Currency as a Weapon

The Chinese would not use their currency as leverage in the China/U.S Trade Wars if they weren’t running out of moves up their sleeve. Why is this move usually not used up front? Because of the Impossible Trinity. 

The Impossible Trinity

The Impossible Trinity theory, popularized in the 1960’s by economists Robert Mundell and Marcus Fleming, says a country must choose between freely flowing capital, a controlled exchange rate, and an independent monetary policy. But… you can only pick two of the three! Trying to have all three invites an economic and financial crisis.

Here are three models that show the Impossible Trinity in action:

• The North Korea Model: If a government wants to control the exchange rate AND domestic interest rates, it must close its borders to capital flows. This is the isolationist North Korea model. 
• The Hong Kong Model: If a government wants control of its exchange rate and wants its borders open to trade and capital flows, it must give up control of its domestic interest rates and allow these to be market-determined. This is the Hong Kong model with the currency peg to the US dollar.
• The United States model: If a government wants control of its domestic interest rates and wants its borders open to trade and capital flows it MUST give up control of its currency by allowing the exchange rate to be freely determined by the Market. This is the United States model which lets the US dollar currency be determined by the market so that the Federal Reserve can control short term interest rates and so that the country can have open borders for trade and capital flows. 

Choose all three policy moves; however, and as Nobel winning economist Milton Friedman once said “you get a pressure cooker with a disabled safety valve. It is simply not sustainable.”

So... What is China's Model?

Over 14 years ago, China partially adopted the US model and let market forces take control of the yuan’s exchange rate as a price for keeping open borders and maintaining control of interest rates. 

This changed during mid-2016, when China decided to adopt a mix of the Hong Kong and North Korea models. lt partially closed off capital flows at its borders while once again trying to get its hands firmly on both the exchange rate AND interest rates. It's not the impossible trinity per se, but it is this bouncing back and forth from one to the other playing "Whack-a-Mole" to whatever distress is the most urgent at the time. 

How It Affects You

The first thing to keep in mind is that there are a LOT of moving parts. Since we can’t predict the future, the Impossible Trinity is the critical framework for understanding possible next steps. For China AND the U.S, this has huge implications. If China continues down this path of using their currency as leverage against the States, something will have to give within their own economic policy strategy. Additionally, it increases the chances that the U.S will retaliate in finding ways to depreciate the dollar.

If the escalation continues on its current path, you can expect changes in consumer prices, interest rates, and stock prices. Here’s our breakdown:

Consumer Prices

Currency wars make imports more expensive. This hurts consumers that purchase goods and services from abroad. Did you want to buy the newest MacBook (which is made in China) in September? It might be more expensive as a result of tariffs.

Interest Rates

If the U.S. tries to go toe to toe with China, one channel that can be potentially used to depreciate the dollar is via monetary policy, meaning continuing to lower interest rates. The Federal Reserve is an independent entity but their hands could be forced if the global economic picture continues to suffer as a result of the trade/currency wars with China. Lower interest rates would potentially make it cheaper to get a mortgage but on the other hand, it would lower the interest rate received in your savings account.

Stock Prices

Markets do not like uncertainty, so continued escalation of conflict with China can further increase short term volatility of markets. The swift negative reaction by the S&P 500 to the latest escalation is a case in point.  In mid-August of 2015, we saw China deliberately devalue their currency over three days, which led to a total drop of -11% for the S&P 500 in the following weeks, compared to the current day one drop of -3.9%. So things can get worse before they get better. Important to note that a -11% drop is not really out of the norm, considering that the average intra-year drop has been 13.9% over the last 39 years.

The "Aha" Moment

China’s move to devalue the Yuan is noteworthy because it shows they are striking back to U.S. tariffs. By going the currency war route, China is showing its teeth in far more aggressive manner. As dictated by the Impossible Trinity, controlling currency as a weapon means that something will have to give in their other tools (Monetary policy, capital controls) to avoid significant economic/financial imbalances. 

Although we emphasize not making investment decisions based on geopolitical news, it’s important to be aware of what’s happening around the world. These are all key moving pieces that will affect us at a personal level in the years to come. It is difficult to compartmentalize the geopolitical news without letting your emotions get the best of you which is why it is so important to have a personalized financial plan that keeps you grounded in days like today.

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