Why the China-U.S. Trade War Won’t Become A Currency War

Global markets were spooked yesterday by the Chinese Renminbi crossing the psychologically important barrier of 7 RMB to the greenback—sparking speculation that the current trade war will metastasize into a currency war between the world’s two biggest economies. The fact that the U.S. Treasury responded immediately by formally labeling China a “currency manipulator,” for the first time in 25 years, has only fanned the currency war flames.

The logic is straightforward. A weaker Chinese currency cushions the blow to Chinese exports of American tariffs. But greater Chinese exports to America would increase America’s trade deficit within China, creating incentives for the Trump administration to retaliate with a tit-for-tat weakening of the dollar.

Despite this logic, there are three powerful reasons why the trade war won’t become a currency war. In increasing order of importance they are:

1. Donald Trump loves showing America’s strength—and to many, there is no better signal of strength than a strong U.S. dollar. 

What’s more, when the global economy wobbles, investors turn to the U.S. dollar as a port in the storm.

2. The Trump administration cannot unilaterally manipulate the dollar, even if it wanted to.

This is true on multiple levels. The dollar floats on global foreign exchange markets without the capital controls that allow a country like China to manage the value of its currency. The single most direct way to weaken the currency is for the central bank to lower interest rates. In the U.S. that is the domain of the Federal Reserve. To Trump’s chagrin, the Fed remains independent of the White House, and its charter asks it to balance the risks of unemployment and inflation, not the exchange rate. And the Fed told the financial markets just last week not to expect further cuts to interest rates.

3. The Chinese government cannot afford the risk of an RMB in free fall.

All the charges by America in the past decade that China is a currency manipulator belie the fact that for more than a decade after 2005, the Chinese currency actually appreciated considerably against the U.S. dollar. This no doubt reduced China’s exports to America, but to China it was worth the price. The specter of mass capital flight has been an existential fear of the Chinese government since the Asian financial crisis in the late 1990s. China then saw the devastating effects of capital flight and vowed that it would never happen in China. With the slowdown of the Chinese economy giving itchy feet to holders of RMB, the last thing China’s government wants is to turn market nervousness into a full-on rush for the exits.

There is no doubt that allowing the RMB to cross 7:1 against the dollar was Xi Jinping’s shot-across-the-bow response to Trump’s threat of imposing tariffs on all Chinese imports on September 1. Just don’t expect the single shot to become an ongoing fusillade. 

Geoffrey Garrett is Dean, Reliance Professor of Management and Private Enterprise, and Professor of Management at the Wharton School of the University of Pennsylvania. Follow Geoff on Twitter.