This currency war reminds me of an old Chinese saying: ‘Even when right a scholar cannot win an argument with a soldier’ — because it defies any common sense about currency manipulation. At one of the earlier G20 meetings, a US official warned that the United States would name China a currency manipulator if it did not intervene to hold up the value of Chinese renminbi (RMB). In fact, it would have been more appropriate to label China the ‘currency non-manipulator’.

The US Treasury Department usually follows three criteria to determine if a trading partner is a currency manipulator — the first is a bilateral trade surplus with the United States of more than US$200 billion; the second is a current account surplus of more than 3 per cent of GDP; and the third is a total purchase of foreign exchange equivalent to more than 2 per cent of GDP within 12 months.

Of these, China only satisfies the first criterion. And even this one needs to be looked at with caution. It is widely known that China’s bilateral trade surplus with the United States is a result of the global supply chain, as its overall trade account is almost balanced. And even this bilateral surplus is shrinking rapidly.

The US Treasury’s action might have been triggered by the weakening of the RMB on 5 August, with its bilateral exchange rate against the US dollar (USD) exceeding 7.0 for the first time in more than ten years. But this depreciation was a direct result of Trump’s announcement of additional tariffs that could deteriorate China’s external account. Several months ago, a senior IMF official suggested to me a hypothetical scenario, in which Trump would push down the value of the RMB by escalating trade tensions and then would call China a currency manipulator. This was exactly what happened.

If there was a cause for the new currency war, it was single-handedly created by Trump.

In July 2005, China started the managed floating exchange rate regime with reference to a basket of currencies. The People’s Bank of China (PBoC) pursues a policy agenda trying to make the exchange rate more market-determined over time but attempting to avoid excessive volatility in the short term. The RMB appreciated gradually before mid-2014 but suffered from periodical depreciation pressures after that. But since the beginning of 2017, the PBoC has avoided intervening heavily in the foreign exchange markets.

‘Management’ of the exchange rate is done mainly through the application of the ‘counter-cyclical factor’ by setting central parity at the start of trading days. The 12-month moving average of exchange rate volatility of the RMB increased steadily from late 2010 and was already close to those of major global currencies — such as the US dollar, the Euro and the Japanese yen — in early 2019.

By and large, the purpose of the ‘management’ is to reduce excessive exchange rate volatility, not to lower the currency value. The perception that a weaker currency strengthens economic growth is also outdated since it only considers the trade channel of the exchange rate effect on growth. But the effect of the finance channel could be the opposite — a weaker currency encourages capital outflow and weakens economic growth. During the second half of 2015, for instance, RMB depreciation was accompanied by sharp declines of net capital inflow.

Empirical analyses also confirm that, in China today, the finance channel already dominates the trade channel. Therefore, it is no longer in China’s own interest to single-mindedly pursue a policy of a weak RMB.

Likewise, a US policy of a weak US dollar would likely be futile, because US comparative advantages are more concentrated in the service sectors rather than in manufacturing industries. As C Fred Bergsten pointed out, Trump’s trade wars with China and many other countries reduced US imports, but did not boost US exports or bring back manufacturing facilities from overseas.

Unfortunately, such an unreasonable currency war would bear serious consequences for China. Given limited options, China could consider the following options. First, it should avoid the temptation of waging a full-scale financial war with the United States. Previously, some experts recommended dumping US treasury bonds and crashing the RMB exchange rate. This is bad advice as it could inflict more pain on China than on the United States.

Source: National School of Development

Second, the PBoC should accelerate its process of moving toward a ‘managed free float regime’. This should be useful for reducing both uncertainty and misunderstandings of China’s exchange rate policy, especially as the IMF will start the new round of Special Drawing Rights review in 2020. And, finally, China should accelerate economic reform, including realising competitive neutrality domestically and opening the economic doors wider to the outside world — especially to the non-US world.