US, China Currency War Just Got Serious

On Tuesday the US Senate passed a “currency manipulation” bill which will impose high tariffs on foreign producers while subsidising those in the US. These protectionist measures are targeted most notably at China whose currency is kept artificially low to help its exports.

Though not at all surprising, these measures will undoubtedly trigger an escalation in the ongoing US vs. China currency war. They could even help bring about a global recession as the world’s two largest economies do battle over trade advantages.

Back Story

Back in 2008, in response to the global financial crisis, China took the step of pegging its currency, the Renminbi, to the US dollar. They did this to help prevent its rise and to give its export based economy a competitive boost. The move had the effect of making Chinese made goods more affordable to Americans (and others around the world) and helped the Chinese overtake that of Japan to become the world’s second largest economy.

Over in the US political leaders responded to the global downturn by printing money through its various QE, or quantitative easing programmes – which worked to cheapen the US dollar. This policy had the serious knock-on effect for the Chinese (and for Hong Kong) because in order to maintain their currency peg they too had to print money to cheapen their currency. This is why China is now suffering from high rates of inflation.

The New Bill

In the words of Senator Charles Schumer under the new bill, The Currency Exchange Rate Oversight Reform Act of 2011, China will no longer be allowed to get away with “economic murder”. In reality by imposing punitive tariffs on imports from China, both Chinese manufacturers and their US partners will be hit hard, as will US consumers.

The fact is, China and the United States are each other’s second-largest trading partners and trade between the two nations accounts for a considerable share of total global trade. Therefore if the Obama administration continues to act self-righteously, they risk an escalating trade war that will hurt every global economy.

5 year chart of the Chinese Renminbi vs. the US Dollar

As the chart above shows the People’s Bank of China has now begun to let their currency appreciate verses the US dollar. The reality is they had little choice. The nation is suffering from serious over-heating and the gradual appreciation of the Renminbi will help to quell its inflation problem. China has also been raising interest rates and increasing bank reserve requirements in an attempt to engineer a “soft landing”.

Whether or not this can be achieved remains to be seen.

 

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