Is China in a currency war with U.S.?

China’s recent surprise decision to devalue its currency, the renminbi (also known as the yuan), versus the dollar sent shock waves through financial markets. It could trigger a race to the bottom to gain an export price advantage, which would have a major impact on the U.S. economy and on looming decisions by the Federal Reserve.

Many believe China’s move was an effort to gain a trade advantage. A drop in the yuan’s value makes Chinese products cheaper, costing thousands of jobs by forcing factories outside China to close.

China said the devaluation was a one-off event, but the move could set off a currency war, which is when two or more countries engage in currency devaluations to improve the competitiveness of their products in global markets.

Over 35 years, China has developed from abject poverty into an economic giant. It is the world’s second largest economy and accounts for about 12 percent of global exports. A country so reliant on trade must maintain the growth of exports, which have been the most important driver of China’s growth since liberalizing its economy in 1978. The U.S. is their biggest customer.

Chinese farmers continuously leave the countryside for higher paying jobs in urban areas. Robust economic growth is needed to absorb this workforce and maintain social stability and the existing political order, which is a top priority. If the economy worsens, China may further devaluate its currency to export its way out of the decline. Chinese exports were down 8.3 percent in July compared to 2014.

More importantly, China’s economic growth has slowed to an annual rate of 7 percent. That’s healthy for most countries- the U.S. struggles to keep annual gross domestic product growth above 2 percentĀ­ but far below the previous decade’s double-digit growth.

Even though its GDP remains smaller than that of the United States, China is the world’s largest trading nation and is many countries’ most important bilateral trade partner. In the future, the yuan may well eclipse the dollar as the preferred currency of trade.

Some believe the devaluation may cause other countries’ central banks to respond, triggering a currency war. Both Japan and the European Union have repeatedly depressed their currencies in the past two years to promote exports. The U.S. certainly does it. The dollar took a deep dive after the Federal Reserve cut interest rates to near zero and flooded the world with cheap money through its quantitative easing initiative.

The devaluation engineered by Beijing also complicates the Federal Reserve’s September decision about whether to raise interest rates, which have been near zero since the 2008 financial meltdown. A weaker yuan would reduce the price of Chinese goods in the U.S. This would further depress the 1.3 percent inflation rate, which is below the Fed’s target of 2 percent.

Last month, the U.S. government reported that the economy added 215,000 jobs and the headline unemployment rate remained at a low 5.3 percent. That could support a Fed decision to raise its key interest rate.

But low inflation, weak increases in hourly wages and continued low labor-force participation could be reasons to delay their planned 0.25 percent increase until early next year. A rate hike would increase the dollar’s value, which would cause even more angst for American exporters, kill manufacturing jobs and sales of American goods; and slow economic growth.

To further complicate the situation, China has stockpiled more than $1.2 trillion in U.S. bonds, which help finance wars and huge budget and trade deficits. If foreign countries stop buying treasury bonds, rising debt would mean higher interest rates because investors would insist on higher returns.

The bottom line is that while there are a number of incentives for countries to devalue their currencies, every effort should be made to avoid the kind of competitive devaluations that exacerbated the Great Depression in the 1930s.

Originally Published: August 22, 2015

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