How a currency war can help China neutralise US tariffs

On March 1, Donald Trump raised the import tax on steel and aluminum, firing the first shot in what could be a protracted trade war. Only 6 percent of American imports of the aforementioned goods come from China, but the message was clear.

China has been in the cross hairs of American foreign policy after Trump’s ascension to the White House. With a larger basket of goods coming under Trump’s import tax umbrella, China has replied in kind with counter-tariffs. However, from a Chinese perspective, tit-for-tat tariffs aren’t the only option on the table. China could dampen the impact of tariffs by allowing its currency to weaken.

The yuan has depreciated 7.81 percent since March 1. Unlike equities, even slight changes in the value of a currency can have ramifications on the local economy, and also global trade. This is the biggest slide in the value of the yuan since 2015.

Given that Trump is ratcheting up rhetoric on increasing punitive tariffs, China can offset the deficit by manipulating its currency to make exports cheaper. Conversely, a weaker yuan will make American imports more expensive. This could reinforce the impact of Chinese tariffs on US goods.

China is the biggest export economy in the world. By allowing its currency to depreciate, Chinese goods will become cheaper in foreign markets. For example, consider the situation where the People’s Bank of China (PBOC) decides to lower the value of the yuan to 8 against the dollar, as opposed to the prevailing rate of 6.

Under the present regime, a smartphone that costs 2,400 yuan would retailed for USD 400 in the US market. If the currency rate is pegged at 8 yuan to the dollar, the same product with a price tag of 2,400 yuan will only cost USD 300. Therefore, triggering a currency war will only be to the benefit of China since exports will become more competitive, driving up volumes.

What is the downside of currency devaluation?

The yuan is not traded freely in the market like the dollar. A hard devaluation could incite herd behaviour among holders of the yuan and destabilise the economy. Chinese companies earn dollars for their wares sold in the export market. This is also true for foreign portfolio investors who have invested in the Chinese market.
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