Will the trade war spawn a currency war?

Will the trade war spawn a currency war?
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President TrumpDonald John TrumpRepublicans consider skipping witnesses in Trump impeachment trial Bombshell Afghanistan report bolsters calls for end to 'forever wars' Lawmakers dismiss Chinese retaliatory threat to US tech MORE’s threat to impose a 10 percent tariff on $300 billion of Chinese imports and his claim that China is deliberately weakening its currency have triggered the largest U.S. stock market sell-off since late last year. But there are two important differences from prior actions.

One is that American consumers will see the price effects on goods such as clothing, electronics and other items that were excluded from previous tariff hikes. The other is that the U.S. Treasury subsequently declared China to be a currency manipulator. It occurred as the Chinese currency (CNY) fell to 7.04 yuan per U.S. dollar, the weakest level in over a decade.

This accusation, however, is not accepted by many economists, who view the yuan’s weakness as the result of natural market forces. In fact, it is exactly what economic theory predicts should happen when tariffs are imposed.  

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The logic is that while tariffs will initially tend to reduce the U.S. trade deficit, they will at the same time cause the U.S. dollar to increase as the international supply of dollars declines. The increase in the price of the U.S. dollar reduces U.S. international price competitiveness, which impacts exporters. 

The danger today is that what began as a trade dispute could escalate into a full-blown currency war. One risk is that an ongoing decline in the price of the yuan could spawn capital flight from China. If so, it could reverberate back to China’s financial markets and lead to a “growth recession.” 

However, the Chinese authorities are well aware of this, as they spent the equivalent of $1 trillion worth of foreign exchange reserves in 2015 to counter capital flight. Therefore, they will likely try to limit further currency weakness barring a further escalation of the trade war.

Another risk is that President Trump has suggested on several occasions that the U.S. government could retaliate by selling dollars to weaken the U.S. currency. While Larry KudlowLawrence (Larry) Alan KudlowMORE has denied the Trump administration is considering doing this, it cannot be ruled out altogether. But with the federal deficit about to blow out and the Federal Reserve under pressure to ease monetary policy further, selling dollars could undermine investor confidence at some point.

The question now is whether cooler heads will prevail before financial markets erupt again, as they did late last year. With China’s government unlikely to budge on issues before the next U.S. election, a lot hinges on how the Trump administration responds.

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First, it should consider whether the goals it set out to achieve are being met. Unfortunately, what began as an effort to redress unfair Chines trade practice and to protect American jobs in manufacturing has instead contributed to a slump in global manufacturing and world trade. And while U.S. manufacturing has continued to eke out gains thus far, it is the most vulnerable sector should the global economy slip into recession.

Second, it should recognize that the positive effects of tax cuts and deregulation on economic growth are being undermined by the proliferation of tariffs that began one year ago. In the meantime, real GDP growth over the past four quarters has slowed to 2 ¼ percent per annum compared with more than 3 percent in the previous four quarters.

Finally, even if tariffs are not good for the U.S. and world economy, the Trump administration should weigh whether they are good politically. There is no denying that Donald Trump’s message of defending workers resonated in areas that had been adversely impacted by foreign competition. Indeed, none of the leading Democratic presidential candidates have challenged him on that, although the picture could change if tariff hikes boost prices of goods American households. 

The main risk for the markets in these circumstances is that the trade war could escalate further. Our base case, however, is that the conflict will not spiral out of control, as it is in the interest of both countries to limit the fallout on their economies and markets. But investors should also be prepared for market turbulence in the meantime.

Nicholas Sargen is an economic consultant to Fort Washington Investment Advisors and affiliated with the University of Virginia Darden School of Business. He is the author of "Investing in the Trump Era: How Economic Policies Impact Financial Markets."