Consensus thinking sees two levers. One is the U.S. tariff and the other is the weakness of the Chinese yuan. They talk as if China may be depreciating the yuan, or tolerating a weaker yuan to offset the tariffs. This feeds the fear that China can escape from U.S. pressure and supports those favoring an aggressive confrontation with China. The view is both mistaken and naive.
Many observe that the yuan and the Mexico peso weakened after the U.S. imposed or threatened to impose tariffs. One Bloomberg report called this an "inconvenient truth" that in an era of floating exchange rates, tariffs can be undermined by currency depreciation. I am not buying it.
A tax on one's exports would, everything else being equal, reduce the demand for the goods, and slow GDP through the net export component of GDP. In the face of downside risks to growth, it would seem natural that a currency softens. It weakens not to offset tariffs but as investors reduced exposures on the margin due to a deterioration in growth prospects, which impact other assets, like equities and fixed income.
The only way the observers are correct is in a very particular narrow situation that does not exist, except perhaps on the margin. This idealized case is a product that is 100% made in China and then exported to the U.S.. A 25% tariff on the Chinese good could be offset by a currency depreciation of the same magnitude.
However, this is not what happens.
UN data on value-added finds that China exports are import-intensive. That is to say China imports components or semi-finished goods and assemble them, for example, or imports say rare earths and refines and processes them. The data suggest that yuan-incurred costs for Chinese exports average around a third of the costs. This means that more than a 25% depreciation of the yuan is needed to offset the 25% tariff.
How much yuan depreciation has taken place? Very little. Since the start of 2018 through today, the yuan has depreciated by 6% against the dollar. It has actually risen a little against the euro. Indeed, it has fallen less than the G-10 currencies over this period, except the Japanese yen and Swiss franc. That is to say that countries that have only experienced U.S. steel and aluminum tariffs have seen their currencies fall more than the Chinese yuan.
Moreover, the data suggests far from trying to offset the tariff impact through depreciation, China has been actively supporting the yuan through the setting of the reference rate and holding off policies that might weaken it, like a cut in interest rates. The benchmark one-year lending rate has been at 4.35% since October 2015. Required reserve ratios for the banking system have not been reduced since early January.
Many reporters and analysts had previously played up the risks of a currency war, which never seemed to materialize, but now argue that the trade war is morphing into a currency war. It is not.
Politicizing or weaponizing the foreign exchange market is understood to be a zero-sum game. A country devalues to secure a competitive advantage simply borrows steals aggregate demand of their trading partners. Monetary policy is not a zero-sum exercise. One country eases policy to stimulate domestic demand. Its currency may fall. Its neighbor may feel pressure to ease monetary policy itself and boost its aggregate demand.
Many observers are so convinced that China wants to devalue that they do not quite believe that its reserves holdings actually increased. The PBOC must be doing it another way, they argued. Pshaw. That thinking leads to poor investment and bad policy. China is pursuing a different strategy. One way to adjust to tariffs is to move up the value-added chain. Let low value-added work move abroad, to Vietnam or Thailand or wherever. Encourage Chinese people to work smarter, not harder. A depreciating currency provides incentives to stick with the current division of labor. Indeed, the U.S. tariffs on China will accelerate a re-drawing of the supply chains that is both necessary and desirable from China and most of the world's perspective.
Japan accounted for a bit more than 40% of U.S. imports in the early 1980s when Reagan accused them of permitting counterfeiting or copying American products and "stealing our future." China accounts for a little bit more than that, but with less value-added really being done in China. Chinese officials did not want to be in the U.S. cross-hairs, but accounting for such a large share of America's imports make it difficult to avoid.
Others will take up China's share of US imports, but the ultimate driver of the U.S. global imbalance is to be found in Washington, not Tokyo, Beijing, or Ho Chi Minh City.