When Donald Trump bemoaned that a weakening yuan had nullified some of the punitive effect of his tariffs on China, he was highlighting, unwittingly perhaps, a crucial flaw in his foreign policy tool of choice: In an era of free-floating exchange rates, currencies adjust so quickly they can offset the intended impact of higher levies before they even take hold.
It’s an inconvenient truth for the U.S. in its escalating trade war with the world’s only other economic superpower, and one that could complicate the president’s efforts to use tariffs as way to pressure America’s major trading partners into making concessions.
After Trump raised tariffs on $200 billion of Chinese imports last month, the yuan quickly fell toward 7 per dollar — a level not seen since the financial crisis. The drop effectively reduced the price of Chinese imports in dollars and has blunted the cost shock of higher tariffs. (The same thing happened with the peso following a similar threat against Mexico in late May; the peso plunged over 2% in less than an hour.) So for all of Trump’s tough talk about punishing China for what he considers unfair trade practices, Americans might not see any meaningful markups on Chinese-made goods.
“It illustrates the difficulty of trying to use tariffs to reduce your trade deficit in a global world,” said Brad Setser, senior fellow at the Council on Foreign Relations and a former Treasury official.
In some ways, Trump’s use of tariffs hearkens back to a very different era, when countries used fixed-exchange rates under the Bretton Woods agreement, which lasted from the mid-1940s to the early 1970s.
Of course, the yuan “floats” far less than most major currencies in global FX markets because of limits imposed by the People’s Bank of China. But based on calculations by Robin Brooks, chief economist of the Institute of International Finance and former head of FX strategy at Goldman Sachs, its decline from 6.4 to 6.9 per dollar since last summer “roughly offset’’ the impact of the first two rounds of U.S. tariffs, which were first announced in June 2018.
These foreign-exchange adjustments are one of many reasons that economists generally take a dim view of tariffs. Not only do they trigger retaliatory tit-for-tat disputes that undermine business confidence and economic growth, but the costs that aren’t offset in the currency market are borne primarily by the consumers in the countries that impose them.
And while Trump has asserted the U.S. is “getting a lot of money from China’’ because of the tariffs, the reality is less clear. U.S. companies that import goods from China can either absorb the additional cost and pay the government an extra 25%, or pass it onto consumers by raising prices. (This doesn’t take into account FX adjustments that may lessen the actual impact of the levies.)
“The cost of the U.S. tariffs has fallen squarely on the U.S.,” Vicky Redwood and Simon MacAdam of Capital Economics, wrote in a note this month.
Foreign exchange has emerged as a focal point in trade talks. On Friday, Trump once again asserted that China is manipulating its currency. The administration proposed taxing goods from countries with undervalued currencies last month — a proposal that was said to alarm even its own Treasury Department officials. The U.S. has also sought a yuan stability pact as part of an eventual deal, according to people familiar with the matter.
For the time being, China seems to be exercising restraint after Trump threatened to impose more tariffs on $300 billion of Chinese imports this week, and keeping the yuan from depreciating even faster. Brooks estimates that fair value for the yuan is close to 7.3 per dollar, versus 6.93 now.
And while the PBOC has routinely stepped in to support the yuan whenever it inched toward 7 per dollar in the past, there are now signs that stance could change if trade tensions worsen. In a rare interview with Bloomberg News this month, Yi Gang, the PBOC’s governor, signaled a new willingness to let the markets dictate the yuan’s value.
“A little bit of flexibility of renminbi is good for the Chinese economy and for the global economy, because it provides an automatic stabilizer,’’ he said.
Of course, letting the yuan fall as much as the market sees fit isn’t without its own risks. The currency’s devaluation in 2015 caused billions of dollars of capital to flee China and forced the central bank to burn through its foreign-exchange reserves, which stand $3.1 trillion, to stem the outflow. What’s more, a weaker currency would reduce the purchasing power of Chinese consumers.
Nevertheless, Trump’s trade war might just force China’s hand.
“He is relying on China not to respond to his tariffs with a weaker currency,” Setser said. “But it’s clearly China’s decision, not Trump’s.”