What Happens When A Country Manipulates Its Currency?

A major part of China’s response to the latest tariff threats by President Donald Trump was to reduce the value of its currency to its lowest level relative to the dollar of the past decade. Trump fired back by having the Treasury Department officially name China a “currency manipulator.”

Markets have been reeling over the past week due to the ramping of the trade war between the U.S. and China.

While much of the focus has been on the tariffs, here’s a look at the impact a devalued yuan could have on the U.S. and Chinese economies.

See Also: US Treasury Declares China A Currency Manipulator

Benefits Of Currency Devaluation

Trump has threatened to levy a new 10% import tariff on $300 billion in Chinese goods starting Sept. 1. By devaluing the yuan, China is essentially offsetting the impact of these tariffs.

The tariffs make Chinese goods more expensive, forcing American companies to either pay more for supplies and raw materials they buy from China or choose to buy elsewhere.

Since U.S. companies buy Chinese goods with U.S. dollars, devaluing the yuan lowers the cost of exporting goods from China to the U.S., negating the impact of the tariffs.

Devaluing the yuan gives Chinese companies an unearned competitive advantage against U.S. companies in the U.S. market. China would argue that Trump is doing the exact same thing with his tariffs on Chinese goods.

By taxing Chinese imports, the U.S. is giving American companies an unearned competitive advantage in the market.

Finally, currency devaluation can help a country deal with a debt problem. Last year, the Institute of International Finance estimated China’s debt-to-GDP ratio was around 300%, a staggering level. Since that debt is owed in yuan, the lower the value of the yuan, the easier it will be for China to pay back that debt.

Dangers Of Currency Manipulation

Devaluing a currency is akin to raising the inflation rate. A small degree of inflation is healthy for a growing economy. The U.S. Federal Reserve, for example, targets 2% annual inflation.

If a currency is devalued too much and inflation gets out of control, a nation’s economy can overheat and prices can get prohibitively high.

Germany famously devalued its currency in the 1920s to help pay off its massive World War I debts. Germany devalued its currency so much that the exchange rate for the German mark skyrocketed from 4.2 marks per U.S. dollar in 1914 to more than 1 million marks per U.S. dollar by 1922.

The currency became nearly worthless, and any citizens with savings were completely wiped out. Germany’s society and political structure became unstable, and many experts blame this period of mistrust for the radicalization that ultimately resulted in the rise of the Nazi Party.

Although this is an extreme example of the impact of hyperinflation and currency devaluation, there are plenty of examples throughout history of the negative impacts that out-of-control inflation can have on an economy. Inflation pressures imports, increases unemployment and decreases tax revenues.

See Also: Market Sell-Off Accelerates Following China Trade War Retaliation

Investors Hoping For A Deal

Trump has argued that the U.S. trade relationship with China has been unfair and unbalanced for years.

The trade war between the U.S. and China is clearly pressuring the economies of both nations and the values of their respective equity markets. In the past week alone, the SPDR S&P 500 ETF Trust SPY is down 5.2% and the iShares FTSE/Xinhua China 25 Index FXI is down 7.5%.

If a deal is reached at some point, the merit of the trade war — and whether the near-term risk and lasting damages it inflicted were worthwhile — will depend on the terms of the deal. In the meantime, China’s currency manipulation will continue to weigh on both the U.S. and the Chinese economy.