- We are facing the possibility of an open trade war with commercial and monetary measures aimed at devaluing both the yuan and the dollar.
- In a trade war between China and the US, both countries would divert at least part of their foreign trade to Europe, but the expected appreciation of the euro against the two currencies would lead to a reduction in the trade surplus.
- What can be expected from the US-China trade war is a deflationary impact on the eurozone, with a net reduction in trade surplus and GDP.
This week began with the news of the designation of China as “currency manipulator” by the US Treasury. Are we at the gates of a currency war, and how can the eurozone be affected?
First, it is not likely that there will be a declared currency war. The People’s Bank of China denies that it is devaluing the currency on purpose. And the Federal Reserve does not have an objective to alter the exchange rate nor is it foreseeable to have it. However, there are other types of trade and monetary policies that have predictable downward impacts on the exchange rate, and both the United States and China are adopting them.
The last round of exchanges in this regard was the threat on the part of Donald Trump to impose tariffs of 10% on 300,000 million annual dollars of imports. This was followed by the decision of the People’s Bank of China not to defend the yuan against a drop in value below seven yuan per dollar. And the US has reacted with the statement that China manipulates its currency.
Legally this is a step that facilitates the imposition of tariffs, which seems to be the ultimate motivation of the Trump administration. China has reacted to the accusation of the US Treasury by banning imports of agricultural products from the US. This is a purely commercial measure that in principle helps to revalue the yuan against the dollar, not to devalue it.
However, the decision of the People’s Bank of China not to defend the yuan exchange rate opens the prospect of further declines in the exchange rate in response to the trade war. Bank of America analysts Merrill Lynch expect the result of the 10% rates announced by Trump to be an exchange rate of 7.3 yuan per dollar.
If the tariff rates reach 25%, as they already do for another 250,000 million dollars of imports to the United States from China, the yuan could fall to 7.5 per dollar. This would make Trump furious and lead to more protectionist measures.
An example of these measures is a bill recently proposed by Senators Josh Hawley –Republican of Missouri– and Tammy Baldwin –Democrat of Wisconsin–, which would force the Federal Reserve to apply a fee to purchases of financial assets by foreign investors, provided that the US trade deficit exceeds 0.5% of GDP. This is an essential capital control measure, but it would have the effect of depressing the dollar exchange rate with respect to the currencies of countries with which the US has a trade deficit.
We are, therefore, faced with the possibility of an open trade war with commercial and monetary measures aimed at devaluing both the yuan and the dollar. If this is not a currency war in the sense of competitive devaluations, it is very similar.
The limits of the economic model of the eurozone
The effect this could have on the eurozone is mixed. In a trade war between China and the US, both countries would divert at least part of their foreign trade to Europe. However, the expected appreciation of the euro against the yuan and the dollar would tend to reduce the eurozone’s trade surplus. In addition, cheaper imports of both Chinese and US products would act as a brake on inflation. This is the last thing the eurozone needs, as the European Central Bank already has problems to stimulate inflation sufficiently to reach its goal of about 2% in the medium term.
If the ECB adopts policies aimed at increasing inflation through the exchange rate that is applied to imports of consumer goods, it could lead to the US Treasury also considering the eurozone as a manipulator of the exchange rate. As we have seen in the case of China, this designation serves as an excuse for Trump to impose tariffs, which seems to be his primary objective.
In the case of Europe, Trump has already applied tariffs on steel and aluminum, has especially threatened Germany with imposing tariffs on cars, and has recently threatened France with tariffs if the country approves a “Google rate.” Trump, in addition, has already accused the ECB of manipulating the currency through its expansive monetary policies, negative rates and purchases of state bonds. This accusation is unfounded, but it is clear that nothing would satisfy Trump more than the fact that the ECB gave him the excuse of imposing additional tariffs on the EU.
Thus, what can be expected from the US-China trade war is a deflationary impact on the eurozone and an increase in the volume of imports and exports with both countries, with a net reduction in the trade and GDP surplus. All this without counting on the deterrent effect that a fledgling trade war can have on investment. And, if the ECB reacts by further relaxing its monetary policy, Trump is exposed to extending the trade war and tariffs to the EU.
The eurozone would be much less vulnerable to Trump’s trade wars if it were less dependent on exports for its economic growth. But the economic model adopted since the crisis is focused on reducing the foreign debt – private and public – of countries like Spain. By depressing investment, the export-based Eurozone growth model also results in low inflation and low productivity growth.
The alternative would be a more closed economy model at the continental level, with policies to stimulate investment and domestic demand. The problem is that the countries called the crisis cannot do this on their own without risking another balance of payments crisis like the one experienced at the beginning of this decade. And the countries of northern Europe are not in charge of providing the eurozone with fiscal and investment tools themselves, because they would imply transfers between countries. Thus, it is up to settle for low inflation, low investment, low growth, and vulnerability to trade wars.