Commentary: How a trade war’s fallout spreads

The trade spat between the U.S. and China over the last two weeks now seems headed toward a new phase, which could prove to be far more dangerous for the global economy.

The recent shifts roiling global markets began with President Donald Trump tweeting on Aug. 1 that the U.S. would impose an additional 10% tariff on $300 billion in Chinese exports, starting Sept. 1. On Tuesday, the administration announced a delay on tariffs on some consumer goods until Dec. 15. But that may not be enough to alleviate the anxiety in world markets. China already reacted last week by weakening the Chinese currency, pushing the exchange rate to 7 yuan per dollar for the first time in over a decade.

Both sides risk considerable harm to their economies. As the Trump administration increases tariffs on Chinese goods purchased by American firms and consumers, Americans will be paying billions more for Chinese goods. Higher prices brought on by tariffs will decrease U.S. business investment and consumption, dampening momentum in U.S. economic growth.

Likewise, China’s imposition of tariffs on American goods — even barring Chinese companies from buying agricultural and energy commodities from the U.S. — since the start of the trade conflict in April 2018 has imposed costs on Chinese firms and consumers, stalling growth momentum in China.

With inflation on food already at 7% in China, more import restrictions or tariffs will put a great deal of hardship on ordinary households. Although Chinese President Xi Jinping does not face any electoral pressure and may not suffer any political fallout from the economic results of the trade war, these consequences still directly contradict his desire to bring about “more prosperous and healthy lives” to the Chinese people.

Now, devaluing the yuan may further jeopardize the stability of China’s financial system. China’s high domestic debt already forces the central bank to expand its money supply at a rate of 8% to 10% a year, a relatively high pace that typically weakens the exchange rate. To guard against the expectation of a weakening currency, the central bank of China has spent years establishing the reputation of the yuan, which has been built on the tacit assumption that it would not fall below 7 yuan to the dollar. This reputation is important for the yuan because, unlike the dollar, the currency does not have a deep and liquid market, where market participants can hedge against various risks at a relatively low price.

The yuan’s stability has increased its credibility, convincing more people around the world to use it instead of the dollar or other major currencies. It also has lowered the hedging costs for businesses that use the yuan because the market assumes there is a limit to its volatility.

Much of this is out the window now because no one knows how far the yuan will fall. Global businesses can no longer count on a stable yuan, at least on a yearlong horizon, and will need to spend significant amounts protecting themselves against a weakening yuan.

Because China remains a major exporter, the yuan’s devaluation may well tempt other countries to devalue their currencies — by expanding money supplies or by cutting interest rates — to maintain the competitiveness of their goods. Such a response may drive yet more countries to devalue their currencies.

With an escalating round of currency devaluation — and India might have fired the first shot by cutting interest rates last week — it’s likely that investors will seek safer assets, namely by putting their money into U.S. Treasury bonds. A big swing in that direction would, in turn, increase the value of the dollar while further driving down other currencies. This will put greater downward pressure on the yuan than is desired by policymakers in China.

Meanwhile, wealthy households in China will be motivated to move their money out of China to protect their wealth, thus accelerating capital flight. As China’s foreign exchange reserve comes under greater pressure, the Beijing government will be increasingly tempted to carry out a “maxi-devaluation,” a steep devaluation of the yuan, to staunch the outflows. This would introduce a great deal of volatility not only in China, but also around the world.

Devaluation also creates a conundrum for China’s foreign currency debtors. According to the Bank for International Settlement and official data on mainland China and Hong Kong, Chinese firms and financial institutions owe close to $3 trillion to foreign counterparties. This is the highest external debt owed by any emerging market economy.

More devaluation will put liquidity pressure on these debtors, especially issuers of $800 billion or so in dollar denominated bonds. Essentially, if the yuan were to devalue by 10%, these debtors would need 10% more in yuan to repay interest and principal to their creditors, who hold claims in dollars. This additional pressure may force some of these debtors to default, further undermining international confidence in China’s economy and financial stability.

The financial markets won’t be pulled back easily once this dangerous dynamic takes root. The trade squabble that began with Donald Trump and Xi Jinping fighting about agricultural products is spreading more broadly. And unless they go back to the negotiating table, global anxieties will increase with perilous consequences.

Victor Shih is the Ho Miu Lam Chair associate professor of political economy at UC San Diego and author of the forthcoming “Economic Shocks and Authoritarian Stability.”