Many things bring displeasure to the forty-fifth president of the United States. One of them is a high American dollar.
Donald Trump frequently accuses China of keeping its currency low to compete unfairly with the United States, and is now accusing Europe of doing the same thing. He has been highly critical of the US Federal Reserve for keeping interest rates — and thus the dollar — higher than he would like, and proposes a simple solution: “We should MATCH,” he tweeted in July, “or continue being the dummies who sit back and politely watch as other countries continue to play their games — as they have for many years!”
It’s not just rhetoric. In May, the commerce department issued a proposal to impose sanctions on countries deemed to be hurting American exporters through currency manipulation. Five days later, the US Treasury lowered its threshold for what constitutes a competitive currency devaluation and expanded its surveillance to include any country that has a trade surplus with the United States of US$40 billion or more. On Monday this week Treasury labelled China a “currency manipulator” for the first time in twenty-five years, dramatically escalating tensions. A global currency war is in the making.
Does Trump have a point? Is the United States getting a raw deal when it comes to exchange rates? And what would be the implications of a weaker US dollar (let alone an all-out currency war) for Australia, particularly given the Reserve Bank of Australia’s decision this week to keep rates steady?
Economists can measure whether an exchange rate is undervalued by calculating what a country’s exchange rate ought to be. They do this by looking at the characteristics of its economy, how much it trades with the world, how much it invests overseas and how much other countries invest in it. Much like the cafe worker who owns a Ferrari, if a country’s exchange rate is dramatically lower than what these fundamentals would imply, then there might be something fishy going on.
The International Monetary Fund does this each year, which is why we know that Donald Trump’s assertions range from overblown to completely baseless.
Trump is at his most inaccurate when he’s talking about China. Despite the yuan’s having recently fallen below the seven-per-dollar level for the first time in a decade, the IMF’s longer-term assessment is that China’s exchange rate was appropriate throughout 2018. And this was not a one-off: the IMF has found China’s exchange rate to be appropriate for at least the past five years, and only marginally undervalued before that.
Experts see the US’s labelling of China as a currency manipulator as arbitrary. In the context of a slowing economy and growing trade restrictions, a weakening yuan is to be expected. Cornell University’s Eswar Prasad has noted that China doesn’t even meet the US Treasury’s own definition of a currency manipulator. Mark Sobel, a forty-year US Treasury veteran, has made a similar point: “By Treasury’s own foreign exchange report criteria, China doesn’t even come close to meeting the terms for manipulation.”
The US dollar, on the other hand, was assessed as being overvalued by between 6 and 12 per cent in 2018, making life harder for American exporters. Trump may feel vindicated by that finding, except for the fact that the United States is by no means alone. Australia’s exchange rate was also assessed to be overvalued by up to 12 per cent, as were the exchange rates of most G20 economies, including Brazil, Canada, France, Italy, Russia, Saudi Arabia, South Africa, Turkey and the United Kingdom.
To be sure, there are countries on the other side of the ledger. The exchange rates of Germany, Japan, Korea, Mexico and the euro area have been persistently undervalued in recent years. But even there, the reality is more complex than the president suggests.
Germany’s exchange rate, for example, is undervalued by between 8 and 18 per cent. But this is primarily because it shares an exchange rate with the rest of the euro area. Although the common currency gives Germany an undervalued exchange rate, it gives France, Italy and a host of other euro area economies an overvalued rate, netting out most of the euro-wide impact.
Economists can also monitor whether countries are manipulating their exchange rates by watching whether they are persistently selling their currencies in global foreign exchange markets. Alas, the US Treasury has never been able to show that any of the countries on its watchlist — including China, Germany, Japan, Korea and Mexico — is engaging in such behaviour.
The “exports good, imports bad” exchange rate policy favoured by President Trump might have been popular in the eighteenth century, but it is as simplistic as it is outdated. Sure, an overvalued exchange rate means your exports are more expensive than those from the rest of the world. But it also means your consumers enjoy cheaper imports, benefiting poorer households the most. It also benefits businesses that rely on imports for their production processes, including the US automakers that use cheaper steel to manufacture cheaper cars.
President Trump’s shaky currency claims mean that any attempt he makes to punish other countries or devalue the US dollar is likely to face retaliation from US trading partners, who may rightly feel unfairly targeted. This sets the scene for a nasty currency war.
What would the implications be for Australia? Luckily, Australia has neither a trade surplus with the United States nor an undervalued exchange rate. Although President Trump rarely lets facts get in the way of a good fight, Australia would probably escape any direct ire. But it would still suffer a range of indirect effects.
A devaluation of the US dollar would make Australia’s already overvalued currency even more overvalued, hurting exporters. It would also make life harder for the Reserve Bank, which has cut interest rates twice to stimulate a sluggish economy. Although it left rates unchanged in its August meeting, options markets are pricing in another 25 basis-point cut by October.
Interest rate cuts boost the economy in two ways. They make borrowing cheaper for firms and households, generally resulting in more investment and consumption. They also tend to depreciate the Australian dollar, boosting our exports overseas. But this second effect is reduced if other currencies are weakening at the same time. So the benefits of the Reserve Bank’s rate cuts to the Australian economy would probably be reduced if the United States (let alone other countries) seeks to devalue its currency at the same time.
But the biggest concern is what would happen to investment. On the one hand, most models suggest that a weaker US dollar and lower US interest rates would boost investment around the world. On the other hand, this may be too optimistic. A currency war is likely to spook investors, encouraging them to sit on their cash and delay investment. Heightened uncertainty could see global lending and investment contract, with significant consequences, particularly for countries like Australia that rely on trade and foreign savings.
Thus far, US institutions appear to be keeping the president in check. While the chair of the Federal Reserve, Jerome Powell, cut interest rates last week, he explicitly stated that it was a one-off. This infuriated the president, to say the least, but sent a clear signal to markets that the US dollar won’t be dramatically weakened anytime soon.
Trump’s other option would be to use the Treasury’s Exchange Rate Stabilisation fund — the fund Bill Clinton used to bail out Mexico in the 1990s — to start selling US dollars. But with only US$100 billion in the kitty, and with dollar holdings of just US$23 billion, that would be unlikely to depreciate the US dollar in any sustained way.
This buys us time. The question is, how much? Twelve months ago, it was the trade war grabbing headlines. Today, it’s the technology war. In twelve months, will it be the currency war? Time will tell. •