Currency wars lead to real ones, so China must be handled carefully
‘‘ In the past two years, the world economy has been gripped by trade wars and real wars.
History suggests that the precursor for both is often a phase of rampant currency wars, which are back in the news.
Currency wars — or manipulation of exchange rates to gain advantage over trading partners — are often a harbinger for trade wars that can morph into real wars. Currency wars are so dangerous to global financial stability that the entire basis of our postwar Bretton Woods system was designed to stop countries from engaging in the beggar-thy-neighbour devaluations of the 1930s. The chaotic collapse of the inter-war gold standard and the breakdown of international monetary co-operation contributed to the world’s second global conflict in two decades.
The ability to manage currency disputes is a good test of global co-ordination. That’s why the Bretton Woods institutions or the 1980s Plaza Accord loom so large in our recent political economy. In both cases, countries sat down and agreed to manage their exchange rates to prevent trade wars from turning into real wars. In the most recent decade, one could argue that the first exchange of fire in the US-China rivalry began in 2019, when the Trump administration officially labelled Beijing as a currency manipulator. These things rarely end well.
Currency wars are back in the headlines for two reasons: a perennial dispute about China’s exchange rate, and a more recent concern about the sliding value of Japan’s yen.
Let’s take Japan first. For the past four years, Japanese authorities have tried in vain to prop up their weakening currency, which has been stuck at 40-year lows against the dollar. Last week, the intervention took a more serious turn when Washington stepped in to strengthen the yen. It is the first time the US has intervened to support the yen, outside the emergency 2011 tsunami, since the 1998 Asian financial crisis.
A weakening currency can cause problems for a domestic economy. It raises the cost of imports for consumers, reducing households’ purchasing power, and stoking inflation. Japan relies on imports for almost all its energy needs and a bulk of its food supply. The yen’s depreciation has become a bigger headache as Japan is finally generating inflation after four decades of stagnant prices.
The US intervention shows that a weakening yen is not just a Japanese problem, but an American one. Why? Washington has not revealed its motives beyond support for one of its steadfast allies and a belief that the yen is undervalued, given economic fundamentals. But the motives for US action are multiple. The first is the concern that Japan’s hypercompetitive exchange rate, which makes its exports cheaper to the rest of the world, is a threat to US exporters. It was the anxiety of American farmers that forced Ronald Reagan into a managed devaluation of the “super dollar’ at the Plaza Hotel in 1985.
The other driver behind US support for Japan is about the risk that solo action from Tokyo could pose to the US government’s borrowing costs.
Japan is the largest foreign holder of US Treasury bonds. Japanese authorities support the yen by selling foreign currency assets, including US debt. This was the case during its interventions in 2022, 2024 and in April this year, according to Goldman Sachs. Selling Treasuries at scale risks raising US government borrowing costs. Scott Bessent, US Treasury secretary, has offered Japan the use of a repossession facility that will allow it to support the yen without offloading US debt. Bessent has also promised further intervention to stop traders betting against the yen.
The rest of Japan’s G7 allies are unlikely to help like the US. But the currency they do have in their crosshairs is China’s. Germany has joined France and the European Central Bank in calling out Beijing for having an artificially low exchange rate that is damaging European industry and contributing to a record $1.2 trillion trade surplus. Fredrich Merz, German chancellor, has said the renminbi is 25-30 per cent undervalued against the euro and the dollar. He wants China’s trade partners and the Communist Party to fix the imbalance.
Germany knows all too well about currency manipulation. It rode the wave of an undervalued euro to become an exporting juggernaut from the 2000s. But Merz’s comments still represent a significant shift in China hawkishness from the US to Europe over the past year. Berlin has joined Paris in calling China’s export model an existential threat to its domestic car, chemical and green energy industries. Trump, having launched an ill-fated trade war against China last year, is far less bellicose.
Does the currency matter in the debate about how to rebalance global trade? Brad Setser at the Council on Foreign Relations says the extent of China’s financial doping is far worse than institutions like the International Monetary Fund have captured. He argues the renminbi is trading at the same levels against the dollar as it was in 2008. Merz’s 30 per cent undervalued figure comes from Setser’s calculations. “There is a clear correlation between periods of weakness in China’s currency, and periods of Chinese export outperformance,” he says.
Those arguing that it doesn’t matter so much are two of the IMF’s former chief economists and the incoming chief economist at the Bank of International Settlements. Writing in The Economist, the trio argue the undervalued renminbi is not the cause of China’s record surplus, and fixing it won’t make much of a dent in the surplus. It is an odd argument from a group of serious economists, because it is one about politics more than the mechanics of trade.
Exchange rates do matter. But telling a country to strengthen or weaken their currency is a highly sensitive, often inflammatory demand. That’s why the IMF has refrained from calling out China and instead urged more sensible policy changes like increasing the country’s social safety net to jump-start consumer spending. Even in the world of free floating exchange rates, currencies remain a prized part of economic sovereignty. That’s why joining the euro was a non-starter in the UK. It’s why calling out China’s undervalued renminbi will fall on deaf ears.
Mehreen Khan is Economics Editor of The Times
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