US Institutions try and keep Trumps Currency war at bay.

US authorities labelled China a currency manipulator on 5 August 2019 for the first time in 25 years after the RMB fell below the 7 RMB-per-dollar level. This was despite China’s actions failing to satisfy the US Treasury’s own definition of a currency manipulator. While US institutions may keep President Trump in check in the near term, this represents a dangerous escalation in tensions and a serious challenge to financial markets, US institutions and the rules-based system.

An undervalued exchange rate makes a country’s exports cheaper than they otherwise would be compared to those of other countries. Economists measure whether an exchange rate is undervalued by calculating what an exchange rate ought to be based on, the characteristics of that economy, how much it trades with the world, how much it invests overseas and how much other countries invest in it. If an exchange rate is below what these fundamentals imply it ought to be, it is possible (though not conclusive) that the country is depreciating its exchange rate to achieve a competitive advantage.

US punishment of these economies for currency manipulation would rightly leave them feeling aggrieved and make the prospect of a currency war more likely. The costs would be substantial. Most economic models suggest that a currency war will distort trade and investment flows. But it is also likely to cause panic among investors. Unpredictable exchange rates, combined with restrictions on trade and cross-border commerce, will see investors sit on their cash and withhold investment. The hit to growth and employment could be substantial.

The critical question is whether Trump is able to wage a currency war or not. The independent US Federal Reserve has so far held its ground. Although it cut interest rates recently, weakening the US dollar, Fed Chair Jerome Powell was crystal clear that this was a one-off and was not part of a new cycle of rate cuts.

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