U.S.–China Currency Trade War: Yuan Peg and Imbalances

Introduction: Trade Tensions and the Yuan Peg

Over the last several years, the issue of trade between the U.S. and China has been increasingly brought to the forefront. The main reason for this is that the reforms that have taken place are allowing China to quickly become a major economic power, as it has become the largest exporter in the world while holding tremendous amounts of currency reserves and foreign debt. This is significant because the large current account surplus China is experiencing has caused some nations — notably the United States and the European Union — to accuse China of engaging in a new form of mercantilism at their expense. Mercantilism, in this context, describes nations competing with one another with the intention of creating large current account surpluses by unfairly flooding trading partners with cheap imports. If left unchecked, this dynamic has the potential to create vast inequalities in the global economy as key areas are deprived of wealth.

As a result, the artificial peg on the Chinese currency — the yuan — has become a source of major contention. Because of the peg, the yuan has become significantly undervalued, making Chinese imports much cheaper in foreign markets. At the heart of the issue is the overall rate at which China should allow its currency to appreciate, as many Western nations are calling for the peg to be completely removed. They argue that this would help address the obvious trade imbalances that are occurring. China, on the other hand, believes it should take gradual steps toward revaluation, fearing that drastic currency moves could negatively affect unemployment and economic growth. Relations between these nations and China have consequently become increasingly strained.

This is the heart of the potential trade war: the overall pace of currency revaluation could spark heightened tensions and animosity between the world's two largest economies.

China's Economic Rise and the Dollar Peg

The growth of China in the world market first began in the late 1970s and involved shifting the allocation of various resources away from the government toward private entities. This was part of a larger plan to modernize China and bring the nation into the ranks of developed economies. Over time, this policy meant that certain mechanisms needed to be in place to sustain continued economic growth — chief among them the pegging of the yuan against the U.S. dollar. This arrangement allowed China to maintain an advantage by exporting cheaper manufactured goods into the United States. As various trade barriers and restrictions were reduced to facilitate increased commerce between the two nations, China was able to experience consistent trade surpluses while the U.S. accumulated large trade deficits. This situation became increasingly problematic, as it meant the U.S. was experiencing a loss of wealth and economic power at China's expense.

To rectify the situation, many in the U.S. began calling for a loosening of the currency peg against the dollar. They felt that allowing greater currency fluctuation would enable the market to correct the natural imbalances that had developed. As noted, the primary reason for maintaining the peg was to provide China with consistent economic growth by keeping its currency at a set rate. This stance has caused sharp divisions between the U.S., broader world opinion, and China, as numerous countries believe the current policy gives the yuan an unfair competitive advantage in world markets.

Fears are running high that a potential currency war could take place between the U.S. and China on an economic front. This situation bears a resemblance to the Suez Crisis of 1956, when Britain was facing declining influence in the world and became involved in a military conflict over the Suez Canal. While no military conflict will occur in the present situation, the U.S. faces similar challenges with China regarding the yuan, which increases the possibility of an escalating currency war.

Calls for Currency Revaluation and Global Divisions

The divisions over revaluation are not limited to the U.S. and China alone. A number of countries, including members of the European Union, have expressed concern that China's undervalued currency creates systemic unfairness in global trade. These nations broadly support calls for more rapid appreciation of the yuan, though they differ on how much external pressure is appropriate to apply on a sovereign monetary policy decision.

Because China has been slow to respond to international pressure, the U.S. has engaged in a policy of weakening the dollar in order to prevent spiraling deflation in its own economy. This policy choice has generated its own controversies, as some countries — such as members of the EU — feel that U.S. dollar weakening is contributing to rising global inflation. The obvious differences in how to tackle the underlying problem of currency imbalance are becoming ever more apparent, with each major economic bloc pursuing its own approach rather than reaching a coordinated multilateral solution.

Conclusion: The Path Forward

A possible trade war could be emerging between the U.S. and China. The differences of opinion on how quickly to revalue the yuan are leading to calls for more aggressive action. The U.S. is contending with a large trade deficit and a stagnant economy, both of which are producing a loss of economic opportunity. As a result, a shift has occurred, with the U.S. government devaluing the dollar to address these issues. This development underscores that at some point, China must eliminate the dollar-based peg on the yuan. Otherwise, the odds increase dramatically that a currency war will take place, with damaging consequences for the global economy as a whole.