The real cause of the US-China trade war is the dollar. Namely, the dollar/renminbi exchange rate.
This may seem paradoxical as tariffs have skyrocketed to levels unthinkable in the recent past and the free trade agreement on both sides of the US-China trade war.
What needs to be considered is a high-stakes macroeconomic agreement between the US and China centered on the US dollar. What is true today:
1. China faces enormous exposure to dollar-denominated debt.
2. Both Beijing and Washington recognize this vulnerability.
3. China has been willing to escalate tariff and trade battles to project a tough stance at home and abroad, and
4. In any trade deal scenario, the price China would seek in return would be concessions from the US that would lead to a “soft” dollar exchange rate.
This would benefit both China and the US, giving the US leverage in ways that mainstream media and news headlines have so far ignored.
The analysis must combine the risks of China’s debt exposure, currency pressures, and the geopolitics of the trade war.
A Growing Mountain of Dollar Debt
China’s external debt has been rising over the past two decades, making it the largest borrower of foreign capital in emerging markets. Officially, China’s gross external debt (total debt owed to foreign creditors) reached $2.5 trillion at the end of 2024.
A very large share of this is denominated in dollars: by the end of 2023, about $1.1 trillion in direct dollar debt for mainland China, and potentially much higher if indirect liabilities are included.
Some analysts estimate that China’s actual exposure to dollar-denominated debt is closer to $3 trillion, when including dollar-denominated debt held by Chinese companies through offshore subsidiaries (e.g. in Hong Kong, Singapore, or the Caribbean). Moreover, these figures are for past years and are likely to be higher now.
At around $3 trillion, that would be about a sixth of China’s annual GDP. In fact, China alone accounts for about a quarter of the total stock of $13 trillion in non-bank dollar credit outside the U.S.—a staggering amount that shows how deeply dependent China is on the dollar system.
Why is dollar debt dangerous (for China)?
Foreign currency borrowing, also known as the “original sin” of emerging markets, carries unmanageable risks.
When an economy borrows in dollars but earns revenue in its local currency (the renminbi or RMB, in China’s case), any depreciation of the local currency against the dollar increases the effective debt burden. More currency is needed to service the same dollar debt, potentially squeezing corporate cash flows or even causing a domino effect of defaults.
This currency mismatch has fueled emerging market crises in the past: for example, the 1997 Asian crash was largely caused by a surge in local debt after currencies collapsed against the dollar. Cheap dollar credit could become a noose if the yuan weakens sharply.
Systemic risk and its contagion
The sheer size of China’s dollar liabilities means that this is not an issue that Chinese authorities can easily overcome. If Chinese companies struggle en masse to refinance or repay dollar debts, the pressure would be transmitted to global credit markets, upsetting credit conditions. Chinese banks alone owed over $1 trillion in cross-border dollar funds by the end of 2023.
A scramble to raise dollars from Chinese entities in a stress scenario could limit global dollar liquidity, raise funding costs, and even set US markets on fire (for example, through massive bond sales or a massive dollar cash infusion).
In short, China’s exposure to dollar-denominated debt represents a potential systemic risk, of which both China and the US are well aware.
Why does a stronger dollar exacerbate China’s vulnerabilities?
A stronger U.S. dollar usually means a weaker yuan. The Chinese currency is stable, but there is a limit to how much pressure the Chinese authorities can withstand before they have to widen the range of fluctuations. This dynamic directly puts pressure on Chinese borrowers with dollar-denominated debt.
Every percentage point increase in the USD/RMB exchange rate makes servicing dollar-denominated loans more expensive in domestic terms. For heavily indebted Chinese real estate developers or Chinese banks that have borrowed abroad, a rising dollar could wreak havoc on their balance sheets.
The dollar is now at its highest level against the RMB since China devalued its currency in 2008-2009. China’s growing external leverage in dollars makes it particularly vulnerable in an environment of tight dollar liquidity and a weakening yuan.
The episode from late 2014 to 2016 is instructive: the dollar rallied sharply as the Fed reversed its quantitative easing (QE) policy and appeared open to interest rate cuts, while the yuan came under intense depreciation pressure.
The risk of capital outflows
A strong dollar tends to drive capital outflows from emerging markets as investors seek the safety and higher returns of dollar-denominated assets.
In the case of China, expectations of a depreciation of the Chinese currency can lead domestic businesses and households to suddenly withdraw liquidity from the country.
This is what happened in 2015-2016: Faced with a potential Fed rate hike cycle and a slowing Chinese economy, people feared a devaluation.
The result was a flood of outflows, and the PBoC (China’s central bank) had to spend huge amounts of foreign exchange reserves to stabilize the currency. As it turns out, reserves fell by about 20% (over $800 billion) during that period.
China’s foreign exchange reserves
Of course they were right to do so, as the dollar started 2015 at 6.2 CNY and ended 2016 at 6.9. Beijing had to impose tighter capital controls to stop the bleeding.
This episode exposed China’s monetary dilemma: its now $3 trillion wartime foreign exchange “reserve,” while vast, is not inexhaustible, especially when faced with the steady strength of the dollar.
Thus, a persistently strong dollar is a nightmare scenario for China’s economic authorities – forcing them to either tighten domestic monetary policy or face a debt crisis with an unknown outcome if the domestic currency weakens.
Monetary Policy Constraints for Beijing
The strength of the dollar also limits China’s flexibility in shaping monetary conditions. Normally, faced with an economic slowdown, the PBoC would ease monetary conditions to stimulate growth.
But if easing threatens to weaken the RMB too much, there is a risk that the dollar-denominated debt of borrowers could worsen and trigger a rapid capital flight.
In other words, a strong dollar traps China in a policy dilemma, especially when its economy is under pressure as it is today.
Therefore, Chinese officials are acutely sensitive to fluctuations in the dollar, as its rise not only tightens global financial conditions but also directly threatens China’s financial stability through its money supply.
Both Beijing and Washington are aware of the situation.
It is no secret that China’s exposure to dollar-denominated debt is a pressure point that Donald Trump will exploit.
Chinese policymakers have openly acknowledged efforts to mitigate reliance on the US currency: for example, diversifying foreign exchange reserves (reducing the dollar’s share from 79% in 2005 to 58% by 2014, after which they have not provided official figures), promoting offshore RMB purchases – notably with Russia and more broadly through the BRICS – and boosting bilateral trade in yuan.
The US, in turn, recognizes that the strength of the dollar can be used as leverage. US analysts and officials watched China’s 2015 scare and subsequent moves.
By 2018, as trade tensions were rising, it became clear in Washington that a combination of Fed tightening and a trade war would put pressure on China’s currency.
Indeed, U.S. Treasury staff even considered whether China might let the RMB weaken in retaliation and how that would affect the negotiations.
The United States Treasury Department accused China of being a “currency manipulator” in August 2019, when the RMB fell below 7.0 per dollar for the first time since 2008. This statement had more symbolic than real value, but it showed that the US was paying attention to the currency aspect of the trade war.
This designation was removed after a few months, as a trade truce emerged.
Donald Trump’s Currency Targeting
President Trump himself is fixated on currencies, breaking away from the traditional strong dollar mantra of previous administrations. He has often complained that a too-strong dollar has hurt U.S. exports and manufacturing.
In mid-2019, as China’s economy appeared to be faltering, Trump publicly pressured the Fed to cut interest rates and even floated the idea of direct foreign exchange intervention to weaken the dollar. Washington insiders and the Fed understood that the dollar’s global strength was tightening financial conditions, and by July 2019 the Fed had turned to rate cuts, easing some of the dollar’s pressure on the Chinese currency.
So both countries knew the unwritten equation: if the trade war escalated and the Fed remained hawkish, the dollar could soar, hurting China and possibly hurting the US itself through global spillovers.
In contrast, a deal that would end tariffs and loosen the dollar system would benefit China’s financial stability and potentially US exporters.
This mutual realization set the stage for using trade negotiations as part of a geopolitical chessboard, with the dollar as a key “pawn.”
Tariffs as a tool for geopolitical bargaining
So tariffs become a bargaining chip. That’s clearly what they are. That’s what they were in the previous trade war in 2018-2019. Trump wants to reduce the US trade deficit. He shows he holds the cards and wants trade concessions. Let’s see how he leveraged tariffs last time.
Trade war theater
The US-China tariff war (2018-2019) became more than just an economic dispute, it was a theater of geopolitical confrontation for both domestic audiences. China retaliated with tariffs for economic purposes, but also to demonstrate its geopolitical and economic power. President Xi Jinping needed to maintain the domestic legitimacy of his regime, so he had to respond to US tariffs in an exemplary manner, because giving in to US demands would make him look weak.
The United States imposed new tariffs, to which China responded by imposing tariffs on American products specifically targeting agricultural products to affect states more friendly to Trump. This extreme behavior served to rally patriotic sentiment at home: China was not going to be intimidated.
Internationally, it sent a message that China would not be swayed by economic aggression. At the same time, President Trumo’s tariff moves were also a show of force, showing his electorate that he was tough on China. Thus, both sides engaged in an escalating trade standoff, even as they understood behind the scenes that a solution would eventually be needed.
The tariffs hurt both economies (disruption of supply chains, increased cost of goods/inflationary pressures, reduced exports), but each side was willing to tolerate short-term “pain” in order to achieve optimal strategic positioning.
The hidden leverage of tariffs
Trade policy thus became a bargaining chip to achieve monetary policy goals, which in turn serve global liquidity goals, which in turn fuel the economy. China could use the prospect of ending the trade war as a carrot to extract concessions from the US.
One such key concession is the dollar. In practice, this means: China would come to the table (agreeing to buy more US goods, modify certain practices, etc.) if the US in return eased tariffs and tacitly allowed the dollar to weaken.
From China’s perspective, a tariff truce without some relief from the pressure on the dollar would be an incomplete solution. After all, if the trade war were to end, but the Fed continued to cut rates and the dollar continued to rise, China’s economic pain could continue.
Beijing’s negotiators likely made it clear that currency stability was integral to any deal. We saw hints of this agreement: in the Phase 1 trade deal (signed in January 2020), China agreed not to engage in competitive currency devaluation.
Both sides included a currency agreement, committing to transparency in currency movements and avoiding manipulation to gain trade advantages. This was essentially leverage on the part of the US that China would not weaken the RMB to offset the tariffs.
Implicitly, it also meant that the US would not intentionally push the dollar higher. Indeed, soon after, the Fed’s stance became downright paranoid. Even if this was reinforced by the pandemic, the seeds had already been sown.
The sequence is telling: as trade tensions peaked in 2018-19, the US dollar index (DXY) rose ~10% during tariff announcement periods and the yuan fell ~10% in 2018 and another 5% in early 2019. As a truce began to be achieved, the dollar flattened and then weakened in 2020, giving relief to China and other emerging economies.
It’s as if the US used tariffs and a strong dollar as a stick… then offered the carrot of tariff relief and a weaker dollar to seal the deal. This time, China would have to come back to the table with trade concessions, perhaps commitments to buy US energy, agricultural products, manufacturing equipment, and in return, the Treasury and the Fed (who, while independent, seem to have some level of cooperation), would allow a weaker dollar.
A Weaker Dollar as Part of the Big Deal
If the dollar weakens broadly, two major benefits accrue to China:
- The RMB can either strengthen or at least remain stable against the USD, reducing the depreciation pressure on the Chinese currency. This eases the burden of dollar-denominated debt – effectively deflating debt in local terms. Chinese companies are particularly finding it easier to service and refinance their loans.
- As global dollar liquidity conditions improve, funds that had fled to the safety of dollars can return to emerging markets, easing pressure on China’s financial system. Typically, a softer USD is associated with increased global trade and commodity prices, as many goods are priced in USD, which can boost export earnings and nominal GDP growth in China, making debt burdens more sustainable.
Global Liquidity and the… Dollar Smile
A weaker dollar tends to coincide with improving global financial conditions.
For example, when the Fed eases monetary policy or when investors feel confident about seeking risk abroad, the dollar depreciates. In the late 2010s, many macro investors argued that the next phase of global growth would require a decline in the dollar to unlock excess liquidity.
We saw this in action after 2019: the Fed’s rate cuts and QE (quantitative easing) in 2020 led the dollar index to slide sharply, and global dollar liquidity measured by cross-border lending, use of SWAPs (swap lines), etc. increased, benefiting not only China but all dollar debtors.
The global money supply M2 soared alongside this dollar weakness, fueling a market rally.
Global M2 (TradingView)
From China’s perspective, securing a weaker USD is like opening a safety valve in its financial system. It reduces the need for Beijing to undertake its own massive QE or bailout programs, although China did ease credit significantly in 2019-2020, and its own M2 money supply expansion was also purely expansionary.
The US Need for a Weaker Dollar
While the US has historically maintained a strong dollar rhetoric, there are times when a cheaper dollar is seen as beneficial to economic growth.
The 1980s and recent years provide examples
In the context of the trade war deal, the weakening of the dollar was actually in line with Trump’s goals of reducing the trade deficit
A cheaper dollar makes US exports more competitive and foreign goods relatively more expensive, which is what the tariffs were intended to do. The US welcomed a mild decline in the dollar until late 2019 as it faced low inflation and strong growth in the manufacturing sector, which prompted the Fed to adopt an aggressive stance. The US has conceded a weaker dollar because China will uphold its trade deal commitments and avoid unilaterally devaluing the RMB.
How will the dollar weaken?
In practice, how does one allow the dollar to weaken? The White House does not set the exchange rate, but it indirectly influences the Fed and the Treasury and has the ability to intervene in the currency markets if it chooses.
With Donald Trump in the White House, the Fed and the hint of intervention have been used to weaken the dollar.
By not raising interest rates and signaling continued easy money, US policymakers have essentially given the green light for the dollar to slide in 2020.
The result was exactly what China and other emerging markets needed.
Historical Parallels and Precedents
This is not the first time the US has faced the following situation: High dollar + high trade deficit. Let’s look back at two overlapping situations in the 1980s and 1990s.
This famous agreement is a clear historical analogue of the coordinated devaluation of the dollar as a policy tool.
In September 1985, the United States gathered its major trading partners—Japan, West Germany, France, the United Kingdom—at the Plaza Hotel in New York and struck a deal to jointly weaken the U.S. dollar. The dollar had risen by 50% in the early 1980s, thanks to the Fed’s high interest rates under the deficits of the Volcker and Reagan eras, and U.S. industries were bleeding under a huge trade deficit.
The Plaza Accord’s stated goal was to reduce the U.S. trade deficit by devaluing the dollar against the yen, the franc, the pound, and the mark. It was successful: over the next two years, the dollar lost 40% against a basket of major currencies. Correspondingly, US trade balances subsequently improved.
Japan and Germany accepted a much stronger yen and the Deutsche Mark as the price for avoiding US tariffs.
In many ways, this was the greatest deal of the era: the US got a weaker dollar in exchange for not adopting tougher trade barriers, while Japan got some respite from trade frictions with its larger economy at the cost of exchange rate pain.
The Plaza Accord is relevant to today’s US-China dynamic: the US is once again running large deficits and there is speculation about a new deal like the Plaza Accord to realign currencies. China’s situation is also analogous to Japan in the 1980s: a country with a large trade surplus under US pressure.
However, in this case it is the country with the trade surplus that actually wants the dollar to weaken, while Japan in the 1980s was somewhat reluctant but also obliged.
US-Japan Trade War
Beyond the Plaza, the late 1980s and 1990s saw ongoing economic friction between the US and Japan. After the Plaza Accord boosted the yen, Japan entered a cycle of monetary easing to offset slowing exports, which contributed to a late 1980s asset bubble in Japan (JPXN) and then the crash that led to the infamous Lost Decade.
Meanwhile, the US pushed Japan into various negotiations to open its markets and reduce its trade surplus. At times, the US threatened tariffs on Japanese goods to force compliance.
A parallel can be drawn: the US in the late 2010s similarly imposed tariffs on Chinese products and demanded structural changes (in IP, market access, industrial policy). In the case of Japan, one result was that by the mid-1990s, the yen had been allowed to appreciate to record levels, which stifled Japan’s export competitiveness and led to deflation.
The US then ironically agreed to reverse the 1995 Plaza Accord to stop the dollar’s decline because it had gone too far.
The stakes today: a controlled revaluation of the exchange rate is difficult
Both China and the US would like to avoid a disorderly plunge in the dollar or a sharp rise in the RMB that could destabilize China’s economy. However, the risk is lower here, given China’s interest rate setting, which has proven to be able to reasonably control credit conditions.
In the 21st century, the dollar fell for almost a decade, which helped to narrow the US-China imbalance somewhat, as the RMB was allowed to gradually appreciate from 8.3 to the dollar. in 2005 to 6.0 by 2013.
This period of RMB appreciation was accompanied by a boom in Chinese exports, allowing the Chinese to easily accept it. This time, they will beg the US for help in easing their currency.
In short, history shows that trade conflicts often result in adjustments in currency rates. This time is no different…
A grand macroeconomic deal for the next business cycle
We are talking about a grand deal where monetary leverage (the dollar) meets trade leverage (tariffs). China’s huge dollar-denominated debt exposure is the Achilles heel on which the US can exploit (either by design or as a byproduct of Fed policy).
But too much push threatens to destabilize the entire global financial system, which would be mutually damaging. So the logical conclusion is a deal: China wins through a softer dollar and greater global liquidity, and the US wins through trade concessions and reduced risk of financial sector destabilization.
The events of 2018-2020 largely followed this scenario. China’s insistence on projecting power through retaliatory tariffs was a domestic necessity, but ultimately both sides sat down to negotiate once the costs increased.
The resulting quid pro quo was exactly what was described: tariff relief and a tacit green light for a weaker dollar in exchange for China’s cooperation.
Looking ahead, conditions are reminiscent of the 1980s: the US is running huge budget deficits and will need a weaker dollar to stabilize its debt and economy. The royal road to avoiding a regime of overvalued currency and twin deficits is devaluation.
China, facing slower growth and high debt, would certainly not refuse a break from the dollar’s strength. We may not have a formal Plaza Accord II, but the pressure for a dollar depreciation is growing. China and the US have engaged in a controlled conflict (tariffs, posture) knowing full well that the real leverage points were monetary.
The public drama unfolding was about fair trade, jobs, negotiations, but the understanding behind the scenes was that stability required the US to not let the dollar rise. In return, the US would get a deal it could sell as a victory.
The direction of the dollar’s exchange rate can be affected by such major negotiations. And when the dollar moves, everything from Chinese corporate creditworthiness to US corporate profits to global equity liquidity moves with it.
Over the next few months, we should see a reduction in the uncertainty that financial markets abhor, both for the S&P 500 and the Nasdaq. That should also be a bullish signal for cryptocurrencies like Bitcoin.
