The value of China’s yuan dropped to a four-month low against the US dollar this week after the latest flare-up in US-China trade tensions as a promise by Beijing that it will not use depreciation as a tool to fight the trade war did little to allay investor concerns.
The Chinese currency’s 2 per cent decline over the last two days to around 6.90 has pared much of this year’s gain on a strengthening view that Beijing might let the exchange rate weaken as part of its retaliation to mitigate the hardship from higher US tariffs and to spur exports to arrest an already slowing economy.
Any further depreciation, analysts warned, would also test policymakers’ resolve to prevent volatility in the partially convertible currency from spilling over to other Asian and global financial markets.
At China’s Belt and Road Forum in April, President Xi Jinping promised that China would keep the yuan stable “within a reasonable range” and would not engage in any “beggar-thy-neighbour” currency devaluation.
But if tariffs were ultimately implemented on all US imports from China, Beijing would have less to gain from supporting the yuan than allowing the market to weaken it, said Julian Evans-Pritchard, senior China economist at Capital Economics.
China’s exchange rate policy is at the heart of trade negotiations because the US administration has demanded that Beijing agree to limit the yuan’s decline to the extent that it did not fully offset the US tariff increase – a condition that analysts said was acceptable to Beijing to end the trade war.
US President Donald Trump’s decision last Friday to more than double tariffs to 25 per cent on US$200 billion of Chinese goods that sent the yuan lower this week, however, has sparked concerns that Beijing may reconsider that agreement.
In addition, the Trump administration is preparing to slap another round of tariffs of up to 25 per cent on US$300 billion more worth of Chinese goods, which could take effect as soon as July after a public consultation period.
“The thing which would utterly torpedo trade talks right now would be if you saw a sudden and sharp depreciation of the yuan,” said Rob Carnell, chief economist and head of Asia-Pacific research at ING Bank.
“Everything else is fair game for policymakers to offset any negative consequence of the increased tariff, such as tax thresholds, or [value added tax rates], or import subsidies.”
While Beijing has countered tit-for-tat with a tariff increase on Monday on US$60 billion of goods, the size of the move underscores the much smaller scale of China imports from the US.
Pressure on the yuan so far was also clear evidence that China had to bear most of the cost of the tariffs, wrote currency analyst Greg Gibbs in a research note published on the fintech research network Smartkarma, because the weaker exchange rate pushes up the cost of Chinese imports and reduces the purchasing power of Chinese consumers.
“[The yuan’s] fall is indicative of lost competitiveness, and the potential hit to sales the tariffs impose on companies in China that are exporting to the USA,” Gibbs said.
The Chinese currency’s slump has dragged down other Asian currencies, with South Korea’s won down to an 18-month low and Indonesia’s rupiah trading at its weakest level against the greenback this year. Japan’s yen is trading near a three-month high, given its safe-haven status.
The yuan has not breached that threshold since the 2008 global financial crisis because policymakers have cautiously kept the level in check, as a sharp fall could dampen the confidence of Chinese investors and businesses, triggering a vicious cycle of currency depreciation and capital outflows. It would also tighten domestic credit conditions, making it more costly for consumers and companies to borrow, as well as resulting in repayment difficulties and more debt defaults.
China’s boom-to-bust equity market cycle in 2015-2016 was accompanied by a sharp yuan devaluation that not only roiled global stock and currency markets, but also led to significant capital outflows and a slowdown in the Chinese economy.
“There’s still a very fresh memory of the panic. The equity market meltdown and the devaluation of the currency triggered concerns about China’s policymaking process,” said Tommy Dongming Xie, economist at OCBC Bank.
“As sentiment turns, people become more cautious. They start to worry about their investments and they start to worry about their consumption.”
Since then, the People’s Bank of China (PBOC) has implemented strict regulatory measures to ward off capital outflows by blocking channels through which Chinese residents and companies can send money abroad.
It has also customarily used moral suasion, its daily yuan reference rate, as well as administrative and capital controls to stabilise the yuan’s exchange rate.
On Wednesday, the PBOC issued 10 billion yuan (US$1.5 billion) each of 3-month and 1-year yuan-denominated bills in Hong Kong, which will result in a withdrawal of funds from the city’s banking system, effectively supporting the Chinese currency offshore, the yuan’s exchange rate outside the mainland.
Analysts warned, however, that no matter how strong China’s capital control framework was, there would always be ways for capital outflows. A deal to end the trade war was still possible, but the volatility of the yuan may continue in the run-up to next month’s G20 Summit in Osaka, where Trump said he would meet with Xi, they said.
“China has installed back stops to slow down the movement of its currency, but in the end it is still decided by the market,” Xie said.
“The 7.00 level is no magic level and ultimately [the pricing of the yuan] would depend on events, how people think, and their expectations.”