Why Weaker Yuan Risks Making Trade War a Currency War

(Bloomberg) -- China's management of its currency, the yuan, is under fresh scrutiny after a record eight-week drop in the exchange rate made it a focus in the U.S.-China trade war. The yuan has tumbled more than 6 percent against the U.S. dollar since mid-June, just as the two sides ratcheted up tariffs and threats of more to come. That's the most significant slide since 2015, when a surprise devaluation roiled markets. Chinese officials say they favor a stable currency, and economists say some weakness in the currency is justified. But since a weaker exchange rate makes Chinese goods cheaper, there's at least some risk the trade war will spiral into a currency war.

1. Is China pushing down the value of the yuan?

At the least, it's been letting the yuan slide. The currency doesn't float freely but is instead managed using a fairly opaque system in which the central bank fixes daily reference rates. Starting in mid-June, the yuan went on a record slide that took it to its lowest level in more than a year against the dollar. Though Chinese leaders have long said they want a more flexible exchange rate, the timing of the yuan's decline has some wondering if the trade war is becoming a currency war. On July 19, U.S. President Donald Trump said that China's currency “is dropping like a rock,” putting the U.S. “at a disadvantage.” The People's Bank of China on Aug. 3 made it more expensive for local traders to bet against the yuan, a surprise move that analysts said demonstrated the depreciation had gone far enough for the central bank. Even so, the yuan weakened after an early rally during the next trading day.

2. What has sent the yuan down?

Unlike in 2015, when the PBOC triggered an abrupt devaluation that spooked global markets and triggered panicky capital outflows, the yuan's latest depreciation is seen by many investors and economists as a reflection of market forces. Those include the contrast of the U.S. Federal Reserve raising interest rates versus China's slowing economy and efforts by policy makers in Beijing to juice growth. Bloomberg Economics estimates that the yuan is overvalued by about 5 percent as of Aug. 6 based on economic fundamentals. None of which is to suggest that China's leaders are not following events closely. Fielding Chen and Tom Orlik wrote in their Bloomberg Economics analysis, “There's a sense that the decline is in line with Beijing's wishes and -- if they want -- under their control.”

3. What's the weaker yuan done to global financial markets?

So far, it has had a noticeably more subdued effect than in 2015 and during another bout of weakness in early 2016. On July 20, after China cut the yuan's daily reference rate the most in more than two years, futures contracts on the Standard & Poor's 500 Index, Asian equities and oil all dropped for a time before rebounding.

4. What does the weaker yuan mean for the trade war?

A weaker yuan will cushion the blow to China of U.S. tariffs, but it comes at a cost. It has already drawn the ire of Trump, who frequently accused China of manipulating its currency when he was campaigning for the U.S. presidency. Those complaints faded as China shifted its focus to strengthening the currency in response to brightened prospects for the Chinese economy. Now the trade war is on and prospects for China's economy are dimming. Hence the risk of currencies re-entering the political fray.

5. How much weaker might the yuan get?

China has reasons to avoid sustained declines in its currency. After the experiences of 2015 and 2016, it burned through about $1 trillion of reserves to stem an exodus of capital. Morgan Stanley estimates that China saw $10.7 billion in cross-border outflows in June. PBOC Governor Yi Gang and other senior officials have emphasized that China favors a stable currency. Chinese authorities have taken steps to ensure the slide doesn't get unwieldy, for example, rigorously enforcing strict rules on moving money into and out of the country. A key milestone for the local currency is 7 per dollar, a level it hasn't weakened past in more than 10 years. On Aug. 3, it tumbled as low as 6.8965 per dollar as the yuan experienced its longest weekly losing streak since China's modern exchange-rate regime began in 1994.

The Reference Shelf

QuickTake explainers on China's path to a liberated yuan and how trade became a national-security issue.
A currency war would be hard on emerging markets.
Could China's currency overtake the dollar?
Timeline to the trade war.

--With assistance from Will Davies and Tian Chen.

To contact the reporter on this story: Enda Curran in Hong Kong at ecurran8@bloomberg.net

To contact the editors responsible for this story: Malcolm Scott at mscott23@bloomberg.net, Laurence Arnold, Grant Clark