The Chinese government has been tightening its control over nearly every aspect of the country’s economy. But the falling value of the Chinese currency in recent months has, for the most part, been an exception. Since April, the yuan has dropped nearly 10 percent against the U.S. dollar, including 3.5 percent since the first round of the Trump administration’s tax on imports kicked in on July 6, to as high as 6.85 against the dollar last Monday. This is important in part because it takes some of the oomph out of the U.S. trade war, as a weakened yuan will offset the effects of tariffs on Chinese exports somewhat. Moreover, it will likely strain ties even further with the White House. In a tweet on July 20, for example, U.S. President Donald Trump lashed out at Beijing, dusting off his oft-repeated accusation that the People’s Bank of China is intentionally weakening the yuan to undercut U.S. manufacturing. And whether or not China is intentionally suppressing the yuan, an even steeper drop would have implications for China’s strategic and economic goals far beyond the trade war. So it’s worth looking at China’s ability to weaponize the yuan in the uncertain months ahead – and just how low Beijing may be willing to let it go.
It’s the Dollar, Stupid
At this point, there’s not much evidence supporting claims that China is actively manipulating the yuan. But it does appear that the PBOC was content to stay on the sidelines for much of the past two months and allow the yuan to fall in line with market forces – at least up to a point. For one, if China were actively propping up the currency, it would have to dip heavily into its foreign exchange reserves to do so. Yet, according to PBOC data released Aug. 7, China’s reserves actually rose in both June and July, by $1.51 billion and $5.82 billion, respectively. (Yes, Chinese data has a well-deserved reputation for being unreliable, but this hasn’t generally been the case for PBOC figures on its foreign reserves.) The PBOC has stepped in a few times when it was concerned about possible capital flight. And, as usual, the bank still allows the yuan to float only within a relatively narrow trading band each day (currently, two points above or below a starting price set by Beijing each morning) to prevent major volatility. But managing the pace of the yuan’s fall is quite a bit different from actively defending it, as the PBOC did forcefully from 2015 until the beginning of this year.
In reality, the downward pressure on the yuan is coming primarily from three dominant factors. The first is the strength of the U.S. dollar, which has been steadily climbing primarily due to the strength of the U.S. economy, tax cuts, tightening Fed policy and, perhaps paradoxically, uncertainties stemming from the trade war. The U.S. Dollar Index, which measures the strength of the greenback against a basket of major currencies, has surged nearly 6 percent since the beginning of April. Indeed, currencies across the world have declined steeply against the dollar. Since April 1, for example, the euro, the South Korean won, the Japanese yen and the Indian rupee have all weakened against the dollar by around 6 percent.
Second, the arrival of the trade war has only compounded fears about the underlying weakness of the Chinese economy, lowering demand for the yuan. The harder Trump swings his tariff hammer, the deeper the yuan is likely to go.
Finally, Chinese President Xi Jinping’s crackdown on shadow lending – the firehose of cheap credit through unofficial channels that has fueled much of China’s growth in recent years, but also created major systemic risks – could actually pull out too much liquidity from fragile sectors. As a result, the PBOC, which had largely been mirroring the Fed’s monetary policy moves for much of the past year, has finally diverged by, for example, cutting reserve ratio requirements three times since April and injecting money into the banking system through its medium-term lending facility twice in July.
China’s Risks and Rewards
Naturally, China stands to benefit from the weaker yuan in some ways. An 8 percent decline in value means that goods saddled with a 10 percent tariff would be, at most, 2 percent more expensive for U.S. consumers, depending on various factors that determine the stickiness of prices for any particular good. Thus, it will help Chinese exporters stay competitive and cushion the blow for the economy as a whole. (Of course, goods facing 25 percent tariffs will still get hit hard, especially large ticket items.) Declining to intervene to stop the yuan’s slide will also help the central bank keep its war chest of foreign reserves brimming and avoid having to tighten capital controls – a move that generally spooks foreign investors and markets, not to mention China’s own business class. It would also burnish the bank’s liberal credentials as China seeks to further internationalize the yuan.
What China wants most is to avoid a disorderly decline of the yuan. If the currency even appears to be nearing free fall, or if speculators think that the PBOC is about to manipulate the yuan substantially downward, those with the ability to swap their yuan for the dollar or another foreign currency are likely to rush to do so. In this scenario, Beijing loses control. This is why the PBOC announced on Aug. 3 that it would reintroduce an opaque “counter-cyclical factor” as part of its calculations for setting the yuan’s opening price each day. (The PBOC used this mechanism to strengthen the yuan from May 2017 to January.) The bank has also announced that banks will need to hold reserves equal to 20 percent of their foreign exchange forward positions to help keep the yuan flexible and, in the PBOC’s words, prevent “herd behavior and momentum-chasing moves in the currency market.”
China has myriad reasons to want the capabilities to step in when things start getting out of hand. Looming large are the ghosts of 2015 and 2016, when a 2 percent devaluation of the yuan sparked mass sell-offs of Chinese stocks and uncontrolled capital flight – despite reasonably strong underlying fundamentals in the Chinese economy. When all was said and done, the PBOC had spent some $1 trillion of its foreign exchange reserves to stabilize the situation. No amount of foreign exchange could repair the damage done to the Communist Party’s credibility as steward of China’s growth “miracle.”
Furthermore, an intentional devaluation would make it harder to attract foreign investment at a time when Beijing is trying to offset some of the trade war pain and portray itself as champion of the global system. Perhaps most problematic is China’s estimated $775 billion in outstanding dollar-denominated corporate bonds (per Nomura estimates), which would get more expensive and risk a cascade of defaults. (According to Bloomberg estimates, there have been $4.9 billion in corporate bond defaults so far this year.)
Finally, it would give China less money to splash around abroad. This would further undermine Beijing’s ability to make strategic investments in Western high-tech companies – a core part of China’s plans to escape what’s called the middle-income trap and compete in the industries of the future – at a time when Western governments are increasingly scrutinizing such investments. Similarly, it would give China less money to spend on One Belt, One Road projects (on which many countries prefer to do business in dollars), undermining Beijing’s strategic and economic goals on multiple fronts. The trade war is certainly going to sting, but China may very well think it has bigger strategic and economic fish to fry.