Why a Weaker Yuan Risks Inflaming the U.S.-China Trade War

(Bloomberg) -- China’s management of its currency, the yuan, is under fresh scrutiny after recent weakening brought it back into focus in the U.S.-China trade war. The yuan slid closer to 7 to the dollar, a line it hasn’t crossed in more than 10 years, just as the two sides again ratcheted up tariffs with threats of more to come. Chinese officials say they favor a stable currency, and economists say some weakness 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. U.S. Treasury Secretary Steven Mnuchin at one point stoked expectations for the “strongest ever” currency agreement to avoid competitive devaluations, even as Chinese officials talked about the need to respect their autonomy.

1. How is value of the yuan determined?

The Chinese currency doesn’t float freely but is managed using a fairly opaque system in which the central bank, the People’s Bank of China, fixes daily reference rates. Starting in June 2018, when the U.S.-China trade war began to heat up, the yuan went on a slide that took it to its lowest level in more than a year against the dollar. On Aug. 3 the PBOC 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. On May 20, 2019, the PBOC set the daily reference rate at a level stronger than analysts and traders projected, a sign that Beijing was seeking to slow depreciation again. The currency stabilized as officials stepped up verbal support.

2. What’s affecting it now?

The trade war. It strengthened after U.S. President Donald Trump called a truce on new tariffs, but began to slide again after talks collapsed in May. Analysts cited souring market sentiment, as China’s economy slows and the U.S. ramps up tariffs. But the decline also hands potential ammunition to trade hawks in Washington. Warning that the escalating trade war could destabilize the global economy, China’s central bank has vowed to continue with targeted stimulus and keep the currency steady.

4. What does a weaker yuan mean?

It would cushion the blow to China of U.S. tariffs by making Chinese goods more competitive relative to the dollar. But that comes at a cost. A weaker currency creates incentives for households and companies to move their money out of the country and into stronger currencies. That would force the government to draw on its reserves -- the world’s biggest at more than $3 trillion -- to buy yuan to prop up its value. In 2015 an abrupt devaluation spooked global markets and triggered panicky capital outflows. The country burned through about $1 trillion of reserves to stem that exodus.

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?
• Is Magic 7 for the yuan a myth?
• Bloomberg Opinion’s Shuli Ren sees more bumps ahead.

--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, Paul Geitner, Jeffrey Black

©2019 Bloomberg L.P.