China’s economy continues to face increasingly severe headwinds from the higher U.S. tariffs. Economists now believe that in response, the country will avoid doing what most other countries might do and aggressively devalue its currency, the yuan. Newly implemented tariffs are adding further weight on China’s faltering export-driven economy. This economy is already calling signs of over-expansive growth. Policymakers are just beginning to contend with the deep challenges of capital outflow and financial market fragility. Consequently, a hard landing and/or major yuan depreciation appears off the table.
Now in recent weeks the U.S. has slapped up tariffs on Chinese goods, up to 145% so far. This action raises the ante, raising the heat on China’s exports, which may now be met with even greater obstacles in markets around the globe. With the Chinese economy still deeply dependent on exports, it is treading carefully in these choppy waters to avoid capsizing its export juggernaut.
The People’s Bank of China (PBoC) plays a critical role in managing the yuan’s value. It also sets a daily midpoint fix, which takes into consideration the previous day’s closing rates and consultations with interbank dealers. This narrow regulatory framework only allows the onshore yuan to trade in a band of 2% above or below the reference rate. In doing this, it serves to dampen market volatility.
In fact, this past Friday was the very first time the Chinese offshore yuan ever dropped to 7.4287 against the U.S. dollar. At the same time, the onshore yuan declined, reaching 7.3509, its weakest point since 2007. Most analysts expect China’s central bank to further steer a slow depreciation of the yuan. It will not, though, take or threaten to take radical action that would undermine its financial stability.
Dan Wang, China Director at Eurasia Group, highlights the delicate balance China must maintain:
“Devaluation is no longer an effective trade weapon.” – Dan Wang, China Director at Eurasia Group
China’s leadership has reason to be especially conscious of the dangers of capital flight. The country saw close to $700 billion in capital outflow in 2015, one of the major issues that keeps Beijing up at night. A sudden and large outflow of capital might undermine policymakers’ ability to effectively stabilize the economy while calming investors’ nerves.
Jianwei Xu, a senior economist at Natixis, emphasized the challenges that come with currency management in this environment:
“How can a country depreciate the same amount of exchange rate by the same level without triggering financial instability? It will be very difficult.” – Jianwei Xu, senior economist at Natixis
The Chinese government is also very focused on reassuring markets that it has the capacity to counter U.S. sanctions by defending the yuan. According to analysts, keeping currency stable is key to keeping consumer confidence and preventing additional capital flight. Joey Chew, head of Asia FX at HSBC, remarked:
“In fact, rapid depreciation could weaken consumer confidence and risk capital flight.” – Joey Chew, HSBC’s head of Asia FX
China’s central bank is likely to pursue a gradual depreciation path. This new, more comprehensive approach seeks to minimize risks associated with the threat of financial instability. This approach aligns with David Roche, a veteran investor who stated:
“I think China wants to be seen as the center of stability on every variable, including the exchange rate.” – David Roche, veteran investor
Roche argues that stability in the currency serves as a strategic response to U.S. tariffs:
“The best way to make the Americans pay for this is to keep the currency stable.” – David Roche, veteran investor
China’s economic picture is equally, if not more complicated. Short-term outlook More recently, many experts think China is unlikely to employ a weaker yuan as an instrument of revenge on U.S. tariffs. Joey Chew emphasizes this sentiment:
“RMB (Renminbi) devaluation will not be part of China’s retaliation toolkit to U.S. tariffs.” – Joey Chew, HSBC’s head of Asia FX
Whatever happens next, it is still evident that China’s economic policymakers are in for very tough times ahead. The sudden spike in U.S. tariffs represents a clear and present danger to exports that could stymie economic growth. By exercising caution and prioritizing financial stability, China aims to manage its currency effectively while addressing external pressures.