A weaker currency is one of China's key tools to deal with Trump's trade war -- but it comes at other costs

VCG/Getty ImagesSHENYANG, CHINA – JULY 03: Students of Shenyang Heping District Nanjing Street No.10 Primary School performing waist drums to welcome their holidays.

  • China’s currency has been weakening in recent months as the Trump administration’s tariffs of Chinese imports loomed.
  • The weaker currency makes China’s products more competitive and can help offset some of the competitive problem tariffs impose.
  • Analysts expect the yuan to continue falling against the US dollar, although its impact is likely to be limited and come at other costs.

A gradual depreciation of the yuan is likely to be on the cards as Beijing tries to deal with the trade war with Washington, but analysts are divided on how a weaker currency will affect China’s exports and the broader economy.

The yuan has already lost 7 per cent against the US dollar in the last four months as trade tensions rise, and US President Donald Trump this month complained about China’s currency “manipulation” – an allegation Beijing denied.

Excluding other factors, a cheaper yuan could help to boost exports because it would make Chinese products more competitive on price.

Based on his calculation, Olivier Blanchard, former chief economist with the International Monetary Fund, tweeted this week that a 7 per cent depreciation of the yuan might be enough for China to offset Trump’s move to impose 25 per cent tariffs on US$50 billion of Chinese imports as well as 10 per cent duties on another US$200 billion of products.

But in reality, the situation could be far more complicated. Aidan Yao, senior emerging Asia economist at AXA Investment Managers, said the exchange rate had implications for trade across the board, but Trump’s tariffs were targeted – so, for example, a 7 per cent devaluation of the yuan may not help a tech product hit with a 25 per cent duty.

Gains from modest currency depreciation “will not be effective for relieving the pain facing China’s tech sector”, Yao said.

Jon Cowley, a partner at law firm Baker McKenzie, said yuan depreciation could only temporarily offset the new tariffs, at best.

“If companies believe these tariffs are going to last for a long time, they will explore other alternatives. One of the more clear alternatives here is the sourcing and diversification of supply chains, looking for production in locations outside the immediate line of fire. This is expensive,” Cowley said at a briefing.

Picture: Getty Images

China has previously tried to offset disruptions through the yuan. In the summer of 2008 when China’s export sector was starting to feel the impact of the global financial crisis, the central bank stepped in to end the yuan’s gradual appreciation since 2005, re-pegging the currency to the dollar at around 6.8. That ended in June 2010, when the People’s Bank of China said it would make the yuan exchange rate more flexible.

A stable yuan partly helped to bring about a rebound in Chinese exports. Overall exports shrank 16 per cent in 2009 before expanding by 31.3 per cent the following year.

But even if Washington goes ahead with the additional tariffs on another US$200 billion of products – or on every import from China, as Trump has threatened – the direct impact on exports is expected to be limited. According to China’s official figures, exports to the US accounted for roughly a fifth of the country’s total overseas shipments.

The depreciation of the yuan since the middle of April has been matched by a noticeable appreciation of the US dollar – the dollar index, which measures the value of the greenback against other currencies, gained about 6 per cent in the period.

Responding to Trump’s currency manipulation claim, foreign ministry spokesman Geng Shuang said China had never tried to drive overseas sales by engaging in “competitive currency devaluations”. Trump tweeted on July 20 that “China, the European Union and others have been manipulating their currencies and interest rates lower”.

How it could backfire

Ting Lu, chief China economist at Nomura International in Hong Kong, expected the yuan to continue depreciating in the coming months as Beijing adjusts its policies. The State Council, China’s cabinet, has decided to increase fiscal spending and relax monetary policy to help growth, which would add to depreciation pressure on the currency.

Teck Leng Tan, a currency analyst at UBS Global Wealth Management, said a strong dollar may rise further to go above 7 against the yuan in the coming months.

But a sharp depreciation of the currency could backfire on Beijing by dampening investor confidence in all yuan assets – from property to stocks – and causing financial losses far larger than any gains in overseas sales.

China had its fingers burnt when it devalued the yuan by nearly 2 per cent in August 2015, a move that, along with a stock market rout, led to an exodus of money from China and a steep fall in the yuan exchange rate.

The central bank was forced to burn nearly US$1 trillion worth of foreign exchange reserves to stabilise the situation and it installed a mysterious “counter cycle” factor in setting the yuan value in May last year, a move that gave it even greater say over the yuan exchange rate. The central bank was already setting the daily midpoint price of the yuan, intervening directly in the foreign exchange market and giving instructions to major forex trading banks.

When the yuan weakened in early July to break the 6.7 level, central bank governor Yi Gang tried to talk up the currency, saying China had the “fundamentals, the ability and the confidence” to keep the exchange rate basically stable.

Rob Koepp, Hong Kong director of The Economist Corporate Network, a research and networking unit affiliated with the British magazine, said China was under pressure to avoid devaluations of the yuan as it seeks to encourage the world to use it for transactions and as a reserve currency.

“It seems that Chinese policymakers are more about building confidence in their system, including their currency. That gives us some reason for hope that it won’t become a currency war,” Koepp said.

This article first appeared at the South China Morning Post. Read the original article. Copyright 2018.

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