Officials at the People’s Bank of China (PBOC) have long insisted that China will not weaponize the yuan. Yet, implicit in their promise not to manipulate the currency for strategic ends is their ability to do so if they so desired.
China’s monetary policy has come to the fore now that US President Donald Trump has imposed import tariffs on a range of Chinese goods. Many are wondering if China will respond to Trump’s trade war by threatening a currency war.
If it does, the world should call its bluff.
To be sure, with more than US$3 trillion in foreign reserves and an established — albeit not entirely successful — system to manage its exchange rate, China has enough financial and monetary leverage to bring the US economy to its knees. However, having the weapons it needs does not mean that China can afford to use them.
In June, the yuan had its worst month on record, dropping 3.7 percent against the US dollar. Analysts are divided about the cause.
Some view it as the result of a slowdown in economic growth, coupled with market concerns about the introduction of US tariffs and US dollar appreciation on the back of rising US interest rates. Others suspect that Chinese monetary authorities intervened to weaken the yuan, in order to offset the effect of US policies.
The Chinese government has a long history of intervening to ensure that the yuan’s exchange rate aligns with its economic goals. However, since 2016, when the yuan was included in the basket of currencies that determines the value of the IMF’s Special Drawing Rights, the exchange rate has been determined mainly by market forces.
Still, despite PBOC Governor Yi Gang’s (易綱) insistence that China’s exchange rate reflects demand and supply — with a basket of currencies as a reference — monetary authorities have the power to intervene when necessary.
Although such interventions have been less frequent than in the past, they have continued to muddle market signals.
However, in the context of today’s trade war, an “engineered” competitive devaluation of the yuan, even if technically possible, would not be in China’s best interest. Unlike in the past — and despite the Trump administration’s view of China as an unreformed currency manipulator — a weak yuan has more costs than benefits for China.
For starters, by increasing import prices and bolstering export sectors, a weaker yuan would undermine the Chinese government’s goal of shifting away from export-led growth and toward a model based on higher domestic consumption.
Moreover, a weaker yuan could invite renewed US complaints about currency manipulation.
Finally, and more crucially, a weak yuan at the same time that US dollar-denominated assets become more attractive could cause China to suffer capital flight.
In this scenario, Chinese monetary authorities might be forced to reverse course and prop up the yuan. By then, such an intervention would have to be large, implying a significant decrease in the country’s official reserves, as happened in 2015 and 2016.
Complicating matters further, China’s monetary authorities are already struggling to maintain financial stability under conditions of slowing economic growth, a total debt-to-GDP ratio of about 250 percent and monetary-policy normalization on the part of the US Federal Reserve.
China thus finds itself between a rock and a hard place. To discourage new lending and reduce the risk of capital outflows, the PBOC should tighten monetary policy, but counteracting the negative impact on growth resulting from rising US interest rates and tariffs calls for more monetary accommodation.
So far, China’s answer to this conundrum has been to relax capital requirements in order to create more liquidity into the banking system.
However, if Chinese savers expect the yuan to depreciate further, this measure could be offset by capital outflows — even with the capital controls the government has in place.
Looking ahead, Yi might have to resort to more than verbal assurances to support the exchange rate. That could mean that China and the Fed would end up selling — or at least not rolling over — US Treasury bonds at the same time.
In that event, US interest rates could go through the roof, implying serious risks for global financial stability.
So, while a weak yuan is worse for China than it is for the US, a PBOC intervention to strengthen the currency could undermine the Fed’s policy normalization and financial stability generally.
China’s lack of a fully liquid and convertible currency means that there will always be a fundamental divergence of exchange-rate regimes across the international monetary system. This divergence will continue to produce distortions that intensify the global effects of new US monetary policy trajectories.
The solution to this problem is straightforward: eliminate the distortions.
China should float the yuan so that its exchange rate becomes truly market-determined, even as it continues to manage capital flows. A “managed” approach of this kind would help China strengthen its financial system and develop the yuan as a major international currency.
Unfortunately, China seems as beholden to its exchange-rate regime as the Trump administration is to its trade policy. The US and China’s irreconcilable approaches are not good for anyone. Everyone should be concerned about what might come next.
Paola Subacchi is a senior fellow at Chatham House and a visiting professor at the University of Bologna.
Copyright: Project Syndicate
Chinese strongman Xi Jinping (習近平) hasn’t had a very good spring, either economically or politically. Not that long ago, he seemed to be riding high. The PRC economy had been on a long winning streak of more than six percent annual growth, catapulting the world’s most populous nation into the second-largest power, behind only the United States. Hundreds of millions had been brought out of poverty. Beijing’s military too had emerged as the most powerful in Asia, lagging only behind the US, the long-time leader on the global stage. One can attribute much of the recent downturn to the international economic
Taiwan has for decades singlehandedly borne the brunt of a revanchist, ultra-nationalist China — until now. Ever since Australian Prime Minister Scott Morrison had the temerity to call for a transparent, international investigation into the origins of the COVID-19 pandemic, Beijing has been turning the screws on Canberra. This has included unleashing aggressive “wolf warrior” diplomats to intimidate Australian policymakers, enacting punitive tariffs on its exports, and threatening an embargo on Chinese tourists and students to the nation. A tense situation became more serious on June 19 after Morrison revealed that a “sophisticated state-based actor” — read: China — had launched a
Asked whether he declined to impose sanctions against China, US President Donald Trump said: “Well, we were in the middle of a major trade deal... [W]hen you’re in the middle of a negotiation and then all of a sudden you start throwing additional sanctions on — we’ve done a lot.” It was not a proud moment for Trump or the US. Yet, just three days later, John Bolton’s replacement as director of the National Security Council, Robert O’Brien, delivered a powerful indictment of the Chinese communist government and criticized prior administrations’ “passivity” in the face of Beijing’s contraventions of international law