Sun, Jul 22, 2018 - Page 7 News List

As the US ratchets up tariffs, China faces a currency catch-22

By Paola Subacchi  /  LONDON

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.

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