[NEW YORK] A dramatic escalation in the trade war has brought China to a crossroads, with policymakers set to decide if they should retain a tight grip on the yuan or let it weaken to counter some fallout from US tariffs.
On Monday (Apr 7), Beijing weakened yuan’s daily reference rate to just 0.03 per cent away from 7.20 per US dollar, a level closely guarded by authorities since the election of US President Donald Trump in November. The move fuelled bets that China may allow the currency to weaken past the soft red line to raise the appeal of its exports and boost growth.
The so-called fixing limits moves in the onshore yuan by 2 per cent on either side.
Whether or not the central bank decides to let the yuan go now, China’s financial markets look set to be challenged by high volatility. Allowing the managed currency to weaken sharply may increase bearish bets on the economy, worsen capital outflows, antagonise the US and dim prospects of any trade negotiations. However, keeping the exchange rate artificially strong may dampen exports and further hurt the already flailing economy.
“The fixing may break the closely watched 7.20 figure” on Tuesday, Joey Chew, head of Asia FX research at HSBC in Singapore, wrote in a note. A degree of yuan depreciation would be a natural outcome of the persistent supply and demand imbalances in the onshore currency market and also the central bank’s potential resumption of monetary easing at some point, she added.
A likely recalibration of China’s currency strategy had been on the radar for traders since the beginning of Trump’s second presidency but policymakers have repeatedly pledged to keep the yuan stable. Investors are now seeking fresh clues from the central bank on where it stands on the yuan after Trump announced the steepest American tariffs in a century, sending shockwaves across markets.
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China’s benchmark government bond yields fell towards a record low on Monday on expectations of further policy easing from the People’s Bank of China (PBOC) to support the economy in light of the latest tariffs. The central bank had been holding off on interest rate cuts amid concern that such a move would further undermine the yuan’s appeal and fuel speculative buying of bonds.
The Chinese currency is already signalling some depreciation risk. On Monday, it touched the weakest in nearly three months as trading resumed after a holiday during which China announced retaliation measures, including commensurate levies on all American goods and export controls on rare earths.
Also Monday, Trump threatened to impose additional 50 per cent import taxes on China if it does not withdraw its plans to respond to his already announced levies.
“After the market saw China’s firm retaliation on Friday, expectation for China to eventually devaluating the currency has jumped and the pressure won’t go away easily,” said Ju Wang, head of greater China FX & rates at BNP Paribas.
Devaluation risks
A growing but non-consensus cohort of analysts are even predicting sharp plunges in the yuan in the near future. Wells Fargo sees risks of up to a 15 per cent deliberate depreciation over a two-month period. China could also “go big” or up to 30 per cent, if they opt to target the yuan, according to Jefferies Financial Group.
But most expect to see a less dramatic move. “We expect the People’s Bank of China to allow further weakening of the fix but in a measured way as opposed to a large one-off depreciation,” said Khoon Goh, head of Asia research at Australia & New Zealand Banking Group.
And even if bearish sentiment starts to take hold, the PBOC has plenty of tools to iron out market volatility. In the past, the central bank has deployed tools such as adjusting foreign-exchange liquidity and offshore bill issuance to rein in the yuan’s slide.
The weak end of the yuan’s trading band will stand around 7.35, if the PBOC ends up setting the fixing at 7.2, according to Bloomberg calculations based on the currency’s 2 per cent trading range. The onshore yuan traded around the 7.32 level on Monday.
“The PBOC will likely allow fixing to move higher in the next few days as well as cut rates,” Citigroup strategists, including Rohit Garg wrote in a note. “The PBOC will allow fixing to eventually move beyond 7.20.” BLOOMBERG
