Trade war escalation tests China’s stomach for weaker yuan

By Winni Zhou and Andrew Galbraith

SHANGHAI, May 13 – An impasse in trade negotiations drove the yuan to a more than four-month low against the dollar on Monday, sparking speculation China’s central bank may be letting the currency weaken as Beijing prepares its response to higher tariffs.

But most market players expect China not to use sharp depreciation of the yuan as a weapon in the trade war, to guard against destabilising outflows and what may be seen as a retaliatory move amid continuing trade talks with Washington.

The U.S. government raised tariffs to 25 percent from 10 percent on $200 billion worth of Chinese imports on Friday, with Washington demanding promises of concrete changes to Chinese law in any trade deal, while China’s foreign ministry has said the country will never surrender to foreign pressure.

China has vowed to respond to the U.S. tariffs, but has not yet announced its countermeasures.

“The stalemate in trade negotiations is bringing great economic uncertainty to China, as trade accounts for more than 20% of Chinese GDP growth,” said Nie Wen, economist at Hwabao Trust in Shanghai. He said the yuan is very likely to breach 7 per dollar against the backdrop of rising trade uncertainty.

The yuan fell 0.8% to end its onshore trading session at 6.8721 per dollar on Monday, its weakest such close since Jan. 3. It later weakened past 6.88 per dollar, erasing all its gains for the year.

The offshore yuan fell as much as 0.9% to 6.9071 per dollar, its softest since Dec. 24.

Sharp drops in the onshore yuan are often followed by a surge in dollar selling by major Chinese state-owned banks, which serves to prop up the yuan. On Monday, however, traders said they saw few signs of such activity.

“I didn’t sense pressure from banks – in fact, I saw many big banks buying dollars, possibly for their corporate clients,” said a trader at a Chinese bank in Shanghai. Companies with dollar financing needs want to hedge against further yuan weakness, particularly as additional U.S. tariffs could put more pressure on the Chinese currency.

DELICATE BALANCE

Another market participant said that the lack of state-backed support for the yuan on Monday showed the “delicate balance” in a market able to stabilise itself – for now.

While Beijing had allowed the yuan to fall, an onshore yuan exchange rate of 6.9 to the dollar is widely seen as a key level the central bank wants to defend, and market players have not yet attempted to push the yuan lower, he said.

“Depreciation would be good for foreign trade, but it could have an impact on the stability of market confidence,” he said. “There needs to be a balance between the two.”

China’s balancing act goes beyond maintaining market confidence. As the country’s current account is seen swinging from a decades-long surplus toward a deficit, the yuan’s exchange rate is expected to become more volatile.

A stable currency is also imperative as China seeks more portfolio inflows and pushes for global equity and bond index inclusions, which will help offset outflows.

“China is concerned that a sharp depreciation could destabilise confidence and lead to more capital outflows,” UBS economist Tao Wang said in a note.

Frances Cheung, head of Asia macro strategy at Westpac in Singapore, said that China was unlikely to rely too much on currencies in its response to the United States, because “it needs capital flows to make up for the slack from trade flows.”

“However, the market may well have the perception that China is more willing to let its currency weaken at this juncture and this (may) undermine the RMB,” at a time when many currencies in Asia are facing pressure, she said.

China’s central bank burnt through $1 trillion worth of foreign exchange reserves to stabilise the yuan following a sharp one-off devaluation in the currency in August 2015.

Major state-owned banks, widely believed to be acting on behalf of the central bank, were constantly seen selling dollars in the onshore spot market to prop up the yuan over the two years following the devaluation.

In 2018, large state-run banks switched to swapping large amounts of dollars for yuan in onshore currency forwards, tempering depreciation expectations by containing the yuan’s price in the forwards market.

The operations in the swaps market allowed state banks to obtain dollars at the short end, and sell them in the spot market to support the Chinese currency without affecting the country’s foreign exchange reserves.

Traders said they did not see signs of large-scale swap operations on Monday. (Editing by Jacqueline Wong)

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