Weakening Yuan Could Mean Big Problems for China and Everyone Else

On August 5th the Chinese currency took a blow, tumbling to its lowest since the 2008 financial crisis – roughly 7 yuan for $1. The US President did not miss an opportunity to go on Twitter and grace the world with a comment on China’s monetary policy, insinuating that the Chinese government voluntarily depreciated the country’s currency, trying to gain benefits through manipulations that are sure to misfire. While his thinking goes in line with most of the media coverage of the matter, assessing something as serious as currency depreciation in a complex country like China would require more than a hasty tweet, since it risks neglecting a few important details. 

The way China manages its currency is perplexing at times, but generally quite consistent. Every morning The People’s Bank of China sets the daily reference rate for the yuan, limiting fluctuations in its value to 2%. Strictly speaking, the official exchange rate of the Chinese currency has not yet breached the psychological barrier of 7 yuan to $1 as of August 6th, floating slightly over 6.9.

The Chinese government has maintained a firm grip over the yuan, using its massive foreign currency reserves to keep it stable. Over the past ten years the Chinese currency stayed between 6 and 7 yuan to $1, never once breaking the lower or the upper bounds. Once, in 2015, the yuan unexpectedly lost 2% of its value. This depreciation caused panic among investors who, fearing a further decline, rushed to withdraw funds from China, propelling a massive capital outflow. The incident could have had a devastating effect on the country’s economy, if the government did not spend over $1 trillion in foreign-currency reserves to stabilize the situation and reinvigorate the yuan.

Now China is accused of artificially depreciating its currency to retaliate against the new batch of US tariffs targeting $300 billion worth of its goods. Indeed, a 10% decline in the yuan’s value could render the 10% US tariffs virtually obsolete, leaving the price for many Chinese products in America unaltered. However, if the solution were that easy, the current US-China Trade War would not be this much of a spectacle.

While it is thought that China voluntarily tweaked the exchange rate, it is more likely that it plummeted naturally, with the Chinese government consciously loosening the reins and letting the yuan’s value dwindle to an acceptable level. 

“People always think that China is going to retaliate with its currency, when from my perspective, it’s the market that’s weakening the CNY, because when you tariff China it hurts its current account surplus,” pointed out Max Lin, EM Asia Strategist at NatWest Markets, in an interview with CNBC.

Lin also suggested that China wouldn’t want yuan to depreciate bellow 7, since it’s a psychological mark that would propel speculations about trade war retaliation, which could also prompt another capital outflow. According to Reuters’ insider sources the Chinese regulators will certainly not let the yuan break 7. This sort of resilience could help improve general trust towards the currency and avoid a backlash from startled investors.

It is true that a weaker yuan could help China alleviate some of the pressures caused by the trade war by making its exports cheaper and more enticing. It could also agitate the stock markets in order to corner the US, where under the Trump administration, lofty stock prices are perceived as a measure of economic success. Most major stock indexes have been slumping within two days after the yuan reeled with Dow Jones down 2.9%, Nasdaq – 3.5%, Japan’s Nikkei – 0.65% and Hong Kong’s Hang Seng – 0.67%. Yet, while this dynamic could, to some extent, benefit Beijng, the negative effects of the yuan’s depreciation could be grim.

First it would strike the rapidly growing Chinese companies that have accumulated over $775 billion in outstanding dollar-denominated corporate bonds and by some estimates over $21 trillion in other debt, which is around 155% of the country’s GDP, the biggest proportion in the world (in Japan – 100% of GDP, in the US – 74%). Servicing these liabilities would naturally be more challenging with a weaker yuan. The shares of many US listed Chinese tech companies are also likely to tumble, meaning investors could lose out on the income from convertible-bonds that once made those companies so attractive of an investment.

The struggles of the renminbi – as the currency is called in Chinese – could also weigh on other currencies in the region, making it harder for them to hedge their own debts. Not to mention it would affect global corporations like Apple whose supply chain and revenues depend heavily on China. According to Bloomberg, 20% of Apple’s 2018 revenue came from the Middle Kingdom, and the fall of the yuan is likely to reflect on the tech giant’s stock. It has already slid down by 4.8% in its biggest drop since May.

Furthermore, with less dollars on its hands China would significantly miss out on the international investment front. Beijing’s current international expansion strategy hinges on high-profile buy-outs, generous corporate investments and ambitious international efforts like the Belt and Road Initiative, which could all be undermined by a weakening yuan.

The depreciation of the yuan seems to have planted seeds of uncertainty within the global financial community. Most investors are on the lookout for possible developments, Donald Trump is torturing Twitter and ordinary Chinese citizens are debating on Weibo whether or not it is the right time to invest in some dollars. The only thing that’s certain is that China might have way bigger hurdles than the 10% tariffs if the national currency keeps plunging, and the local authorities are most likely keenly aware of that.