By Christopher Balding
Since April, the yuan has fallen by almost 8 per cent against the US dollar. This has led many analysts and politicians to speculate that China is intentionally trying to devalue its currency to offset the effect of President Donald Trump’s tariffs. It almost certainly isn’t.
In theory, the price of the yuan is set by a basket of more than 20 currencies, many of which are either pegged to the dollar or managed implicitly against it. Consequently, the value of the yuan is effectively the opposite of a US dollar index; when the dollar goes up, the yuan goes down, and vice versa.
In recent weeks, though, the yuan has been falling quite quickly. Prior to the imposition of tariffs, as the dollar was rising, China appeared to be keeping its currency above the level predicted by the basket. But since the trade war started in earnest, it has let the yuan drop rapidly closer to the implied value. That quick decline has prompted worries that China might be engaging in competitive devaluation.
A closer at the numbers, however, should dispel this fear. Since January, the broad US dollar index has risen 8.5 per cent, while the yuan has fallen only 6.1 per cent against the dollar. In the same period, the broad MSCI Emerging Markets Currency Index has declined by 6.4 per cent — almost perfectly matching the yuan and suggesting that, if anything, China’s currency needs to fall further to reach the level implied by the basket. Moreover, even as the yuan declined in the second quarter, China had net settlement inflows of $32 billion. That surplus combined with a declining currency further suggests that China is simply pegging the yuan’s value to the basket.
More important, it’s unlikely that China wants a significant and sustained fall in the yuan. That would amount to trading one set of problems for another: Consumers and businesses would face a double whammy of price increases due to tariffs and reduced purchasing power due to a weakening currency. Recent history suggests that China tries to limit moves in the yuan once it hits either 6.9 on the lower bound or 6.3 on the upper bound. With the onshore yuan trading at 6.79 and the offshore even weaker — indicating that investors expect a further decline — it’s likely that officials will step in before long.
That’s especially true because things will probably get worse for China’s economy before they get better. A major risk to Chinese finances has always been the path of US monetary policy. With the Federal Reserve indicating that it intends to keep tightening — thereby likely pushing the dollar up and the yuan down — and US-China bond spreads hovering at less than 1 per cent, the landscape ahead looks increasingly rocky.
The most important thing China can do right now is to clarify its intentions. For all the data, staff and expertise at the Fed, arguably its most important job is communicating with markets. China’s central bank, by contrast, announces most policy or pricing changes by surprise and provides little guidance about its targets.
Especially during periods of turmoil, such silence can allow speculation to run rampant. In truth, there’s little reason to think China is pushing down its currency to offset Trump’s tariffs, nor that it intends to do so any time soon. Markets would welcome some reassurance to that effect.