One US dollar bought 6.92 yuan on Friday. The Chinese currency has weakened by almost 2.7% this month and is now uncomfortably close to the symbolically important level of 7 to the dollar, last breached during the 2008 financial crisis.
What happens next is important. China has a vested interest
in stabilizing the currency, as does the United States. President Donald Trump has long argued
that China devalues its currency to make the country more competitive.
But Beijing is in a tough spot.
Currency depreciation could help China by canceling out the impact of new US tariffs and keeping its exports affordable in America. But a big drop in the yuan could spark an outflow of money from China and hurt economic stability.
At the same time, the Chinese government may be hesitant to prop up its currency, since doing so could open Beijing up to further criticism from Washington.
“China is caught between a rock and a hard place,” said Miguel Chanco, senior Asia economist at Pantheon Macroeconomics.
China may be tempted to use its currency as a weapon against the United States, Bank of America Merrill Lynch analysts Athanasios Vamvakidis and Claudio Piron said in a note to clients on Friday.
Letting the yuan depreciate would be a “softer” option than targeting US businesses or investments in China, they said. Veteran hedge fund manager Mark Yusko thinks China could do this without causing its own economy too much pain.
Typically, as the yuan weakens, China would have to worry about an exodus of money from the country, as investors lose confidence and swap yuan for assets in dollars and other currencies.Yusko argues that’s not a problem for Beijing, which could enforce capital controls.
That doesn’t mean such a strategy is without risks.
The yuan falling below 7 to the US dollar could trigger further selloffs, pushing it still lower, Chanco said. That would likely be unattractive to Beijing, he added.
Letting the yuan weaken could also boost Chinese inflation. That’s a risk at a time when the economy is already showing signs of weakness
, with retail sales cooling significantly.
Another big question is whether China chooses to sell US Treasuries at a more rapid pace, in turn buying yuan and shoring up its value.
China reduced its holdings of US debt in March to $1.12 trillion in US Treasuries, the lowest level in almost two years.
Chanco sees dumping US government debt as the nuclear option, while Yusko thinks China will absolutely speed up sales of Treasuries if a resolution isn’t reached soon.
“I think it’s very likely,” he said.