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Currencies

China plays with fire by drawing on currency card

Weaker yuan reemerges as trigger in US tensions

An unexpected devaluation of the yuan in 2015 resulted in capital flight.   © Reuters

TOKYO -- China's central bank has weakened its reference rate for the yuan for a second day amid rising tensions with the U.S., stoking market concerns of capital flight and a rekindled trade war.

The People's Bank of China on Tuesday set its central parity rate for the yuan to 7.1293 against the dollar, responding to downward pressures in the market. The bank had just brought the rate to its weakest in more than 12 years the day before.

"I thought China would avoid weaponizing its currency," a strategist at a U.S. brokerage said. "We'll need to keep a close eye on its moves for a while."

The PBOC had also allowed the yuan to weaken last year at the height of the Sino-American trade war. A softer yuan helped Chinese exporters offset a portion of the additional costs stemming from higher American tariffs.

The bank brought the reference rate into the 7 yuan range for the first time in 11 years last August, shortly after the U.S. Treasury Department labeled China a currency manipulator, fueling concerns that the trade war would turn into a currency war.

The U.S. and China have since signed their "phase one" trade agreement in January, with Washington dropping the currency manipulator designation. Beijing says it is committed to carrying out the trade deal.

But tensions are rising once more amid the coronavirus outbreak. With China also proposing new national security legislation that many worry would criminalize pro-democracy protests in Hong Kong, markets are bracing for the trade war to resume.

A soft yuan may be a sign from Beijing that it will not budge. Yet a gradual weakening of the currency could also trigger massive capital outflows.

In 2015, an unexpected devaluation of the yuan resulted in capital flight and a greater burden on companies repaying dollar-denominated loans. Uncertainties over the yuan spurred demand for foreign currencies. The drop in China's foreign-currency reserves, caused by efforts to stem capital outflows, only added to market concerns. This led to a negative feedback loop between a weakening yuan and capital flight.

The Chinese authorities have since strengthened restrictions on capital outflows and are likely confident that they can prevent a similar cycle this time around. But Chinese companies still carry large amounts of dollar-denominated debt. China's foreign reserves are also under the International Monetary Fund's recommendation, especially considering the amount of the country's exports and short-term liabilities.

Capital outflows from China over March and April reached more than $50 billion, according to one estimate. The exodus was driven by decreased access to the dollar in March and capital flight from emerging countries. Hasty threats of a weaker yuan could lead to an even greater outflow.

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