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Trade war

World braces for dangerous US-China currency standoff

Yuan hovers beyond former line of defense after 'manipulator' designation

U.S. President Donald Trump listens to a question from the news media as he sits behind the Resolute Desk in the Oval Office of the White House. Trade tensions with China have now spilled over into currencies.   © Reuters

WASHINGTON/HONG KONG -- With the Trump administration designating China as a "currency manipulator" for the first time in a quarter century, tensions over trade and high tech between the U.S. and China have now extended to currencies.

Talk of the U.S., home to the world's key currency, intervening in the market to push down the dollar -- as at least one of U.S. President Donald Trump's advisers has reportedly raised -- shows just how unconventional the discussions are, as the world's two largest economies race to keep their currencies lower.

If China's yuan dropped past 7 to the dollar, or "cracking seven" in trader talk, Treasury Secretary Steven Mnuchin was going to act, a Treasury official told Nikkei, noting that 7 was the trigger for slapping Beijing with the manipulator tag.

That happened Monday, and the Treasury sent out a statement in the afternoon.

"China has a long history of facilitating an undervalued currency through protracted, large-scale intervention in the foreign exchange market. In recent days, China has taken concrete steps to devalue its currency," it said.

It was the first time since 1994 that the U.S. has labeled any country a currency manipulator. In its semiannual report to Congress in May, the Treasury Department had refrained from calling China so. The environment quickly changed as the U.S.-China trade war accelerated.

China is believed to have let the yuan "crack seven" in response to last week's U.S. announcement of more tariffs on Chinese imports.   © Reuters

The People's Bank of China issued an angry statement Tuesday following the designation, calling it a "capricious act of unilateralism and protectionism," and saying it will "severely undermine international rules and have material impacts on the global economy and finance."

The pressure from Washington stems from Trump's frustration at the dollar's steady upward march, driven by an economy that remains solid compared with those of other industrialized nations. The effective dollar exchange rate is hovering around its highest in 17 years after the Federal Reserve cut interest rates for the first time in a decade last week.

"China dropped the price of their currency to an almost a historic low. It's called 'currency manipulation.' Are you listening Federal Reserve?" Trump tweeted Monday -- a comment taken by some observers as a push for the U.S. central bank to guide the dollar lower.

The idea of U.S. intervention has gained adherents in Washington. White House trade adviser Peter Navarro reportedly presented such a proposal to Trump late last month.

While Trump rejected the idea of currency market intervention at that meeting, the president told reporters a few days later that he could intervene "in two seconds if I wanted to."

But critics contend that the president's anger, and the government's moves to act on it, are misguided.

China's "interventions in currency markets over the past several years have been to prop up its currency rather than to drive it down," former U.S. Treasury Secretary Larry Summers wrote in The Washington Post on Tuesday. "And the move down in the yuan on Monday was not artificial -- it was an entirely natural market response to newly imposed U.S. tariffs."

"By labeling as Chinese currency manipulation an exchange-rate move that was obviously a natural response to his boss's policies, [Treasury Secretary Steven Mnuchin] has damaged his credibility and that of his office," argued Summers, who served as former President Barack Obama's top economic adviser.

The yuan remained weaker than 7 against the dollar on Tuesday, with the Chinese central bank's guidance suggesting that Beijing is allowing the currency to soften in defiance of U.S. pressure.

After "cracking seven" on Monday, the Chinese currency reached a fresh 11-year low against the dollar in the onshore Shanghai market on Tuesday, weakening past 7.06 at one point.

The redback ended the session at 7.0321, slightly stronger than Monday's close, suggesting that the rush to sell has died down for now.

Beijing has sent a clear signal that with trade tensions intensifying, it has no intention of defending the psychologically important level of 7 yuan to the dollar, Germany's Commerzbank said in a report Tuesday. Bank of America Merrill Lynch slashed its year-end exchange rate forecast to 7.3 yuan from 6.63 yuan.

The drop on Monday past a level previously seen as a line in the sand for Beijing followed Trump's announcement of another round of tariffs on Chinese imports to take effect in September, a move expected to further squeeze China's economy. A weaker yuan would counteract the duties' negative effect on exports.

As Beijing runs out of room to retaliate with its own tariffs, letting the yuan soften is its most viable response, Bank of America Merrill Lynch analysts said.

The depreciation is widely considered to have the government's tacit blessing.

In the onshore market, the yuan is permitted to trade up to only 2% above or below a reference point set daily by the People's Bank of China. This fix factors in the yuan's movement against a basket of currencies including the dollar, the euro and the yen -- and, on some occasions, intervention to keep it from falling too far. Market watchers use this to get a sense of what Beijing is thinking.

Tuesday's fix of 6.9683 yuan to the dollar, the weakest in 11 years, keeps the 7 level within the trading band. On Wednesday, the People's Bank of China announced a fix of 6.9996, signaling further weakening of the currency against the dollar. 

The lack of a surge in short-term interest rates backs up this view. Higher rates would encourage traders to buy yuan, thus firming up the currency, but monetary authorities are believed to be maintaining a wait-and-see stance for now.

Yet Beijing seems to be keeping an eye on the speed of the yuan's decline, as letting it fall too far too fast could accelerate capital flight and rile Washington further.

The PBOC said Tuesday it will sell about 30 billion yuan ($4.28 billion) in yuan-denominated bonds in Hong Kong, an apparent effort to absorb Chinese currency circulating there and tap the brakes on its decline.

Yuan trading in Hong Kong and other offshore markets lacks the restrictions imposed in mainland China, leaving the currency more prone to speculative selling. The yuan's drop below 7 in the onshore market was led by offshore trading.

The PBOC's bond float is an effort to counter the one-sided downward pressure on the yuan and contain the risk of capital flight, according to Citigroup.

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