After the yuan's recent sharp decline, markets are nervous that China intends to wield its currency as a weapon in its trade tussle with the U.S. The worries are understandable but overblown. Beijing stands to lose more than it would gain by devaluing the yuan.
This is not to ignore the danger. Managed depreciation could become a serious tactical option if U.S. President Donald Trump implements tariffs on $200 billion more of Chinese imports as threatened this week; this would come on top of the duties on $34 billion in imports that came into effect on July 6 and another set in the works covering $16 billion of goods.
Strategically, however, it is in Beijing's greater interest to keep the yuan broadly steady for a number of reasons. Chief among them is China's goal of promoting the currency's international usage.
Investors could be forgiven for fearing that China has pushed the replay button on 2015 when an equity market rout and a bungled mini-devaluation of the yuan sparked a sell-off across global markets. This year, Shanghai stocks have slid into a bear market while the yuan in June suffered its biggest monthly fall since China established its foreign exchange market in 1994.
The international context is notably less propitious for Beijing than it was in 2015. Central banks are withdrawing monetary stimulus and Trump seems intent on overturning the rules-based post-World War II global order that, among other things, helped enable China's meteoric economic rise over the past 40 years.
China is in Trump's crosshairs for two reasons: he resents its $375 billion trade surplus with the U.S. and he fears that its "Made in China 2025" industrial modernization program will erode America's lead in high technology. Hence the U.S. tariffs against Chinese imports and the crackdown on Chinese telecom companies ZTE, Huawei Technologies and China Mobile.
To date, China's reaction has been measured. Like the European Union, Canada and others penalized by Trump's import taxes, Beijing has imposed tit-for-tat tariffs on $34 billion of U.S. goods and promised to match the next $16 billion batch.
To go further and devalue the yuan might help Chinese exporters but it would be an act fraught with danger. First, in all likelihood it would trigger massive capital flight, as in 2015, depleting China's foreign exchange reserves and sending markets at home and abroad into a tailspin.
Second, it would risk enraging Trump and thus invite yet more punitive tariffs. China is probably not ready to confront the U.S. in an all-out economic war.
Third, it would gravely damage China's efforts to encourage the use of the yuan beyond its borders for trade and investment purposes: why buy into a currency that cannot be trusted to hold its value because it might be used as a political weapon?
China is already struggling to internationalize the yuan. The yuan's share of China's international goods trade slumped from 27.6% at its peak in 2015 to 12.3% in 2017. A precipitous slide in the exchange rate would mock China's claim to be a beacon of stability and set back its global ambitions for the yuan by years.
Nevertheless, China is set to keep the threat of major depreciation in its back pocket -- and not only as a defense in case trade hostilities escalate. The economy might also need the short-term boost that a lower exchange rate would provide if Beijing's efforts to reduce financial risk start to damage growth.
Financial de-risking is urgent given the rapid buildup of debt and the explosion in speculative shadow banking in recent years. But deleveraging is a dangerous game. Bond defaults are on the rise and a growing number of small and mid-sized banks need to be recapitalized. Domestic demand is holding up well in China for now, but the safety valve of a much weaker currency might yet come in useful.
Indeed, the June swoon will already have come as a great relief to Chinese exporters, who had been struggling with the yuan's strength. Measured against the dollar, the yuan had risen 8.1% in the year to mid-May. Because export contracts are commonly fixed in dollars, this had the effect of depressing exporters' yuan revenues at a time when their labor costs were rising relentlessly.
A big, deliberate devaluation, however, would create more problems than it would solve. Trump's trade tantrums may well make for continued market volatility and pressure on emerging market currencies, but China is unlikely to be provoked into weaponizing the yuan this year.
Diana Choyleva is chief economist of Enodo Economics, a macroeconomic forecasting company in London.