Yuan devaluation market chatter grows as trade war worsens

The deepening trade war is raising speculation in financial markets that China may resort to aggressively devaluing the yuan against the US dollar in a break of their policy of pursuing a stable currency.

Strategists from New York to Hong Kong are game-planning if Beijing’s Friday (Apr 4) warning of a “resolute” response to US President Donald Trump’s tariffs could include allowing the yuan to weaken sharply, a controversial and non-consensus move which would in theory make Chinese exports cheaper but risk capital flight. President Xi Jinping’s administration already announced a 34 per cent tariff on all imports from the US starting Apr 10.

Wells Fargo sees risks of up to a 15 per cent deliberate depreciation of the managed currency over a two-month period. China could also “go big”, or up to 30 per cent, if they opt to target the currency, according to Jefferies Financial Group. Mizuho Financial Group is more conservative, as it sees potential for authorities to guide the yuan around 3 per cent weaker from now to 7.5 per US dollar.

“China can play hard ball with the US on retaliation,” Aroop Chatterjee, Wells Fargo strategist, said on Friday in New York. “A currency move directly addresses any loss of competitiveness. Devaluation risk has gone up here significantly.”

Chinese officials have prioritised a stable currency since well before the trade war began, even at the expense of at times roiling the repo market and disrupting funding for corporates. The country has for years been promoting the internationalisation of its yuan and sees stability – without extreme moves in either direction – as being key to further success on that front.

But some strategists say the latest tariff blow may spark a rethink, given the worse-than-expected duties risk augmenting deflationary forces already plaguing the economy. A weaker yuan would make Chinese goods cheaper abroad, offsetting some of Trump’s tariff impact, and make it costlier for local consumers to buy US goods.

Any bold move on the currency would be a controversial option for authorities mindful of the negative impact the last time it was used, the shock devaluation in 2015. That hammered yuan assets, spilled over into global securities and evolved into a crisis of confidence in China’s ability to control markets.

Robin Brooks, a senior fellow at the Brookings Institution in Washington, has said on X that the 2015 repricing also weighed on US shares. Using the yuan to hit back against Trump would be the most “potent weapon” for China and “huge for global markets”, he wrote.

PBOC signal

The People’s Bank of China (PBOC) signalled a slightly looser grip on the yuan with its daily reference rate on Monday. It set the so-called fixing at its weakest since December and just below the closely watched 7.20 per US dollar level that investors see as a soft red line, one that has held since the US election.

The daily rate, which limits moves in the onshore yuan by 2 per cent on either side, is the PBOC’s most frequently used tool to manage the currency.

The onshore yuan dropped as much as 0.5 per cent to just below 7.32 per US dollar, the lowest since January. China’s stock market plunged as it reopened from a holiday, while bond yields fell towards a record low as investors confronted the reality that a much-feared trade conflict has entered a new phase. 

“They have told the market that fiscal stimulus and yuan stability were their preferred paths, but given the magnitude, maybe a little help from the currency is what they desire,” Brad Bechtel, strategist at Jefferies, wrote in a note dated Apr 3. “They need to believe that this 54 per cent tariff is going to stick in order to even consider going to that place” of a big devaluation. 

Yuan deal

Others such as Ray Dalio, founder of Bridgewater Associates, suggest China could do the opposite and negotiate a deal to strengthen the yuan in exchange for an easing of tariffs. 

That’s not the base case for strategists such as Mizuho’s Jordan Rochester. Authorities may look to avoid a redux of the 2015 devaluation shock. They could though follow the 2018 playbook which “will allow for a weaker currency, but in a manner that makes it hard for speculators”, said the London-based strategist. 

Along with a weaker currency, rate cuts and targeted support for affected sectors could also be considered, strategists say. One big consideration for Beijing is the risk of foreign investors pulling their money out of China if the currency sinks. 

Such a move may also draw the US’ ire. Trump’s first administration labelled Beijing a currency manipulator in 2019, the first time a US government had done so since 1994. They dropped the label a year later.

“The rapid devaluation of the yuan can offset costs of tariffs, but it will also incur capital outflow costs,” wrote Alicia Garcia Herrero, chief economist Asia Pacific at Natixis.

Others maintain that it’s still a powerful tool, made even more relevant today given its ability to swiftly counter the trade war’s hit to growth.  

“It’s the most obvious way for China to play the imposition of tariffs,” said Kathy Jones, strategist at Charles Schwab in New York. BLOOMBERG