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China 'weaponizes' yuan to counter US$300B tariff threat

China has opened a new front in its trade conflict with the U.S.

Unable to match the U.S. dollar-for-dollar on tariffs, China has responded to U.S. President Donald Trump's latest escalation by allowing its currency to weaken past 7 per dollar for the first time in 11 years.

The People's Bank of China has consistently defended the 7.0 barrier, but finally relented in the wake of U.S. President Donald Trump's Aug. 1 decision to impose a 10% tariff on the $300 billion of imported Chinese goods not currently subject to levies. The U.S. already has tariffs of 25% on $250 billion worth of Chinese goods, while China has only been able to respond with tariffs on $60 billion of U.S. goods.

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"The PBoC has effectively weaponized the exchange rate, even if it is not proactively weakening the currency with direct FX intervention," Julian Evans-Pritchard, senior China economist at Capital Economics, wrote in a research note. The devaluation suggests China has "all but abandoned hopes for a trade deal," he said.

The latest salvos in the trade war come after another inconclusive round of talks in Shanghai last week, which are due to be followed up with another meeting in Washington in early September. Trump met with Chinese President Xi Jinping on the sidelines of a G-20 summit in Osaka, Japan, on June 29, after which they pledged to restart talks and China said it will increase purchases of soybeans from the U.S.

Trump response

President Trump responded on Twitter with a call to label China a currency manipulator: "China dropped the price of their currency to an almost a historic low. It’s called "currency manipulation." Are you listening Federal Reserve? This is a major violation which will greatly weaken China over time!"

The PBoC, which allows the yuan to trade 1% either side of a daily reference rate, fixed the currency at 6.9225 on Aug. 5, allowing traders to weaken it beyond 7 per dollar for the first time since April 2008. The yuan was trading 1.6% lower at 7.0496 as of about 10 a.m. ET.

FX markets have long sought a weaker yuan as declining economic growth, which slowed to 6.2% in the second quarter from 6.4% in the January-March period, and the burgeoning trade conflict with the U.S. weighs on the country's outlook.

"They've taken the decision to offset tariffs but also send an explicit message to Washington that they won't be bullied," said Peter Kinsella, global head of FX strategy at Swiss bank Union Bancaire Privée (UBP).

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Trade talks between U.S. President Donald Trump and Chinese President Xi Jinping have repeatedly broken down.

Source: Associated Press

Stocks in the U.S. opened lower with the S&P 500 index dropping 1.7% after China's Shanghai Composite Index closed down 1.6%.

China has also directed state-owned companies to cease orders of U.S. agricultural products. The lack of Chinese imports of soybeans has been a particular bugbear of Donald Trump. The president has been keen to alleviate some of the strain on American farmers who were dealt the duel blow of lost sales to both China and Japan through various trade policies.

China came to an agreement with the U.S. to import more U.S. soybeans in February, but that agreement has coincided with a catastrophic outbreak of swine flu in China which has seen millions of pigs die and reduced the requirement for animal feed.

2015 comparisons

In a statement published soon after the devaluation, the PBoC explicitly linked the measure to "the imposition of tariff increases on China" but suggested future movements could go either way, noting that China remains an attractive destination for investment, particularly in comparison with the U.S. and Europe where interest rates are low and falling.

"The valuation of RMB assets is still low and the stability is correspondingly stronger. China is expected to become a 'squatting place' for global funding," the bank said.

The measure has drawn comparisons to August 2015 when China surprised markets by devaluing the yuan to the tune of 3%. At the time, China was looking to bolster its economy in the wake of weak export data.

Freya Beamish, chief Asia economist at Pantheon Macroeconomics, said in an email that China "won't burn through FX reserves" in order to defend the currency, but expects the reserve requirement ratio for banks to be cut by 25 basis points this quarter in order to support the economy.

Kinsella expects the yuan will weaken further to 7.20-7.30 and "could easily move to 8.30-8.40" should Trump's tariffs be fully implemented.