A weakening yuan tests Beijing’s resolve as Trump tariff threats loom

The Chinese yuan is widely expected to depreciate against a rising US dollar. A thornier question facing market observers: How far and how fast could the currency slide?

The stakes are enormous. The impact of a pronounced weakness in the yuan could not only ripple around the world by weakening the export competitiveness of countries that compete with China to sell goods and services to the world, but also jeopardize the efforts of Chinese authorities to boost growth in the world’s second largest market. economy.

China’s offshore yuan has lost more than 3% since Donald Trump’s presidential election victory in early November, as the monetary policy outlook of the United States and China diverges. The tightly controlled domestic yuan also fell to a 16-month low.

Many investors are pessimistic about China’s prospects. The country is struggling with a housing crisis and subdued consumer spending. As market participants worry about deflation and banks struggle to stimulate demand for loans, funds have flowed into government bonds, pushing yields to historic lows.

On the other hand, policymakers at the US Federal Reserve now anticipate fewer rate cuts than before. Higher tariffs proposed by new US President Donald Trump, if they materialize, could fuel inflation and further slow the Federal Reserve’s easing cycle, thereby maintaining interest rates, and therefore bond yields, at a high level for longer.

The yield on the US Treasury at 10 years has been rising steadily since June and exceeded 4.7% this month, a level last seen in April. THE US Dollar Indexwhich measures the greenback against six other currencies, reached its highest level in 26 months.

Markets have lowered their expectations for the number of rate cuts by the US Federal Reserve this year, pricing in only a quarter percentage reduction in 2025, according to to the CME FedWatch tool starting Friday.

With the yield gap between US debt and Chinese debt widening, investors pushed the dollar higher and pulled the yuan lower.

Market fluctuations test the resolve of policy makers. While a weaker yuan should help improve the attractiveness of Chinese exports, authorities also want to avoid a sharp fall in the currency that could trigger excessive volatility.

In a bid to raise bond yields, the People’s Bank of China suspended its purchases of government bonds last week, citing excess demand in the market, while accelerating ticket issue in Hong Kong to help stem the decline of the yuan.

The central bank recently accelerated announcements to warn against speculation against the currency and signaled that rising government bonds could harm financial stability.

“We will resolutely avoid the risk of exchange rate overshooting, ensuring that the yuan exchange rate remains broadly stable at a reasonable and balanced level,” he added. said People’s Bank of China Governor Pan Gongsheng last week.

This echoed the sentiment expressed in another press conference last Tuesday where senior officials reiterated the moderately accommodative stance of monetary policy while emphasizing the importance of exchange rate stability.

“Such communication implied that the PBOC might prioritize currency stability over short-term monetary policy easing,” Goldman Sachs economists said in a note last week.

The central bank kept prime benchmark loan rates unchanged on Monday in a bid to maintain currency stability.

Still, the offshore yuan could weaken to 8.5 per U.S. dollar by the end of the year, said David Roche, a strategist at Quantum Strategy, taking into account the scenario in which Trump imposes the promised tariffs 50 to 60% on Chinese products.

The currency last traded at 7.3357 against the greenback on Monday.

“Chinese authorities will attempt to bring down the yuan in an orderly manner,” Roche said, while warning that Beijing’s stimulus measures were “insufficient” to do more than stabilize the economy, as they failed to address key issues such as sluggish demand and excessive household saving. .

The central bank should refrain from sharply cutting short-term interest rates, despite growing pressure on domestic growth, said Helen Qiao, China and Asia economist at Bank of America, given the temporary political priority given to exchange rate stability.

She expects the central bank to continue defending the currency by strengthening capital controls and providing liquidity advice to financial institutions.

While the hawkish Fed limits the People’s Bank of China’s room to lower interest rates, Beijing still has many policy tools to prevent excessive currency fluctuations, including verbal intervention, adjustment offshore liquidity through the issuance of banknotes and “the use of public financial companies to purchase directly”. CNH [offshore yuan]” said Lynn Song, chief China economist at LNG.

For the domestic market, the main tool used by the PBOC to manage the currency is the daily reference rate: the domestic yuan is only allowed to trade within 2% of this reference rate. Since last year, the central bank has maintained its exchange rate guidance stronger than 7.20 per dollar, despite the rise in the greenback.

The national yuan was set at 7.1886 per dollar on Mondaybut the markets pushed it towards the weaker side of the band, and it was last trading at 7.3249.

Chinese economic activity accelerates more than expected in the final quarter of 2024, supported by robust exports as companies ramped up shipments ahead of tariff hikes, but experts have warned that growth momentum could run out of steam later this year with the Trump’s tariff hikes take effect.

“Beijing doesn’t want to see a collapse in the currency before it knows what the situation is,” said Kamil Dimmich, portfolio manager at North of South Capital, referring to uncertainty over the scale and pace of the rises. tariffs imposed by the Trump administration.

Trump, who takes office Monday, has promised universal tariffs of 10 to 20 percent on all imported goods, and 60 percent or more on shipments from China, although some thought the tariffs would be imposed gradually.

“Although tariff hikes may be larger under trade war 2.0, the chances of yuan depreciation may be much smaller this time,” said Larry Hu, chief China economist. at Macquarie, as Beijing has indicated its political preference for a “relatively stable” policy. yuan.”

It forecasts the offshore yuan will peak at 7.50 to the dollar in the third quarter of this year.