The Chinese yuan falls against the dollar: here's what happens

Could the Chinese currency become a new flashpoint in its commercial struggle with the United States?

The Chinese yuan has fallen more than 3% against the dollar in the past two weeks as tensions between the world's two largest economies have worsened. Both parties have threatened waves of new tariffs on their respective exports.

A rapidly weakening yuan has caused turmoil in global markets in the past – and has drawn criticism from the United States.

Here's what's happening right now:

Why is the yuan falling?

Accusing China of unfair trade practices, President Donald Trump has threatened to hit the country with tariffs on hundreds of billions of dollars in exports. Beijing has promised to fight back.

Investors worry that new trade barriers may inflict significant damage to the Chinese economy, which is already showing signs of slowing down.

Another reason is the strength of the US economy, which has led the US Federal Reserve to raise its interest rates this year. This makes assets in US dollars more attractive to investors, driving up the value of the greenback versus other currencies.

Related: The Chinese economy is showing signs of slowing down. A trade war will not help

The central bank of China is on a different path. It is expected to release more than $ 100 billion into its financial system because of concerns about the health of the economy.

A dollar now buys more than 6.6 yuan, the lowest level of the Chinese currency since December. The yuan had spent most of 2017 and the beginning of this year has strengthened against the dollar.

In another sign of investor nervousness, Chinese equities entered a bear market this week, falling more than 20% from their recent high.

But some market observers do not panic yet about the fall of the yuan.

"We do not see any dramatic panic in the yuan market up to now," said Ken Cheung, strategist of the Hong Kong-based bank, Mizuho.

Does China weaken its currency on purpose?

A weaker yuan could make China's huge export industry more competitive globally, as it makes Chinese products cheaper for buyers who pay in dollars. In the past, Trump repeatedly accused China of manipulating the value of its currency to achieve it.

But analysts do not believe that is the reason for recent declines in the yuan.

"The main reason is a stronger dollar, not China targeting a weaker yuan in the trade dispute with the United States," said Hao Zhou, a Singapore-based monetary analyst at Commerzbank investment bank .

Related: White House decides against absolute limits on Chinese investment

He points out that the yuan is still relatively strong compared to the currencies of its other major trading partners, such as the euro. And other emerging market currencies, including the Indian rupee and the Turkish lira, also collapsed against the dollar.

The Chinese authorities are aware that if the yuan falls too much, it could fuel new tensions with Trump, who could resume his accusations of handling the currency.

"It is not in the interest of China," Zhou said.

What does a weaker currency mean for China?

A cheap yuan can also create problems for the Chinese economy.

According to financial data provider Dealogic, Chinese companies have accumulated huge debts in US dollars in recent years through bond sales in Hong Kong. When the yuan slips against the dollar, it is more expensive for companies to repay these debts.

The situation is "worrying that companies that have been issuers of US dollar debt may face difficulties in paying down their debt, repaying or refinancing," said Tai Hui, Hong Kong's chief strategist for Asia at JPMorgan Asset Management.

Related: Chinese stocks enter the bear market as trade war heats up

If the yuan falls too quickly, it could also lead to significant flows of money from China, investors losing confidence and seeking to trade for dollar-denominated assets and others. currencies.

This occurred during the last major periods of market volatility in China in 2015 and early 2016.

The Chinese government "will remain cautious about the fact that sustained falls could trigger a new wave of capital outflows," said Mark Williams, chief economist for Asia at the Capital Economics firm.

What happens next?

Analysts believe that the Chinese government will only tolerate the fall of the yuan.

"Any profit for exporters would be overwhelmed if the depreciation resulted in economic and financial instability," said Williams in a note to customers this week.

If the currency continues to slide, the Chinese central bank could take steps to support it by selling dollars from its huge currency chest.

But some experts suggest that the dollar will probably not increase much further. Sim Moh Siong, currency strategist at Bank of Singapore, said that a large-scale trade war with China would also hurt the US economy, thus weakening the attractiveness of dollar assets.

"The periods of protectionism in the history of the United States have been associated with the weakness of the US dollar," he said.

CNNMoney (Hong Kong) First published on June 28, 2018 at 02:53