3 reasons why China won’t ‘weaponize’ its currency as trade-war escalates - UBS analysts

Get ready for a further weakness in the Chinese yuan, but look for Beijing to limit the drop even as the U.S.-China trade war intensifies, analysts said after the currency this week fell to an 11 1/2-year low versus the U.S. dollar.

The fear of a sharp, continued fall in the yuan is one item keeping investors and policy makers awake at night after the yuan’s 2015 devaluation sparked global financial market volatility. While rising U.S. tariffs on imported Chinese goods further muddy China’s economic outlook, and warrant a weaker yuan, Beijing is likely to ensure that the decline is “both controlled and limited,” wrote analysts at UBS.

They offered three reasons:

• Rapid yuan depreciation would likely further provoke the White House. When USDCNY climbed past the 7.0 mark in early August the U.S. Treasury in turn labeled China a “currency manipulator.” China this week called for “calm negotiations” in the wake of the latest trade escalation, and is unlikely to pursue a currency policy that would fuel U.S. claims of yuan weaponization.

• Beijing is well aware of the potential negative consequences of currency depreciation. It needs to adopt a balancing act that weakens the yuan quietly to offset the effects of U.S. import tariffs without creating expectations for a sharp fall that could spur a repeat of the capital outflows of 2015-16.

• USDCNY (U.S. dollar/yuan) trade is a two-sided affair. A stronger monetary easing bias from the Fed amid heightened trade tensions could potentially limit USDCNY upside. At the same time, if the U.S. continues to raise tariffs, China might find holding a specific line on the yuan to be counterproductive and unfeasible.

Nevertheless, the direction for the yuan is likely to be to the downside barring any significant improvement in U.S. - China trade relations, said analysts who look for the yuan to weaken to 7.4 per dollar over the next three and six months and 7.3 per dollar over the next 12 months.