Risk of Chinese Currency Devaluation Rises With Latest Tariffs Threat

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Such a maneuver would help to offset the economic impact of the tariffs but also threaten to worsen trade tensions and rattle global markets

The Trump administration’s threat to slap tariffs on another $200 billion in Chinese goods has reignited fears that Beijing will turn to a powerful but risky weapon: a depreciation of its currency.

The latest salvo in the brewing trade conflict between the world’s first and second-largest economies would raise the amount of Chinese goods taxed by the U.S. to $450 billion. That would mean tariffs on nearly all of the $505 billion in goods that China exported to the U.S. last year.

Analysts say the tariff escalation could eventually lead China to depreciate its currency, the yuan—a maneuver that would help to offset the economic impact of the tariffs but also threatens to worsen trade tensions and rattle global markets.

“If the U.S. goes ahead with tariffs, China would need to consider some of the more aggressive options,” said Brad Setser, a senior fellow at the Council on Foreign Relations. “Letting the yuan weaken becomes something that logically the Chinese would consider.”

It is uncertain which of the proposed tariffs that the U.S. and China have threatened will be implemented. Both countries have said they would begin imposing tariffs on about $34 billion in goods starting July 6.

Still, trade worries and the potential yuan devaluation rippled through currency markets on Tuesday, driving the yuan down 0.5% against the U.S. dollar in offshore trading to its lowest level since January. Other Asian currencies also slid, with the Korean won down 0.8% against the dollar and the Singapore dollar off 0.4%.

Brad Bechtel, global head of foreign exchange at Jefferies Group, says the risk of a yuan depreciation “has risen significantly.”

“I see it as a primary risk in the market; it would be very disruptive” he said. “China is going to protect the home front.”

China has faced criticism in the past for manipulating its currency to gain a trade advantage, but those allegations have died down over the past few years as Beijing took steps to stabilize the currency and allow it to trade alongside market forces. Despite the recent selloff, the yuan remains up 5% against the dollar over the past year.

Mr. Setser sees a yuan depreciation as more likely now because China has a smaller pool of U.S. goods to target.

China has vowed to respond against U.S. tariffs with equal tariffs on American goods. But the country only imported $130 billion in U.S. goods last year, meaning it cannot fully match the tariffs now being threatened on $450 billion in its goods.

By weakening its currency, China would help make its exports cheaper to overseas buyers. While that would help insulate the Chinese economy from the impact of U.S. tariffs, such a move could have severe political and economic repercussions.

A key concern is that a devaluation would revive a cycle of capital outflows that the Chinese central bank spent more than $1 trillion in reserves attempting to halt. Fearing further currency weakness after a 2015 devaluation, Chinese companies and individuals began sending money out of China, amplifying weakness in the currency and raising concerns about the health of the Chinese economy.

“There is clearly a risk that a depreciation in response to an escalating trade war would renew concerns about China’s commitment to keeping the currency stable,” said Mr. Setser. “You could see that China would have difficulty limiting initial depreciation.”

Fred Bergsten, founding director of the Peterson Institute for International Economics, believes it is more likely that China would retaliate by clamping down on business with U.S. companies. China could limit purchases of U.S. products by the government or domestic companies, he said.

“The currency issue has been amazingly quiet and the Chinese wouldn’t want to reignite that by taking any overt action to add another source of alarm,” he said. “If they intervene in the currency market, that would add a new front to the trade war.”