China holds the yuan steady

The People's Bank of China is holding the onshore yuan near 7.20 per dollar, using firm daily fixings and dollar sales by state banks to keep it from weakening. Many had expected Beijing to answer America's tariffs by letting the currency fall to offset the duties. The central bank has made plain it will do no such thing.

How the line is held

The machinery is not complicated. Each morning the central bank publishes a reference rate, and onshore trading may move no more than 2 per cent either side of it. By setting that fixing stronger than market prices imply, the PBoC tells dealers where it wants the currency to sit. When selling builds regardless, the big state banks sell dollars, and the central bank can drain yuan from Hong Kong's offshore market to make betting against the currency expensive.

The offshore squeeze works through the cost of borrowing. A trader who wants to short the yuan in Hong Kong must first borrow it, and when the central bank and its agents mop up offshore liquidity, the overnight rate for borrowing yuan there can jump to punishing levels within a day. The tool has been used before to shake out speculators, and the mere expectation that it could be used again keeps short positions small.

The system was tested in April, after Washington raised its tariffs on Chinese goods to 145 per cent and Beijing answered with 125 per cent on American ones. The onshore yuan slid to its weakest level since 2007 and the offshore rate fell further. The fixing was nudged only fractionally weaker. Beijing let the market lean on the currency but declined to lead it down.

A cheap yuan would cost too much

In theory a weaker yuan would soften the blow of American tariffs for Chinese exporters. Beijing's leaders know the price would be high. A sharp fall in the currency would spark capital flight, shake property and stock markets that are already fragile, and invite tariffs from the European and Southeast Asian partners that Beijing is busy courting.

The arithmetic also argues against it. With American duties in the triple digits, no devaluation Beijing could tolerate would close the gap, so a weaker currency would mostly subsidise sales to everyone else. That is exactly what Europe fears. Brussels put countervailing duties on Chinese electric cars last autumn, and a cheaper yuan would hand it grounds for more.

The lesson of 2015

Beijing has tried the other road. In August 2015 the central bank cut the fixing by nearly 2 per cent without warning, and the surprise set off a rush of money out of the country and a sell-off in markets worldwide. China's foreign-exchange reserves, which had peaked near $4trn in 2014, fell below $3trn by early 2017 as the authorities spent heavily to steady the currency and tightened capital controls. Officials who lived through that episode have little appetite for a repeat, least of all with the property market still weak.

A later episode points the same way. When the yuan broke through 7 per dollar in August 2019, at the height of the first trade war, the American Treasury labelled China a currency manipulator on the same day. The label was dropped in January 2020, as the two sides prepared to sign their first-phase trade deal. A managed slide now would invite the same charge and hand Washington a ready excuse to escalate.

Building a reserve currency

China also has a longer game. It wants the yuan to become a stable currency for cross-border payments and reserves across the Global South. A sudden devaluation to ease a short-term trade squeeze would undo years of slow work on internationalising the currency.

That work includes the yuan's admission to the IMF's Special Drawing Right basket in 2016, a home-grown network for settling cross-border payments in yuan, and currency-swap lines with dozens of central banks. The yuan still accounts for a small share of global payments, far behind the dollar and the euro. Central banks and commodity traders will hold a currency only if they trust it will not be used as a weapon of trade policy, and that trust is built in episodes like this one.

Who a steady yuan helps

Stability has domestic beneficiaries. Chinese companies that borrowed in dollars, including many property developers still working through defaults and restructurings, would see their debts grow in local-currency terms if the yuan fell. China is also the world's largest importer of crude oil, iron ore and soyabeans, all priced in dollars, and a weaker currency would raise input costs for refiners, steelmakers and pig farmers at a time when domestic demand is already soft.

The regional picture matters too. Other Asian currencies have been rising against the dollar, and in early May the Taiwan dollar posted its sharpest gains in decades as exporters and insurers there rushed to sell dollar holdings. Against that backdrop, a falling yuan would stand out and invite accusations that China was exporting deflation to its neighbours. A yuan that holds its level lets Beijing present itself as the steady party in the region while Washington's tariffs cause the turbulence.

Steady against the dollar, softer elsewhere

The strongest objection is that Beijing is having it both ways. The dollar has fallen against most major currencies this year, so a yuan held flat against it has cheapened against the euro and the yen. Chinese goods have become less expensive in Europe and Japan without any visible devaluation, and European trade officials will notice. None of this helps in the American market, where the exchange rate is doing nothing to offset the duties.

Someone still has to pay. Chinese factory-gate prices have been falling for more than two years, a sign that exporters have little pricing power left, and a steady currency leaves them to cut margins further or give up American orders. The call would change if the fixing began to drift steadily weaker, if monthly reserve figures showed heavy intervention, or if talks with Washington collapsed and tariffs rose again. The gap between Chinese and American bond yields, with China's ten-year yield far below America's, will keep pressure on the currency whatever the central bank prefers. By keeping the yuan at 7.20, Beijing has put stability and credibility ahead of quick help for its exporters, and it has denied Washington a pretext for a currency war. Chinese exporters will have to absorb more of the tariffs themselves, and unless the tariffs come down, the pain will show up over the coming months in thinner profits and lost American orders rather than in a cheaper currency.