September 3, 2018 / 3:52 AM / a year ago

Trade war could force heavier hand from China on yuan

* 7-per-dollar remains key psychological level for yuan

* PBOC may resort to tighter capital controls

* Economists say direct intervention cannot be ruled out

By Winni Zhou and Andrew Galbraith

SHANGHAI, Sept 3 (Reuters) - China’s central bank may have to decide soon whether to intervene more forcefully to support the wobbling yuan currency as the United States readies more sweeping tariffs on Chinese goods.

After tinkering around the edges while the yuan fell for four straight months, the People’s Bank of China (PBOC) recently signalled it was not comfortable with further losses and managed to steady the currency before it tested the sensitive 7-per-dollar level.

But market watchers say renewed pressure on the currency is inevitable as the Sino-U.S. trade war escalates, threatening to put more pressure on China’s already cooling economy.

President Donald Trump’s administration could slap tariffs on another $200 billion of Chinese imports as early as this week, the latest punitive measures aimed at forcing Beijing to improve market access, cut industrial subsidies and slash its huge trade surplus with the United States.

Such a move could sharply amplify risks to the yuan, which is already facing downward pressure from Beijing’s domestic monetary easing, rising U.S. yields and the broad-based rise in the dollar.

“The central bank is now keeping a delicate balance, and any unexpected outcome from the Sino-U.S. trade talks or risk events in the market could weaken such balance,” said Ji Tianhe, China rates and FX strategist at BNP Paribas in Beijing.

That could spur the PBOC into tightening foreign exchange measures, Ji said.

Analysts at Bank of America Merrill Lynch see the yuan ending the year at 6.95 per dollar, another 1.6 percent decline following the currency’s losses of about 5 percent so far this year.

Goldman Sachs maintains a forecast of 7.1 per dollar by early next year, although their senior China economist M.K. Tang expects it will strengthen thereafter as trade tensions ease.


The PBOC has taken a number of steps in recent weeks to support the currency and make it more expensive for traders to bet against it, helping to ease jitters in global markets where memories are still fresh of China’s shock devaluation in 2015.

The latest came on Aug. 24, when the central bank said it had reintroduced a “counter-cyclical factor” in its daily yuan fixing, arresting a record-breaking 10-week fall in the yuan’s value that saw it dip to 6.9340 per dollar.

State banks were seen swapping yuan for dollars in the forwards market, presumably to stock up on dollars and to dampen expectations for a fall in the yuan’s value in the future.

Controls on capital flows that China imposed in 2016 and 2017 also seem to have helped prevent a recurrence of the volatility seen then, when China unsuccessfully burned through a trillion dollars worth of FX reserves to try and contain the yuan’s fall and stem capital flight.

But analysts think the PBOC has only bought itself some time, and expect renewed yuan weakness as the dollar rises.

“Further depreciation of the yuan will run the risk of triggering market panic and large scale capital outflow,” said Jonathan Cavenagh, head of FX strategy for emerging Asia at JPMorgan Chase in Singapore.

Analysts expect the next measures won’t be as light as the ones announced so far.

Going by the PBOC’s response in 2017, it could potentially impose heavier reserve requirements on offshore yuan deposits in China, change the settlement method used in currency forward contracts or significantly raise the cost of yuan for foreign short-sellers in offshore markets.

Goldman Sachs’ Tang says it is not possible to rule out other measures to tighten capital flows, or even direct dollar-selling intervention, though he says the latter would require “quite a lot of pick up in FX outflows” to spur the bank into direct action.

For now, though, market participants still don’t know which lines in the sand the PBOC will defend most aggressively.

On the surface it appeared the PBOC was stopping the yuan from a potential breach of 7 per dollar — a level not seen since the global financial crisis a decade ago. But it also seemed to have stepped in when the trade-weighted index fell near 92 — a level it possibly felt made the yuan too cheap and which it defended in 2017.

Its willingness to cross a possible third line in the sand — China’s $3 trillion safety cushion of foreign exchange reserves — is also in doubt.

Top Chinese officials have repeatedly vowed they will not use yuan depreciation as a weapon in the trade war, while Trump has accused Beijing in recent weeks of manipulating its currency to offset the impact of U.S. tariffs.

But a senior trader at a foreign bank in Shanghai warned that a sharp escalation in the dispute could leave the PBOC at a loss unless it put its money where its mouth is and defended the yuan more aggressively.

“If the authorities really want to stabilise the currency, they have to come up with real money. All this sleight-of-hand is not enough,” he said.

Reporting by Winni Zhou and Andrew Galbraith Editing by Vidya Ranganathan and Kim Coghill

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