Is a weaker yuan the panacea? For the risks and side-effects see…

The quantification of the economic consequences of an escalating trade dispute may still be being discussed world-wide, but the foreign exchange markets have long since passed judgement on the yuan. The USD-CNY movement, which initially started as a simple mirror image of global USD strength, has picked up momentum rapidly in the last few days and has become a fully-fledged yuan weakness. In historical trade disputes, the use of the exchange rate has proven to be at least as good a remedy as the imposition of penal tariffs. Especially for China, which has a long-standing tradition of the state supporting the country’s export sector by way of the exchange rate, a deliberate weakening of the yuan to improve international competitiveness is seductive. But those imputing China with an irresponsible yuan devaluation policy should not forget how energy-sapping the fight against capital flight was just two years ago. If the weakness of the yuan were to get out of control, it would poison the already fragile equity markets and the desolate banking sector. Nor should the loss of confidence among foreign investors be underestimated; after all, RMB internationalization is a prestige government project and a currency crisis would thwart the renminbi’s ascent to the rank of global reserve currency for a long time. The unilateral perception of China as a pure export economy is obsolete anyway. Exports are no longer the country’s sole growth engine. Consequently, a yuan devaluation is also no longer exclusively a matter of generating positive impulses for international competitiveness, but also entails a loss of purchasing power within the country (due to increased consumer expenditure on energy and other imports). For us it is beyond question that the yuan will remain groggy for the time being, including because of the global strength of the USD and the worsening economic outlook. But China would probably intervene decisively to counter any excessive depreciation and in the most extreme of cases it might impose also capital movement controls.

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