Will currency be next battlefield of US-China trade war?

Trade tensions have been escalating between China and the United States recently, and it seems US President Donald Trump is not backing down from his tariff plans toward China and other trading partners.

It could be just a matter of time for the Trump administration to launch a currency war with China. So is China well prepared for a potential threat toward the yuan?

Trump has announced a series of tariffs and investment measures for Chinese imported goods, including 25% on steel and 10% on aluminum. He also plans to impose more tariffs on a wide variety of Chinese goods, valued at US$200 billion. Reports from Washington also suggest that the administration could impose restrictions on Chinese investment in the US tech sector.

Though White House economic adviser Peter Navarro has dismissed such reports, market sentiment remains low and uncertainties still loom over the future relationship between the two largest economies in the world.

So far reactions from Beijing remain subdued. President Xi Jinping says China will retaliate and will begin to impose 25% tariffs on more than 500 categories of US products, including soybeans, beef and cars, worth up to $34 billion. China is also targeting the US energy sector and could add another $16 billion worth of tariffs later on.

But things could change very soon. Just this week Xi said that in Chinese culture, “if somebody hits you on the left cheek, you turn the other cheek and punch back,” implying the country could take a strong stance against the US.

From the US point of view, what could the Trump administration possibly do if it decides to tighten the grip further? Perhaps targeting the yuan could be its next step. China has been making every possible effort to internationalize the yuan. The country has been promoting the usage of the Chinese currency outside China, such as in international trade transactions, foreign-exchange settlements and clearings, and bond issuances.

In 2015, the International Monetary Fund included the yuan it its Special Drawing Rights (SDR) currency basket, considered one of the milestones internationalization of the yuan.

China’s ambition to replace the dollar and the euro with the yuan as the world’s new reserve currency is more obvious than ever. If the purpose of Trump’s trade war with China is to challenge its expanding international influence, a currency war with China looks almost certain for policymakers in Washington to consider.

What could Beijing do to “punch back”? Some suggest that the country has two choices – “weaponize” its currency or liquidate its US Treasuries holdings. China could weaponize the yuan by allowing it to depreciate, which could be the quickest way to fire back at the US tariff measures. The move would increase the US trade deficit with China and help boost exports of Chinese goods. US manufacturers would also take a direct hit.

However, this could be the last action Beijing would take because it would probably do more harm than good. Lowering the value of the yuan would drive up inflation in China, and the government’s efforts of maintaining a stable inflation rate in the past few years would be in vain.

Moreover, wealthy Chinese would probably speed up the process of moving their money out of the country, causing additional capital outflow and triggering panic in China’s equity market. And in the biggest impact of all, the global markets would likely lose faith in the yuan, which is something Beijing doesn’t want to happen.

What about selling China’s US Treasuries holdings? China’s holdings of US Treasury bonds have jumped by 2.5 times over the past decade, providing major support for increasing supply of the yuan globally. Selling some of the bonds seems not to match with Beijing’s plans for the yuan as well.

In all, China has limited options when facing a trade war with the US. To survive such a conflict, China may have to sacrifice some of its exports to the US, instead of punching back with a currency war.