China's yuan is falling against the dollar: Here's what's going on

Can the US win a trade war with China?
Can the US win a trade war with China?

Could China's currency become a new flashpoint in its trade fight with the United States?

The Chinese yuan has fallen more than 3% against the dollar in the past two weeks as tensions between the world's two biggest economies have worsened. Both sides have threatened waves of new tariffs on each other's exports.

A rapidly weakening yuan has caused turmoil in global markets in the past -- and drawn criticism from the United States.

Why is the yuan falling?

Accusing China of unfair trade practices, President Donald Trump has threatened to hit the country with tariffs on hundreds of billions of dollars of its exports. Beijing has promised to retaliate.

That has investors worried that new trade barriers could inflict significant damage on China's economy, which is already showing signs of slowing down.

Another reason is the strength of the US economy, which has led the US Federal Reserve to raise interest rates this year. This makes US dollar assets more appealing for investors, pushing up the value of the greenback in relation to other currencies.

Related: China's economy shows signs of slowing. A trade war won't help

China's central bank is on a different path. It's set to free up more than $100 billion into its financial system amid concerns about the economy's health.

One dollar now buys more than 6.6 yuan, the Chinese currency's lowest level since December. The yuan had spent most of 2017 and the start of this year strengthening against the dollar.

In another sign of investor jitters, Chinese stocks entered a bear market this week, falling more than 20% from their recent high.

But some market watchers aren't freaking out about the slump in the yuan just yet.

"We do not see dramatic panic selling in the yuan market so far," said Ken Cheung, a Hong Kong-based currency strategist at investment bank Mizuho.

Is China weakening its currency on purpose?

A weaker yuan could make China's huge export industry more competitive globally, as its makes Chinese products cheaper for buyers who pay in dollars. Trump has in the past repeatedly accused China of manipulating its currency's value in order to achieve this.

But analysts don't believe this is the reason for the yuan's recent declines.

"The main reason is a stronger dollar, not China aiming for a weaker yuan in the trade dispute with the United States," said Hao Zhou, a Singapore-based currency analyst at investment bank Commerzbank.

Related: White House decides against outright limits on Chinese investment

He points out that the yuan is still relatively strong compared with the currencies of its other major trading partners, such as the euro. And other emerging market currencies, including India's rupee and Turkey's lira, have also slumped against the dollar.

Chinese authorities are aware that if the yuan falls too much, it may fuel further tensions with Trump, who could renew his accusations of currency manipulation.

"This is not in China's interests," Zhou said.

This is what a trade war looks like
This is what a trade war looks like

What does a weaker currency mean for China?

A cheap yuan can also create problems for China's economy.

Chinese companies have amassed huge levels of US dollar debts in recent years through bond sales in Hong Kong, according to financial data provider Dealogic. When the yuan slides versus the dollar, it makes it more expensive for the companies to pay back those debts.

The situation is "raising concerns that companies who have been heavy US dollar debt issuers could face challenges to service their debt, repay or refinance," said Tai Hui, Hong Kong-based chief market strategist for Asia at money manager JPMorgan Asset Management.

Related: Chinese stocks enter bear market as trade war heats up

If the yuan falls too quickly, it could also prompt large amounts of money to flow out of China as investors lose confidence and seek to exchange it for assets in dollars and other currencies.

This happened during China's last major periods of market volatility in 2015 and early 2016.

The Chinese government "will remain wary that sustained falls could trigger another bout of capital outflows," said Mark Williams, chief Asia economist at research firm Capital Economics.

What happens next?

Analysts think the Chinese government will only tolerate the yuan falling so far.

"Any benefit to exporters would be swamped if depreciation triggered economic and financial instability," Williams said in a note to clients this week.

If the currency keeps sliding, China's central bank could take action to support it by selling dollars from its huge foreign currency war chest.

But some experts suggest the dollar is unlikely to rise much further. Sim Moh Siong, a currency strategist at Bank of Singapore, said a full-blown trade war with China would also damage the American economy, weakening the appeal of dollar assets.

"Periods of protectionism in US history have been associated with subsequent US dollar weakness," he said.

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