Since President Trump canceled the trade-deal with China earlier this month. And instead raised tariffs – global markets (and currencies) have plunged.

Especially the Chinese yuan – which is now down nearly 3% against the U.S. dollar this month. (And one of the worst performing currencies in the world). . .

Putting things in perspective – the last six months of yuan gains (beginning November 2018) were wiped out entirely over just a couple weeks.

But now – it appears that the Peoples Bank of China (aka PBOC – China’s central bank) has drawn a red-line in the sand.

And that’s because they can’t afford for the yuan to continue weakening – so they have kept the daily fixing for the onshore yuan price stronger than the actual spot rate. (Meaning the PBOC intervenes by selling foreign reserves – like the USD – and buys yuan instead to prevent further declines).

Clearly the Chinese authorities can’t risk the yuan depreciating below the “all-important psychological level” of the seven-yuan-for-one-USD exchange rate.

This would cause a wave of turbulence in Chinese stocks and assets (which it historically has). Especially as Chinese citizens begin trying move their assets out of the Mainland. And foreign investors dump Chinese stocks so that they can pull their capital out – causing markets to plunge.

This is the last situation Chinese leaders want to be in. . .

China’s already slowing economy can’t handle this outcome – and neither can their fragile banking and corporate sector.

Remember – 2018 was a record year for Chinese corporate defaults – and so far this year – things look like they’ll be even worse.

Keep in mind that onshore Chinese firms have massive dollar-denominated debts. (With $2 trillion-plus worth maturing over the next 24 months alone).

And with the yuan even weaker – it takes much more for these Chinese firms to service their dollar-debts in ‘real’ terms.

That’s because domestic Chinese firms get paid in the yuan – but must convert them into U.S. dollars so that they can repay the dollar-debts. (And the weaker the yuan is, the more it takes to convert into that same dollar).

Thus – China’s economy has a constant need for foreign capital (aka dollar-inflows) so that they can keep growing. And for onshore firms – and banks – to stay solvent and operating.

But – there’s a catch. . .

China’s constant need for foreign capital only grows as their once massive current account surplus quickly shrinks into a deficit. (Meaning that China’s spending more than what they’re receiving in income).

And according to Morgan Stanley – factors causing this are:

A slowing economy (the lowest expansion rate in 28 years), declining exports (which a trade-war would only make worse), rising domestic demand for imported goods, and a declining savings rate. . .

Thus – this vanishing current account surplus makes China even more fragile as they must carefully prevent any large capital outflows – and instead encourage further inflows.

So – in summary – China’s authorities understand why they must draw a thick-line in the sand and prevent any further yuan declines (even if it’s costly). Because if both domestic and foreign capital begin fleeing from China – a ‘tipping-point’ may be reached.

Still – a weaker yuan could help China in a trade-war with the U.S.

For instance – if the U.S. places 20% tariffs on all Chinese goods – China could simply devalue the yuan by 20%. This would offset the increased costs of the tariffs – keeping the price for U.S. consumers unchanged. Basically rendering the imposed tariff worthless.

(No doubt that President Trump would notice this – and retaliate with further tariffs). 

But – like I detailed in this article – there’s many direct (and unintended) consequences from a much cheaper yuan.

And at this point – in China’s eyes – a weaker yuan has greater risks than the potential rewards (aka negatively asymmetric).

So – for now – keep an eye on the yuan. And let’s see if the PBOC can keep it below that $7 mark.

(But – in all honesty – I wouldn’t be surprised if it eventually slides below that line. . .)

Stay tuned.

P.S. – I’m still short China.