In the trade war with the US, China should fight smart – and weakening the yuan or selling its US Treasury notes wouldn’t help

Will China weaponise or weaken its currency as a retaliatory measure amid rising trade tensions with the United States? And will Beijing offload a trillion dollars in US Treasury holdings? These are some of the most frequently asked questions of late, given that trade talks seem to be deadlocked. Both the US and China have seemingly taken a tougher stance and are now preparing for a prolonged dispute. 

Certainly, both options are available and probably feasible for the Chinese government, since the US has taken a hard line against Chinese companies and Beijing needs to flex its economic muscles, as well. However, rationally speaking, it doesn’t make much sense for China to devalue its currency or sell its holdings of US Treasury bonds before things really get out of control. One thing is clear: both the options are double-edged swords that could hurt both the US and China.

Let’s look at the idea of yuan devaluation. At first glance, it seems to make sense to allow the currency to weaken when Chinese exports will be hit by higher tariffs. In theory, a country could increase its exports by devaluing its currency.

However, in a trade war scenario, the US could levy more tariffs on Chinese goods if China deliberately weakens the yuan to gain a competitive advantage. In the meantime, a yuan devaluation could also reduce China’s imports from the US, as import prices will rise.

And this is likely to result in complications: China’s trade surplus with the US could widen further and US President Donald Trump might ratchet up the pressure, making more accusations that China is stealing from the US.

As it is, the Chinese yuan is very close to its weakest level in a decade, and further weakness will ultimately spark concerns about financial stability, and spur further capital outflows. At the National People’s Congress in March, Yi Gang, the governor of the People’s Bank of China, said the Chinese currency had been under depreciation pressure since 2015 and in response, China had reduced its foreign exchange reserves by US$1 trillion.