Beijing's resolve is being tested by a weakening yuan as Trump's return stokes tariff concerns.

• The Chinese yuan is expected to depreciate further against a stronger U.S. dollar, but the extent and speed of the fall will depend on Beijing's efforts to control volatility while maintaining economic growth, according to market observers.
• Since Donald Trump's presidential election victory in early November, China's offshore yuan has lost more than 3%, while the tightly-controlled onshore yuan has retreated to near a 16-month low.
• The central bank's ability to lower rates is being restricted by the fall in the yuan.

The Chinese yuan is predicted to depreciate against a rising U.S. dollar. However, a more challenging issue for market observers is determining the extent and speed of the currency's decline.

The consequences of a weakened yuan could have a significant impact on the global economy, particularly on countries that compete with China in exporting goods and services. Additionally, it could jeopardize the efforts of Chinese authorities to stimulate growth in the world's second-largest economy.

Since Donald Trump's presidential election victory in early November, China's offshore yuan has lost more than 3%, while the tightly-controlled onshore yuan has retreated to near a 16-month low as the outlook for monetary policy in the U.S. and China diverged.

Government bonds are experiencing record low yields due to a flood of funds from investors concerned about deflation and banks struggling to stimulate demand for loans.

If incoming U.S. President Donald Trump's proposed higher tariffs become a reality, they could increase inflation and slow down the Federal Reserve's easing cycle, keeping interest rates and bond yields high for a longer period.

Since June, the yield on the has been steadily increasing and reached a high of 4.7% this month, which is the same level seen in April. Meanwhile, the dollar index, which measures the greenback against six other currencies, has risen to a 26-month high.

The CME FedWatch tool indicates that markets expect only one quarter percentage cut in interest rates by the U.S. Federal Reserves in 2025, with expectations for the number of rate cuts being lower than previously anticipated.

The widening gap in yields between U.S. debt and Chinese debt has caused investors to push up the dollar and drag the yuan lower.

'Orderly decline'

The fluctuations in the market are challenging the determination of policymakers. Although a weaker yuan may enhance the attractiveness of Chinese exports, officials are concerned about a sudden drop in the currency that could cause excessive instability.

Last week, the People's Bank of China halted its government bond purchases due to market excess demand, while simultaneously increasing its bills issuance in Hong Kong to mitigate the decline of the yuan.

The central bank has recently increased its warnings against speculating against the currency and stated that the surge in government bond investments could threaten financial stability.

Last week, PBOC Governor Pan Gongsheng stated that they will take measures to prevent the yuan exchange rate from fluctuating excessively and maintain a stable level that is reasonable and balanced.

The moderately loose monetary policy stance was reiterated by senior officials at a separate press conference last Tuesday, while they emphasized the importance of FX stability.

Goldman Sachs economists suggested last week that the PBOC may prioritize FX stability over monetary policy easing in the near term, implying such communication.

On Monday, the central bank decided to keep the benchmark loan prime rates unchanged in an effort to maintain currency stability.

By the year-end, the offshore yuan could weaken to 8.5 per U.S. dollar, according to David Roche, a strategist at Quantum Strategy, considering a situation where Trump imposes the 50%-60% tariffs on Chinese goods.

The currency last traded at 7.3357 against the greenback on Monday.

Beijing will attempt to control the yuan's decline in an organized manner, according to Roche. However, he warned that the stimulus measures implemented by Chinese authorities are inadequate to address the root causes of the economic slowdown, such as weak demand and high levels of household savings.

Prioritizing yuan

Prioritizing the prevention of a sharp decline in the yuan has hindered the central bank's ability to lower interest rates in order to stimulate economic growth.

Despite Gongsheng's prediction in September of a possible reduction in bank reserves by the end of 2024, the cut has not yet occurred, even though the policy stance has shifted to "moderately loose."

Despite mounting pressure on domestic growth, the central bank is unlikely to cut interest rates sharply in the near term due to its temporary policy priority on exchange rate stability, according to Helen Qiao, China and Asia economist at Bank of America.

The central bank was expected to maintain its defense of the currency through stricter capital controls and liquidity directives to financial institutions.

Although the Fed is taking a hawkish stance and limiting the ability of the PBOC to lower interest rates, Beijing has a range of policy tools at its disposal to prevent excessive currency fluctuations, including verbal intervention, adjusting offshore liquidity through bill issuance, and enlisting state-owned financial firms to directly purchase CNH (offshore yuan), according to Lynn Song, the chief China economist at LNG.

The PBOC manages the onshore yuan's currency value using the daily reference rate, which sets a 2% trading range for the onshore yuan. Despite a rising greenback, the central bank has maintained a stronger exchange rate guidance of over 7.20 per dollar.

On Monday, the onshore yuan was set at 7.1886 per dollar, but markets have been pushing it towards the weaker side of the band, and it is currently trading at 7.3249.

Exports at stake

In the last quarter of 2024, China's economic activity grew faster than anticipated, driven by strong exports due to businesses moving up shipments before tariff increases. However, experts cautioned that the growth rate may decline later this year as a result of President Trump's tariff hikes.

Kamil Dimmich, portfolio manager at North of South Capital, stated that Beijing does not want to see a collapse in the currency before determining the extent of tariff hikes from the Trump administration.

On Monday, Trump will take office and has promised to impose universal tariffs of 10% to 20% on imported goods, and 60% or higher on shipments from China, although some speculated the tariffs would be implemented gradually.

"Larry Hu, Macquarie's chief China economist, stated that while the tariff hike in trade war 2.0 could potentially result in a larger increase, the scope for yuan depreciation may be smaller this time due to Beijing's preference for a "relatively stable yuan.""

In the third quarter this year, the offshore yuan is expected to reach a peak of 7.50 per dollar.