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China last Monday dropped to its lowest value since 2008. The currency is now trading at just over 7 yuan to the dollar.
Later that day, the US Treasury Department immediately labeled China a "currency manipulator."
The decision is a step toward what could become an unusual type of currency war, in which the United States would intervene to counter the effects of China's weakening currency, or both. countries even take steps to increase the value of the other's currency relative to their own.
Here are four things to know about how China manages its currency and what a currency war can mean for the two countries.
Why did the yuan fall in value initially?
China's central bank, People's Bank of China, signals each morning what the desired exchange rate for the yuan will be, and lets it rise or fall throughout the day. For the past 11 years, China has kept its currency under a symbolic 7-to-1 ratio to the dollar – until last week.
That's a big change. In fact, since 2016, China's monetary policy has been supporting the value of the yuan.
"In recent months, the pressure [market] has been against a weaker yuan, but China has resisted [depreciation of the yuan]," said Brad Setser, senior fellow in the Council on Foreign Relations and a former assistant secretary of the Treasury.
But economic forces make it much more difficult. China is experiencing symptoms of a declining economy as domestic debt and an outdated industrial sector are taking their toll. Exports have also hit a hit due to US tariffs introduced over the past year, which has put more pressure on the yuan. Monday's fall in the yuan's valuation now brings the currency closer to what economists consider the true market value.
"China is not required to withstand market pressures for a weaker currency," Setser says.
In one way, analysts say, China has succumbed to monetary pressure that is largely due to US tariffs. A weaker currency has the bonus of making China's goods cheaper for American buyers, which may offset some of the tariffs.
So is China a currency manipulator?
The Commerce Management Act of 2015 establishes three criteria for what constitutes manipulation:
– an annual bilateral surplus of $ 20 billion with the United States
– a large enough total surplus on the current account (over 3% of the country's annual GDP).
– "sustained, one-sided intervention" in the foreign exchange market to weaken the currency.
China meets only the first of these three criteria, according to the Finance Ministry's latest report on the subject in May.
China carefully manages its currency to keep the yuan at a stable and targeted value through a variety of measures, mainly through buying and selling US dollar bonds and controlling the outflow of the yuan from the country's borders. But these activities do not rise to the level of currency manipulation, say experts in China and the United States.
"I personally see this as an American tactic to put extreme pressure on China," said Wang Huiyao, president of the Beijing-based think tank, Center for China and Globalization, and an adviser to China's Cabinet.
Setser says there was a period when China unequivocally qualified as a currency manipulator. From 2003 to around 2013, he says China has consistently intervened to weaken the yuan by buying up billions of dollars in foreign currency. When China buys many dollars, it makes the US currency more expensive compared to the yuan, which means the Chinese currency is weakening. The United States still complained, but did not declare China as a currency manipulator.
"The perception was that China could react negatively and that the more productive path was one of quiet negotiation and quiet dialogue. You can discuss whether it was the right choice," Setser says.
What would a currency war look like?
The US could threaten to buy up large amounts of Chinese government bonds, which would increase the value of the yuan, even if China wants it to weaken. But China can also counteract that by buying more US government bonds and raising the dollar.
China has also long pushed for the currency to take over the dollar in international influence. "If the United States continues to press in [a currency dispute]China is likely to accelerate the globalization of renminbi as a currency for international trade," said State Council adviser Wang, using an alternative name for the yuan.
What happens next?
The Trump administration could create a legal justification for hiking tariffs for Chinese goods to the United States to offset any export advantage gained through a weaker yuan. It would break global trade rules, but the United States has already merged those regulations by introducing tariffs on Chinese imports as part of the ongoing trade war.
The United States could start negotiations with China through the International Monetary Fund, but the talks may be seen as symbolic: the United States lacks legal means to retaliate against a country for manipulating its currency.
China has so far argued that the fluctuations in the yuan exchange rate are due to market forces. Chinese trade experts say further devaluation will be risky for China's own economy, suggesting that the country will not push the yuan much lower.
"It's bad for imports, and it's bad for our capital," explains He Weiwen, a former commercial attache to Chinese consulates in the United States. That's because making the yuan weaker means China will have a harder time paying down debt in dollars and buy imports. It would also depreciate the value of Chinese assets in Chinese yuan.