Will a Weaker Yuan Help China Tackle the U.S. Tariff Threat?

Recent reports suggest that Chinese policymakers are contemplating a significant devaluation of the yuan in 2025 as a strategic response to the potential 60% tariff on Chinese imports proposed by U.S. President-elect Donald Trump. This would mark a notable shift in Beijing’s currency policy amidst growing economic challenges. But the critical question remains: will it work, or will it backfire?

The Context: U.S. Tariff Impact and Beijing’s Strategy

Trump’s proposed tariff structure—10% on all imports and a staggering 60% on Chinese goods—has sent shockwaves through global trade and economic circles. In response, Beijing is reportedly weighing the option of allowing the yuan to depreciate, which could:

• Make Chinese exports cheaper, counteracting the increased costs caused by tariffs.
• Support export-driven industries to buffer the economic impact.

However, China is walking a tightrope. Analysts, including Lynn Song from ING, predict that the People’s Bank of China (PBOC) will tread cautiously to avoid a drastic yuan devaluation, which could invite harsher retaliatory actions from Washington.

Financial News, a PBOC-affiliated publication, has downplayed the currency devaluation rumors, maintaining that the yuan remains fundamentally stable and could even strengthen by year-end.

China’s Deeper Crisis: A Balance Sheet Recession

The tariff issue, while significant, is only part of China’s broader economic woes. The country is battling a balance sheet recession, characterized by:

• Collapsing real estate markets, eroding household wealth.
• A weak stock market and sluggish consumer spending.
• Businesses and consumers prioritizing debt repayment over investment or spending.

Alfonso Peccatiello, Chief Investing Officer at Palinuro Capital, explained:

“The gentle de-leveraging of the housing market that policymakers had in mind turned into a vicious balance sheet recession. Trillions in wealth tied to real estate have been wiped out since 2021.”

In this scenario, traditional monetary tools like interest rate cuts or currency devaluation often prove ineffective. Peccatiello compared China’s predicament to the Eurozone debt crisis (2011-2012), where fiscal austerity neutralized central bank measures.

Why a Weaker Yuan Won’t Solve China’s Problems

While a devalued yuan may appear as a quick fix to offset tariffs, many economists are skeptical. Here’s why:

1. Limited Impact on Domestic Demand

• In a balance sheet recession, households and businesses prioritize financial recovery over spending. A weaker currency doesn’t rebuild confidence or net worth.

2. Rising Retaliatory Risks

• A sharp yuan depreciation could provoke escalated U.S. trade penalties or further tariffs, exacerbating trade tensions.

3. Foreign Investor Concerns

• A rapidly falling yuan could scare off foreign investors, leading to capital outflows and further market instability.

Peccatiello summarized this sentiment:

“In a balance sheet recession, consumers and corporates can’t be encouraged to spend more by cutting interest rates or weakening the currency. They are bleeding.”

Beijing’s Response So Far: Small Steps, Limited Impact

China’s policy measures have been reactive rather than bold, with efforts including:

• Small-scale fiscal stimulus programs.
• Preventing market destabilization by deterring short-selling of stocks.
• Aggressive interest rate cuts to improve liquidity.

Despite these actions, China’s economy has failed to show meaningful improvement. The iShares MSCI China ETF, a benchmark for Chinese equities, remains 50% below its peak from February 2021.

What’s the Real Solution? Targeted Fiscal Stimulus

Economists argue that China needs a more decisive approach: a large-scale, targeted fiscal stimulus. This strategy would focus on:

1. Supporting struggling corporations with direct financial assistance.
2. Rebuilding consumer confidence through subsidies and stimulus checks.
3. Investing in infrastructure to drive economic activity.

Unlike currency devaluation, fiscal stimulus addresses the root causes of a balance sheet recession by helping households and businesses regain financial stability.

Can China Rise Above the Crisis?

While devaluing the yuan might offer short-term relief against U.S. tariff threat, it’s unlikely to solve China’s deeper economic problems. The current balance sheet recession requires bold fiscal measures to restore confidence, rebuild wealth, and stimulate domestic demand.

With mounting economic pressures and global trade tensions on the rise, all eyes are on Beijing. Will the Chinese leadership take the decisive action needed to chart a course to recovery, or will it resort to short-term fixes like currency devaluation? Only time will tell.

Key Takeaways:

• A weaker yuan may make Chinese exports cheaper but poses risks of escalating trade conflicts.
• China’s economic issues stem from a balance sheet recession, not just U.S. tariffs.
• Fiscal stimulus, rather than currency manipulation, may be the real solution for economic recovery.