![Investors are hoping that US President-elect Donald Trump might be moderating his aggressive approach to China.](/content/dam/images/g/t/n/m/o/p/image.related.afrArticleLead.620x350.gtno0x.png/1483913849436.jpg)
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Investors heaved a sigh of relief last week, as Beijing and the new Trump administration appeared to step back from the brink of a dangerous currency war that is threatening to disrupt world trade and roil global financial markets.
Beijing was the first to act, staging an aggressive intervention to prop up the Chinese yuan as it threatened to breach the important milestone of seven yuan to the US dollar – a level not seen since mid-2008.
To punish speculators who were betting on the currency's decline, China's central bank, the People's Bank of China, engineered a major short squeeze, which pushed the cost of borrowing yuan in Hong Kong's overnight lending market to staggering levels.
The People's Bank of China directed state-owned banks to reduce the amount of yuan they lent to other banks, which pushed the cost of borrowing yuan overnight in Hong Kong's interbank market to 61.3 per cent on Friday – the second highest level on record – up from 38.3 per cent on Thursday.
The sharp rise in borrowing costs scorched speculators who had bet on a continued fall in the yuan by borrowing the currency in Hong Kong and swapping it into US dollars, with the hope of making a profit by exchanging back into yuan at a more favourable rate. Faced with soaring yuan borrowing costs, these speculators scurried to close out their bearish bets by buying back yuan. As a result, the yuan gained more than 2 per cent over two days.
Last week's intervention highlights the dilemma the Chinese central bank faces as it tries to gradually guide the yuan lower, without exacerbating capital flight. The problem is that if Chinese individuals and companies believe the yuan will keep falling, they will step up their efforts to move money abroad – and this puts further downward pressure on the currency. To prevent the yuan from falling too sharply, the PBoC has spent about $US1 trillion ($1.4 trillion) of the country's foreign exchange reserves in the past 17 months.
Figures released on the weekend showed that this pattern continued in December, with China's foreign exchange reserves dropping by a further $US41 billion to $US3.01 trillion, the lowest level since March 2011. As was the case in previous months, December's fall in reserves was largely due to the Chinese central bank selling foreign currency to slow the yuan's decline, according to a statement by the State Administration of Foreign Exchange.
Beijing is clearly anxious to steady the yuan in the lead-up to the January 20 inauguration of US President-elect Donald Trump, who has pledged to declare China a "currency manipulator" for pushing the yuan artificially low to gain an export advantage and threatened to impose punitive tariffs of up to 45 per cent on imported Chinese goods.
But investors breathed a sigh of relief last week, when Trump and his transition team decided not to risk escalating tensions with Beijing by meeting with Taiwanese president, Tsai Ing-wen, who stopped over in the United States on the weekend on her way to a tour of Central America.
Some analysts argue that the decision not to meet with the Taiwanese president shows that Trump is moderating his aggressive approach to China for fear of unleashing a trade war between the world's two largest economies.
Others, however, disagree. They point out that Trump has appointed a team of staunch protectionists and China hawks to take charge of US trade policy, which increases the risk of a damaging trade war.
Chinese officials have already warned that Beijing will retaliate with its own import duties if the Trump administration imposes new tariffs. But the even bigger risk is that Beijing responds to charges that it is a "currency manipulator" by allowing its currency to float freely.
Such a move would result in a sharp fall in the yuan, and trigger a dangerous global currency war as China's trade competitors race to devalue their own currencies. And as was seen in early 2016, turmoil in currency markets quickly translates into a huge sell-off in global equity markets.