How China's Central Bank Works, and How The Trade War Is Affecting It

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In the midst of escalating trade war tensions between China and the U.S., the economic health of each country seems to be going in the opposite direction. The U.S. has a robust economy, while China, on the other hand, has been showing signs of an economic slowdown.

Respectively, the U.S. dollar has been rallying, whereas the Chinese Yuan has been sliding. Although China has supported the declining Yuan by easing its monetary policies, government advisers say that they don't want it to be too cheap.

Unlike many nations that have a single representative policy force like the Federal Reserve which sets federal funds rates, China's central bank, the People's Bank of China-or PBOC-uses multiple tools to control the amount of money available to Chinese banks and the economy.

The PBOC also announces the daily exchange rate fixes of the Yuan against other currencies within a certain range. The more capital inflow there is, the stronger the Yuan, and the less capital inflow, the weaker the Yuan.

If the currency is too high compared to those of other countries, then Chinese goods for exporting will become more expensive and thus can become less popular. On the other hand, if the currency is too weak, it can often be a signal of a bear market. Thus, just like with any other country's monetary policy, it is the PBOC's job to carefully adjust the amount of money in the system.

Recently, as China has been suffering through sluggish growth, it announced in the beginning of July the PBOC's decision to cut the reserve requirement ratio by 50 points, which will release around 700 billion Yuan into the banking system.

The Reserve Requirement Ratio (RRR) is the amount of money that banks must hold in their reserves as a percentage of their total deposits. This changes means that there will be higher influx of liquidity in the economy that banks can lend out, which should lower borrowing costs. This will ultimately encourage more borrowing of money and could eventually stimulate the economy. Such easing of monetary measures has further pressured the Yuan to slip.

The Yuan's slide makes sense, however. If the Yuan is cheap, it means goods for export are cheaper in foreign markets, which can make these goods more appealing. Even though Chinese officials have said that China won't use the weakening of the Yuan as a measure to retaliate against the U.S.' trade threats, the slide is logically sound. Nevertheless, government advisors also said that they don't want the Yuan to be too cheap either, since that is a sign of slowdown of the economy.

This Friday, soon after China showed its intention to fully retaliate against Trump's tariff threats, investors bid down the Yuan to its weakest level in more than a year. This lead to the PBOC trying to move towards preventing even more depreciation of the Yuan.

As the trade threats from both sides escalate, the Yuan's unique dynamic is worth watching out for, alongside the intensifying trade war itself.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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