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China fires a warning shot as the trade war escalates

China’s currency, the yuan, has weakened significantly against the dollar. That suggests the trade war will only get worse, says John Stepek. Here’s what it means for you.

A woman counting Chinese yuan bills © TEH ENG KOON/AFP/Getty Images

Quick thing before I get started this morning if you're in Edinburgh for the festival this year, don't miss the chance to see Dominic Frisby (until 16 August) and Merryn Somerset Webb (from the 17th to the 25th) discussing some of the meatiest political and economic topics of the day with a wide range of guests (including me on the 22nd and 23rd) in Panmure House, which was Adam Smith's final home.

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Get your ticket here last year's was a big hit with the audiences and this year's promises to be even better.

Now to this morning's business and no sooner had the digital ink dried on yesterday's email than the yuan broached the magic "more than 7 to the US dollar" level that we've been highlighting for a while.

So what does it mean, and why does it matter?

The Chinese are manipulating the yuan but not to weaken it

Yesterday, China's currency, the yuan (renminbi) weakened to the point where one US dollar now buys more than seven yuan. That's the first time in over a decade that the yuan has been this weak against its American counterpart.

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The move followed US President Donald Trump's threat last week to impose tariffs on pretty much any other import from China. That in turn, came after the Federal Reserve, America's central bank, was less dovish than (it appears) Trump had hoped.

The US response has been to label China a "currency manipulator". The US has always been vaguely threatening China with this label. But it has refrained in the past. Not anymore.

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China has "a long history of facilitating an undervalued currency". But now, says the US Treasury, it "has taken concrete steps to devalue its currency, while maintaining substantial foreign exchange reserves despite active use of such tools in the past".

Markets didn't like it. The S&P 500 saw its biggest one-day drop so far this year. That makes it sound worse than it was a 3% fall is nasty but it's falling from close-to record highs. However, it makes it pretty clear that investors are now genuinely worried about the trade war.

So what's the big deal about the number seven? Clearly the number itself means nothing. It's relevant because markets have viewed it as a line in the sand.

China's currency is managed. It doesn't float freely in the way that sterling, or the euro, or the Aussie dollar do. In other words, it's manipulated as a matter of policy.

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However, most foreign exchange experts would argue that China has in fact been keeping the yuan artificially strong, rather than weak, against the US dollar. One reason for that is because China wants the yuan to be a contender for global reserve currency one day. You don't get that by being a flaky emerging-market yo-yo.

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Also, in the shorter-term, but in a similar vein, China has been worried about capital flight. If you're a wealthy Chinese person, or have even a bit of money, the last thing you want to do is to keep it in a depreciating currency, one which is also subject to capital controls that may well get even stricter. Defending the yuan is one way to discourage capital flight.

So the fact that China is no longer doing this shows that the US has sufficiently irritated it to change policy. In fact, as John Authers points out on Bloomberg, data from Bank of New York Mellon suggests that China intervened to stop the yuan from weakening even further than it did.

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So the breaching of the 7 mark is a deliberate warning shot. And it suggests the trade war will escalate, rather than settle down whatever political expediency and game theory suggest.

Here's what you need to do now: either do nothing, or get organised

So why are markets so rattled?

One thing underpinning this bull market has been the belief that central banks could solve any conceivable economic issue by printing money (that's not the only thing underpinning it, but it's an important pillar).

And that wasn't an unreasonable belief. Fears of a return to a 2008-style debt collapse are understandable. But we now know (or have been reminded) that central banks can step in and make a bust banking system liquid and (with the tacit permission of governments) even solvent again.

It's also become clear that there is nothing that central banks won't buy in the quest to prop up growth statistics, asset prices and balance sheets. The European Central Bank has been flying kites about the idea of investing in equities. The Japanese central bank already does this.

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So we know that central banks are able to tackle asset-price crashes and, more than that, we know that they're more than willing to do so. It does rather erode away the principles and the point of having a free market economy. But that's for the long term, and the long term is typically someone else's problem.

What they can't do, however, is make a trade war go away. And the US central bank would also have a job on its hands to try to restructure China's economy in such a way that it can avoid a painful adjustment that will probably be damaging to global economic growth.

Basically, if the two global economic powers are at each other's throats, then all the stimulus in the world from central banks is not going to be able to contain the fallout.

What does that mean for investors? As always, if you have a plan in place that you are happy with, it shouldn't mean a huge amount. What really matters at times like these (it always matters, but panic-prone moments matter more), is that you do have a plan in place that you're happy with. Because otherwise you'll make mistakes.

Think for a moment: is your long-term asset allocation plan really contingent on Trump's Twitter feed? Of course it's not.

But if you don't really know where your money is right now; or what you want to do with it; or if you're focusing on getting-rich-quick from the one tiny successful stock pick in your "fun money" portfolio, while your neglected workplace pension, in which the bulk of your funds are languishing, is hopelessly overweight in one market or another well, you need to take an afternoon to go through your finances.

Oh and if you enjoy the intellectual challenges of markets and geopolitics, by all means continue to enjoy them (and if you're in Edinburgh, you can join the dialogue at the Adam Smith show I mentioned above) but don't expose your entire portfolio to your predictions.

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