In Tokyo this week, Donald Trump had a bad case of China on the brain.

Best as Japan’s Shinzo Abe tried, be couldn’t quite hold the U.S. president’s attention. Neither sumo nor golf nor an audience with the new emperor nor a naval base visit could distract U.S. President Trump from his China-bashing habit.

One likely reason: the Chinese yuan. Though President Xi Jinping doesn’t tweet, his sliding currency is trolling Trump in tantalizing ways. The question is whether the yuan’s slide to 7 versus the U.S. dollar triggers Trump to intensify his trade war? Odds are it will.

Only Xi’s government can say whether it sanctions the biggest monthly yuan retreat since July 2018. At least on the surface, Beijing officials are fighting the trend. Take Guo Shuqing, China’s lead banking and insurance official, who warns that traders “shorting the yuan will inevitably suffer from a huge loss.”

As Chinese growth slows, possibly even into the 5% range, a more competitive exchange rate might be a welcome dynamic, say economists at Bank of America Merrill Lynch. Beijing could use all the stabilizers it can find as Trump’s tariffs throw sand in the gears of the all-important export engine. But Guo’s line in the foreign exchange sand makes sense on a couple of levels.

First, China Inc.’s huge and rising debt load. The roughly $1.3 trillion of dollar-denominated debt coming due over the next 12 months is greater than Beijing’s holdings of U.S. Treasury debt. The more that yuan slides, the more expensive that debt is to service, and the more likely big mainland companies are to default.

That leaves Chinese officials with a devilishly difficult decision. They can let companies fail and stomach the resulting chaos in markets–including big stock losses at the Shanghai and Shenzhen exchanges. Or they can bail out companies, denting Xi’s promise to let market forces play a “decisive” role in reform efforts. This would reward bad behavior, which investors call “moral hazard.”

Second, the risk of trolling Trump. In the days before Trump landed in Tokyo on May 25, Trump hiked taxes on $200 billion of Chinese goods to 25% from 10%. His White House effectively barred Huawei Technologies from doing business in the world’s biggest economy. He threatens to tax all goods China ships America’s way, just over $500 billion annually. He also has previewed a 25% duty on imports of cars and auto parts.

Clearly, bowing to Trump’s mercantilism isn’t in Xi’s DNA. It’s the economic version of an immovable object versus an unstoppable force. Xi isn’t just the strongest Chinese leader in generations, he’s also a leader who knows he’ll be around long after Trump leaves the White House, whether that’s in 2021 or 2025. But then, provoking Trump isn’t in Xi’s interest, either.

Letting the yuan weaken past 7 would increase the odds Trump’s Treasury Department will label Beijing a “manipulator,” adding a currency war to the trade battle. On Wednesday, the Treasury Secretary Steven Mnuchin reminded China what’s at stake. Though Mnuchin didn’t slap the “M” word of the yuan, he added Singapore, Malaysia and Vietnam to Washington’s currency watchlist.

It seemed a bit gratuitous, considering Trump’s own attacks on the Federal Reserve to cut interest rates. That is, until you consider the common thread: countries with deep, and deepening, China trade links.

Shinzo Abe’s Japan, also on the Treasury’s watchlist, now ships more goods to China than the U.S. So does Moon Jae-in’s South Korea, which is also on the list. Looked at through this prism, Mnuchin firing bow shots at Singapore, Malaysia and Vietnam fits a Trumpian pattern.

The yuan’s 2.5% drop in May is coming just ahead of Trump’s planned chat with Xi at next month’s Group of 20 summit in Osaka. The trajectory could have Trump upping the pressure in the weeks ahead.

Economists at Citigroup, for example, think the yuan breaking the 7 level will trigger a stock selloff. Hence talk Beijing might intervene in markets to cap the yuan. This, it’s worth noting, is the third time since 2015 that speculators tested China’s exchange rate tolerance. Trump’s trade war makes this time the most dangerous.

Count Kyle Bass among short sellers assuming Beijing will hold the line. Earlier this month, the Hayman Capital hedge-fund manager disclosed that he exited a long-held bet against the yuan. One possible reason: it’s gotten tougher to trade the yuan offshore. That makes shorting China very expensive. Bass also may see 7 as Xi’s limit for yuan weakness.

This currency war risk has Tokyo on guard. Though Abe and Trump just shared a glorious bromantic experience in Tokyo, Trump has zero tolerance for a weaker yen. That’s quite a downer to Abe. A 30% depreciation was the main driver behind Japan’s longest expansion since the 1980s. That run is now ending, thanks to Trump’s tariffs. Abe, like Xi, would risk a Trump tantrum as the dollar moves higher.

As Trump’s political and legal jeopardy increases at home, the odds of him lashing out abroad, wagging the proverbial dog, are increasing. Officials from Venezuela to Iran can attest to that. So can Xi’s China, which is loath to provoke a fresh Trumpian attack that shakes world markets. – William Pesek (Forbes Asia)

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