The U.S. Treasury Department designated China a currency manipulator for the first time since 1994, after Beijing let the yuan depreciate Monday, marking an escalation of the trade war.
The drop in the yuan's value on Monday triggered a harsh rebuke from U.S. President Donald Trump, and a sharp sell-off on Wall Street, as speculation grows that Beijing is intervening in the currency market to lift flagging exports.
Financial markets in Asia tumbled on Tuesday morning as fear of rising tensions between world's two largest economies sent shares plummeting.
Japanese stocks opened sharply lower. At one point in morning trade, the benchmark Nikkei 225 was down more than 600 points, or 2.9%, from Monday's close, following steep declines in New York. South Korea's Kospi index fell 2.8% to 1,891.81. Taiwan's Taiex was down 2.3% at 10,180.
China's benchmark Shanghai Composite Index was 1.6 % lower at 2,776.98 in the morning. Hong Kong's Hang Seng Index opened lower, at 25,473.43, down 2.6% from Monday's close.
Overnight, U.S. stocks nose-dived, with the Dow Jones Industrial Average closing 767 points lower, its biggest fall this year. The Dow sank 961 points at one stage. The S&P 500 fell by as much as 3.75% and the Nasdaq Composite by 4.26%.
The yen softened to 106.3 against the dollar from the mid-105 range in late-morning trade. The South Korean won fell to 1,208.31 versus the greenback.
The People's Bank of China, the central bank, on Tuesday set the yuan's reference rate at 6.9683 to the dollar, down 0.0458 from the previous day and the lowest point since May 2008. Spot rates for the yuan slid to 7.13 in offshore trade, as more investors sold the Chinese currency.
"Stocks fell sharply as investors expected U.S.-China tensions to further intensify after the U.S. labeled China a currency manipulator," said Hirokazu Kabeya, chief global strategist at Daiwa Securities. "But the drops have softened in recent trading, which indicates that investors want to look carefully at the situation," he added.
On Monday, the Chinese currency crossed the politically sensitive threshold of 7 yuan to the dollar to its lowest level in roughly 11 years. But while a weaker currency could provide a boost to export-focused companies, it also risks sapping investors' confidence in China and driving capital abroad.
"China dropped the price of their currency to an almost a historic low. It's called 'currency manipulation,'" Trump tweeted Monday morning.
Calling it "a major violation," Trump noted that "China has always used currency manipulation to steal our businesses and factories, hurt our jobs, depress our workers' wages and harm our farmers' prices. Not anymore!"
Hours after Trump's tweets, the Treasury Department formally designated China a currency manipulator.
"Secretary [Steven] Mnuchin, under the auspices of President Trump, has today determined that China is a Currency Manipulator," the Treasury Department said in a press release. "As a result of this determination, Secretary Mnuchin will engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China's latest actions."
China until now has carefully avoided the yuan softening to more than 7 a dollar, given Trump's criticism over the yuan's weakness. Beijing intervened when the Chinese currency came close to crossing the line both after the U.S. presidential election in 2016 and when trade tensions escalated in 2018.
But monetary authorities on Monday let the currency weaken beyond the threshold, likely in response to Trump breaking the countries' truce on trade with a new round of tariffs. He announced Thursday that he will impose a 10% tariff on $300 billion worth of Chinese products starting Sept. 1, which would mean virtually all shipments from China would face penalties.
Immediately after the exchange rate crossed the 7 yuan mark in Shanghai on Monday, the People's Bank of China issued a statement attributing the drop to unilateral and protectionist measures on trade, as well as the expectation of additional tariffs on Chinese goods. The statement was an indirect swipe at the U.S.
The Chinese economy is under heavy pressure from the trade war. Real economic growth came to 6.2% in April-June, the lowest figure since quarterly figures became available in 1992. Production and investment have both slowed as tariffs squeeze exports, and globally focused companies have pinned their hopes on a weak yuan to lift their bottom line.
"Should the U.S. further escalate trade tensions, we cannot rule out the possibility that the Chinese government will further weaken the yuan in order to help exporters," said Zhang Ming, senior research fellow at the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. More within the government seem to be advocating for a certain level of softness in the yuan.
Still, there is the risk that the situation spins out of control. The yuan continued to weaken after a surprise devaluation in 2015, leading to massive capital flight and a plunge in stock prices.
It "would do more harm than good to the country for the yuan to depreciate beyond 7 to the dollar," Sheng Songcheng, the former director of the PBOC's statistics department, said back in May. A devaluation risks hurting the market's trust in the yuan's stability and could lead to another bout of widespread capital flight.
As a responsible country, China will "remain committed to the market-based exchange rate regime, refrain from competitive devaluations, and will not target exchange rate for competitive purposes," said PBOC Gov. Yi Gang in a statement on the central bank's website.
"Exchange rate will not be used as an instrument in dealing with trade disputes or other external disruptions," Yi said.
He likely wanted to curb expectations of a further weakening in the yuan.
Concerns about a further economic slowdown could push investors to offload the yuan, which in turn could trigger turmoil in the currency market. The PBOC is eyeing firm measures against short-term, speculative investments.
But the bank does not have the wherewithal it once did to intervene. Its foreign reserves have shrunk to $3.1 trillion from nearly $4 trillion as a result of efforts to stem the yuan's decline since 2015. It could take aggressive measures like limiting overseas transfers if speculative investors persist.