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As trade tensions flare up between the U.S. and China, many investors are asking whether Beijing will look to weaken its own currency to retaliate against Washington tariffs. The Chinese yuan, which trades in a band versus the dollar, has now weakened to its lowest level since December 20 and saw a daily loss of 0.3 percent on Thursday. The trend lower has led many market participants to believe that Chinese policymakers may be paving the way toward a sustained depreciation, and that caution is warranted. The weakening currency comes amid a slowing economic backdrop and a pickup in financial market volatility that has seen Chinese equities officially enter into bear territory this week.

This has prompted a policy response. On Sunday, the People's Bank of China (PBOC) announced it would lower its reserve requirement ratio (RRR) by 50 basis points. This cuts the amount of cash that some banks must keep in reserve, and is designed to help provide liquidity to small businesses. The cut in the ratio was the central bank's third in 2018. The last few episodes of sustained yuan weakness, in summer 2015 and early 2016, also led to significant capital outflows, a seizing up of credit markets and a tightening of domestic financial conditions. It has taken years for these capital flows to stabilize. But Morgan Stanley analysts highlighted in a research note last week that only in the last few months has there been capital flowing into China, rather than out of it. This coincided with the inclusion of about 200 Chinese stocks in the MSCI Emerging Markets index — a widely-traded index that can boost the credibility and liquidity of the stocks that it holds. Foreign investment accounts for only 2 percent of the total value of the domestic stock market in Beijing and it was seen as crucial for these firms to gain an international exposure. Many analysts believe that, at this juncture, a stable currency that continues to attract capital inflows is more important to China. Politically, it may not be in Beijing’s interests either. Analysts at political research firm Eurasia noted Wednesday that a strategy of weakening the yuan could also “cost China the opportunity to build alliances with other countries at the receiving end of U.S. tariffs.”