What China did this week is the strongest counteraction it has taken so far in its ongoing trade war. It might have achieved the desired effect of causing market panic, but it will end up hurting China the most.

President Donald Trump announced last week that the United States will impose 10 percent tariffs on $300 billion of Chinese imports beginning Sept. 1. At the beginning of this week, China retaliated by ordering state enterprises not to purchase U.S. agricultural goods and letting the Chinese yuan fall below the psychologically important rate of 7 yuan against $1.

The world hasn’t seen the yuan devalued to this level since 2008. China denies that the devaluation of its currency was a deliberate retaliatory step against Trump’s tariff threat. But no one believes it.

Stock markets worldwide experienced significant losses in reaction to China’s retaliation. The Dow Jones Industrial Average dropped more than 900 points during Monday’s trading hours. According to MarketWatch.com, the U.S. major stock markets’ indices ended the day with “the S&P 500 off 6% from its record close set on July 26, while the Nasdaq is off 7.3% from its all-time closing high set the same day and the Dow has pulled back 6% from its July 15 record finish.”

The steep sell-off reflects investors’ concern that the escalating U.S.-China trade war means more uncertainty ahead, and investors hate uncertainty more than anything. What China did this week is its strongest counteraction so far in its ongoing trade war with the United States. It might have achieved the desired effect of causing panic among U.S. investors and businesses, but its action will end up hurting China more than it hurts the United States

The Domino Effect of Devaluing Currency

Devaluing a country’s currency in such a subjective way is a double-edged sword. It’s true that currency devaluation will make Chinese exports cheaper and more competitive, while making U.S. goods more expensive and less competitive. Exports of goods and services make up 20 percent of China’s gross domestic product but only 12 percent of U.S. GDP. So the harm it will do to U.S. exports is limited.

When a country devalues its currency, it will inevitably face capital flight risk. That’s exactly what happened to China back in 2015. It is well known that China controls the value of its currency by setting a daily exchange rate for the yuan versus the U.S. dollar.

In August 2015, the People’s Bank of China (PBOC) arbitrarily devalued the yuan several days in a row. PBOC explained the move was to liberate yuan’s management and bring its value more in line with the market. But many economists point out that economic data in the previous months showed China’s economic growth had slowed down and exports fell. So the bank intentionally weakened China’s currency to boost exports and economic growth.

But to the PBOC’s surprise, its yuan devaluation also caused stock markets worldwide to fall, and both domestic and international investors lost confidence in the Chinese economy. Nervous investors began to pull their capital out of China. To stem capital flight, China implemented extreme capital control measures, including:

Prohibiting outbound investments of U.S. $1 billion or more by state-owned enterprises in a single real estate transaction

Reviewing outbound money transfers of U.S. $5 million by foreign companies

Requiring foreign banks operating in China to seek preapproval from authorities to buy foreign exchange for their clients

Setting a personal foreign exchange allowance that permits a Chinese citizen to buy up to U.S. $50,000 worth of foreign exchange a year. In actual practice, the personal allowance is even lower. A former People’s Bank of China adviser confirmed at a conference early this year that he couldn’t even transfer U.S. $20,000 out of China to pay for a trip abroad.

Taking Their Capital Elsewhere

But heavy capital controls only inspired people and businesses to find creative ways to move capital out of China, including creating fake invoices, false trade records, and customs forms. One Chinese national reportedly “used the US$50,000 annual foreign exchange purchase quotas of 84 people to remit US$4.35 million to his own accounts in Australia and Hong Kong.”

This is why, despite the strict capital control, China still saw more than U.S. $500 billion capital outflow in 2015. Capital flight out of China continued in 2016, mainly due to the concern of currency devaluation and Chinese President Xi Jinping’s aggressive anti-graft campaign.

Capital flight is a huge problem in China because it reduces the country’s tax base and thus reduces the government’s revenue. It negatively affects the Chinese government’s ability to cover domestic and foreign expenditures.

No wonder China reportedly has spent U.S. $1 trillion in foreign reserves to fight capital flight since 2015. But this week’s devaluation of the yuan stirred up fresh concerns that China may see another massive capital flight, which harms China more than anyone else.

Deeper in Debt Than They Say

Devaluation not only causes capital flight, but also worsens China’s debt problem. China’s official debt to GDP ratio is at 47.6 percent. But few believe that’s true. The Bank for International Settlements records China’s debt to GDP ratio at 255.7 percent and corporate debt to GDP ratio at 160.3 percent. The Institute of International Finance estimates China’s debt to GDP at 300 percent.

Last year, S&P Global Rating issued a warning to China about its growing debt problem. Devaluation of the yuan will amplify the debt burden of U.S. dollar-denominated debt and add to the risk of defaults by overleveraged Chinese corporations and local governments.

Besides risks of capital flight and its debt burden, China’s deliberate devaluation of its currency will cause more retaliation from the United States. Through a tweet, Trump called China’s action a “currency manipulation” and demanded a response from the Federal Reserve.

U.S. Treasury Secretary Steven Mnuchin followed the president’s tweet by officially designating China as a currency manipulator, stating the U.S. will work with the International Monetary Fund to “eliminate any unfair competitive advantage gained by China.” Many previous administrations made noise about officially designating China a “currency manipulator,” but shied away from it since 1994. Such a designation will justify any further retaliation against China by the Trump administration.

Playing Plenty of Politics

Even China recognizes the many downsides of devaluating its currency. On Tuesday, the People’s Bank of China took steps to prevent the yuan from devaluating too much, too soon. What we learned from China’s latest retaliation is this: China has little interest in compromising and meeting the U.S. demand on thorny trade-related issues such as forced technology transfer.

The several rounds of trade negotiations between the United States and China from last year to this year appear more like China’s delay tactic. What is China waiting for? Xi is a president for life, and he doesn’t face reelection. As the head of an authoritarian state, Xi has little trouble silencing any dissent.

But Trump has to face an election. China is willing to endure economic pain to certain level as long as it can inflict sufficient pain on the U.S. economy and possibly influence the outcome of the U.S. election in 2020. Xi is probably waiting Trump out so he can negotiate with someone new in the White House.

The economy has been a bright spot in Trump’s first term. Monday’s stock market sell-offs show that even though China is hurting more than the United States in this ongoing trade war, China still has tools to harm the U.S. economy and public psyche. Stock market performance doesn’t necessarily correspond to the underlying health of our economy, but a steep sell-off does harm the general public’s perception of and confidence in the U.S. economy.

In the past, Trump avoided bringing up China’s human rights violation and flattered Xi openly on social media, probably hoping to bring China to a trade deal he wants. So far, that approach hasn’t yielded any desired outcome.

When the proposed tariffs on Chinese goods go into effect on Sept. 1, American consumers and businesses will suffer. If Trump wants to win in 2020, he needs to do a better job convincing the American people what he hopes to achieve though the trade war and why the economic price American businesses and people are about to pay is worth it.