Hong Kong CNN Business —  

The United States just formally labeled China a “currency manipulator.” The move is largely symbolic, but it does show that the trade spat between the world’s two largest economies is likely to get much worse before it gets better.

The implications of the designation are pretty complicated. First of all, the Trump administration’s claim about whether China rigs its money to gain an unfair competitive advantage in trade isn’t cut and dry. And Beijing, for its part, has denied that it manipulates the yuan.

But the symbolism has already had obvious effects on the global marketplace. Investors were clearly nervous after China let the yuan decline in value on Monday, and those jitters carried over for a bit during early trading hours Tuesday.

The designation “will worry markets as a sign of deepening tension over the currency’s entanglement in the trade conflict — rather than the olive branch investors were hoping for,” analysts at the Eurasia Group wrote in a research note Tuesday.

Symbolic threshold

The Trump administration is upset because China let the yuan go past 7 against one US dollar, a symbolically important threshold that was last crossed during the 2008 financial crisis. US officials say China is deliberately weakening the yuan, which makes Chinese goods cheaper for foreign buyers.

But most experts and analysts say that China’s central bank has actually been taking measures to prop up its currency for years as a way to prevent companies and the business community from pulling money out of the country.

The People’s Bank of China knew that “going through 7 would be an irritant in trade negotiations,” said Logan Wright, director of China markets research at Rhodium Group. “Now that trade talks have deteriorated, the case for holding the line at 7 [was] weaker,” he added.

In other words: Yes, China has in recent years intervened in its currency market. But it hasn’t been to weaken the yuan.

The country also has the backing of the International Monetary Fund, which hasn’t deemed China to be guilty of currency manipulation. In a report issued last month, the IMF said it found China’s handling of the yuan in 2018 “broadly in line with fundamentals and desirable policies.”

Christine Lagarde, the IMF’s outgoing managing director, also pushed back last year on the Trump administration’s accusations that China was manipulating its money. She said the decline in the yuan, also known as the renminbi, is a reflection of a strong US dollar.

“If you compare the position of the renminbi relative to the dollar, it’s one particular story which has also a lot to do with the strength of the dollar,” Lagarde said at a meeting in Indonesia, according to Bloomberg.

The one-two punch of breaking through 7 and the currency manipulation label will rattle investors. But markets will be paying far more attention to how China’s central bank manages its currency. Going forward, China has strong incentives for avoiding a fast drop in the yuan because it is not in the country’s interest to have an unstable currency.

The People’s Bank of China is “trying to contain expectations of a more rapid depreciation […] that’s the more important mid-term significance for markets,” Wright said.

A bad reputation can be bad for the economy

Countries don’t want to be called currency manipulators. The label carries a stigma that can affect a country’s reputation in the international community.

In the past, China, South Korea and other countries that were on the brink of being labeled a currency manipulator took actions to avoid that designation, because the signal to the global community is that the country is not being a fair macroeconomic player.

And that can have knock-on effects.

Private sector investors may not want to invest in a country that isn’t playing by the rules, and countries may not want to trade with someone who has an obviously unfair competitive advantage.

China being labeled a currency manipulator now is unlikely to have that effect, however, given that many in the international community will view the Trump administration’s move as politically motivated.

What happens next

Slapping a “manipulator” label on another country was a tactic designed as a “tool of leverage” in negotiations, Wright said. But the situation between the United States and China makes it difficult to use effectively here.

Now that the United States has applied the label to China, Washington can either engage in negotiations with China or with the IMF, according to a 1988 law. The end goal: to ensure both countries adjust the rate of exchange between their currencies and get rid of any unfair advantage.

Many experts point out that the United States and China are already in negotiations, and the issue of currency manipulation has been included in the many rounds of trade talks. Tensions have already escalated between the two countries. The United States just announced that it will slap new tariffs on Chinese exports, which decreases the chance that the outcome of the negotiations will be good.

Given the situation, “the manipulator designation does not do very much at all,” Wright said.

The state of the trade talks makes IMF intervention the more likely next step. And the US Treasury department has already said that Treasury Secretary Steven Mnuchin will go straight to the fund to deal with the issue.

When a country joins the IMF, as the United States and China have both done, it agrees to subject its economic and financial policies to the scrutiny of the international community. It’s also not supposed to manipulate exchange rates to gain unfair competitive advantage.

If Mnuchin complains to the IMF board about China, the IMF will be prompted to review the situation, according to experts. After the review, there would essentially be a conversation among IMF board members about whether China is acting in a manner that is inconsistent with international law.

And after all that is said and done, the end result is a “summary of the [b]oard’s views is subsequently transmitted to the country’s government,” according to the IMF.

“In this way, the views of the global community and the lessons of international experience are brought to bear on national policies,” the fund says.

And there’s no guarantee that the IMF will side with the United States. After all, the fund has supported China’s handling of the yuan.

Bottom line, the United States can complain about China to the IMF, but there are no real economic penalties that come as a result of the global body’s review.