China's Weak Currency Conundrum: China finds itself between a rock and a hard place.

• Author: Subacchi, Paola

Officials at the People's Bank of China have long insisted that "China won't weaponize the renminbi." And yet, implicit in their promise not to manipulate the currency for strategic ends is their ability to do so if they so desired. China's monetary policy has come to the fore now that U.S. President Donald Trump has imposed import tariffs on a range of Chinese goods. Many are wondering if China will respond to Trump's trade war by threatening a currency war. If it does, the world should call its bluff.

To be sure, with more than $3 trillion in foreign reserves and an established--albeit not entirely successful--system to manage its exchange rate, China has enough financial and monetary leverage to bring the U.S. economy to its knees. But having the weapons it needs does not mean that China can afford to use them.

In June, the renminbi had its worst month on record, dropping 3.7 percent against the dollar. Analysts are divided about the cause. Some view it as the result of a slowdown in economic growth, coupled with market concerns about the introduction of U.S. tariffs and dollar appreciation on the back of rising U.S. interest rates. Others suspect that Chinese monetary authorities intervened to weaken the renminbi, in order to offset the impact of U.S. policies.

The Chinese government has a long history of intervening to ensure that the renminbi's exchange rate aligns with its economic goals. But since 2016, when the renminbi was included in the basket of currencies that determines the value of the International Monetary Fund's Special Drawing Rights, the exchange rate has been determined mainly by market forces.

Still, despite PBOC Governor Yi Gang's insistence that China's exchange rate reflects demand and supply (with a basket of currencies as a reference), monetary authorities have the power to intervene when necessary. And though such interventions have been less frequent than in the past, they have continued to muddle market signals.

In the context of today's trade war, however, an "engineered" competitive devaluation of the renminbi, even if technically possible, would not be in China's best interest. Unlike in the past--and despite the Trump administration's view of China as an unreformed currency manipulator--a weak renminbi has more costs than benefits for China.

For starters, by increasing import prices and bolstering export sectors, a weaker renminbi would undermine the Chinese government's goal of shifting away from...