Regular readers are fully apprised of virtually every notable development in the Chinese yuan since the late May/ early June PBoC-engineered short squeeze, an event which included the introduction of an absurdly opaque “counter-cyclical adjustment factor” that effectively marked a partial reversal of the FX liberalization push that began in August, 2015.
Over the past couple of weeks, amid escalating tensions between the US and North Korea and as the unravelling of the Trump administration weighed on the dollar, USDCNY hit a 12-month high. Indeed, there was considerable discussion about the extent to which circumstances had conspired to make the yuan a high-yielding safe haven.
Recall this annotated chart from a week ago that gives you some perspective:
Notably, the yuan pushed higher despite disappointing July trade data as traders focused not on the imports/exports miss, but rather on the still sizable surplus.
Minutes (literally) after we originally posted that chart last Friday, the PBoC fired a warning shot about excessive yuan strength, strengthening the fix less than pretty much everyone expected. That caused the USDCNY to rally the most since January.
Well now, with the Trump administration sounding increasingly aggressive with regard to their displeasure around Beijing’s efforts to discourage Pyongyang from further provocations, some folks are concerned that the PBoC might just decide to retaliate by engineering a sharply stronger USDCNY.
While that could serve as the trigger point for a renewal of capital outflows that by some measures never completely abated, with USDCNY still sitting near a one-year low and with China’s economy cooling off, this wouldn’t be the worst time to create some renewed depreciation, especially if Xi wanted to jab back at Trump.
Of course in addition to sparking renewed capital flight, a quick devaluation would risk another 2015-like episode and it would also undercut confidence in Chinese assets just months after the MSCI inclusion. Needless to say, it could also roil global markets.
Here with more on this is Barclays…
Via Barclays
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“There are roads which must not be followed, armies which must be not attacked, towns which must not be besieged, positions which must not be contested…” – Sun Tze, The Art of War
Would China weaken the CNY if the US steps up trade and North Korea pressures?
Geopolitical tension surrounding North Korea’s nuclear threat has escalated in recent months. In the view of the US, China is the country with the most leverage over North Korea, given their trade and historical ties. But US president Donald Trump thinks that China has been too passive in containing North Korea’s nuclear ambitions. On 29 July, Trump tweeted: “…they [China] do NOTHING for us with North Korea, just talk…”. Since then, China has voted in favour of tougher UN sanctions and has implemented a ban of some important imports from North Korea. Despite these actions, President Trump has authorised an investigation of China’s intellectual property practices, citing his commitment to campaign promises as the reason for this decision.
The escalating rhetoric between the US and China raises the question whether the currency détente that seemingly followed the Mar-a-Lago Trump-Xi meeting in April will be broken. If the recent “managed” appreciation of the CNY is related to the “100 day trade cooperation plan”, China appears to have been successful in reversing the trend in USDCNY with a “counter-cyclical adjustment factor” (CCAF) added to the CNY fixing formulation in late May.
However, if the US continues to publicly complain about China’s approach to North Korea, we think investors could start to question if China might decide to retaliate by weakening its exchange rate, or simply send a message, by introducing a temporary spike in USDCNY. Recent developments could add to China’s incentives to consider this tactic: US Commerce Department’s preliminary finding that Chinese aluminium foil producers were receiving subsidies and the introduction of countervailing duties; investigation into alleged IP violations; and a rebound in the USD.
We believe there would be substantial costs involved in any retaliation strategy using the exchange rate. Below we present [two] arguments why China would most likely refrain from retaliating against US protectionism by weakening the CNY.
Argument #1: Currency retaliation would jeopardise efforts to curb capital outflows and reverse depreciation expectations
China would gain little from an intentional currency devaluation, in our view. While exporters might see some benefit from a weaker exchange rate, we think China would risk creating unnecessary financial market volatility, invite international criticism, create expectations of more depreciation and spark renewed resident outflows.
During the past two years, China has invested significant efforts to counter depreciation speculation as well as to curb capital outflows. As outflows accelerated and the PBoC expended FX reserves following the August 2015 devaluation, China implemented a slew of measures to curb resident outflows and limit CNY short positions. These included closer scrutiny of FX remittances, introducing a reserve requirement for Chinese banks on FX forward transactions, restrictions on overseas purchases of insurance policies, and liquidity squeezes in the offshore yuan market that induced spikes in CNH HIBOR, among many other micro-level control measures. The Chinese authorities continue to focus on this area, as highlighted by the recent crack down on proposed large overseas acquisitions by some Chinese conglomerates.
We think China could reverse a lot of the gains it has made if it decided to use FX changes as a retaliatory tool. Such action would likely send a wrong signal to market participants, and drive changes in currency expectations that could drive a rebound in capital outflows. In China, household and corporate expectations of the direction of CNY are a key determinant of capital flows and directional pressures on the currency. Recall, capital outflows accelerated after the August 2015 devaluation, mainly through informal channels as captured by the “errors and omissions” and “other investments” categories in the balance of payments data. Given the rapid credit growth of the post-crisis years, China’s M2-to-FX reserves ratio — a crude measure of an EM country’s vulnerability to capital outflows — has risen sharply. We estimate that if just 4% of China’s population exercised their annual right to move USD50k out of the country, the hypothetical capital outflow would theoretically wipe out the stock of foreign reserves. While an unlikely scenario, we think it is recognition of this vulnerability, along with the fragility of the domestic banking and financial sectors, that tends to prompt Chinese policymakers to tighten the capital account regulatory framework whenever pressures on outflows and FX reserves intensify.
With China having successfully reversed market expectations of CNY depreciation with the CCAF, and with resident outflows under better control, we doubt that the government would want to jeopardise this “success” by causing a currency shock. Apart from beta-related adjustments in reaction to fluctuations in the USD-pairs of the CFETS basket, we believe China would likely want to avoid sparking renewed fears of CNY underperformance or create impressions that the exchange rate would be used as a political tool.
Argument #2: Currency retaliation would likely undermine foreign investor confidence at a time when sentiment is improving
Policymakers would likely not want to undermine the confidence of foreign investors at a time when the latter appear to be warming up to improved accessibility to China’s onshore capital market and lower market volatility. A-shares were only approved for inclusion in the MSCI’s EM equity indices in June this year, following three rejections. Actual MSCI inclusion starts in 2018, but QFII investment data show that equity inflows are slowing rising after stagnating over much of 2016. This suggests that investors are now re-entering the A-share market following the turbulence in 2015. The PBoC has introduced measured to gradually allow freer foreign participation in its onshore debt market. We believe China would welcome the formal inclusion of Chinese Government Bonds (CGBs) in major benchmark indices and that the PBoC is committed to improving accessibility for overseas investors. Therefore, we see China looking to avoid any actions seen as being “market unfriendly.”
