Following the Trump administration’s Thursday evening announcement that the USTR is studying whether to propose an additional $100 billion in tariffs on China, everyone was quick to note the obvious which is that if Trump were to up the ante to a total of $150 billion, it would make it mathematically impossible for Beijing to craft a proportionate response using levies of their own.
We covered that in “Is This The Chart Trump Is Looking At When It Comes To ‘Winning’ A Trade War With China?” Here’s the chart with some humorous annotations:
As Goldman reminds you, Trump’s “strategy for winning” (to the extent it even partially relies on the assumption that all he has to do is ratchet the number higher than the total amount of US exports to China) is a fool’s errand and in the event Beijing feels like America is cornering them by introducing tariffs which exceed China’s capacity to respond, Xi could be forced to retaliate via the currency or else by selling Treasuries, two options that could roil global markets. Here’s GS:
Reducing a bilateral deficit, e.g. vs. China, is not difficult. After all, retaliatory trade restrictions are limited by the fact that the US only exports about $150bn of goods to China but imports more than $500bn. However, China would have other means of retaliation. Although China would be unable to fully retaliate through tariffs on goods in the event that the White House imposed sanctions on $150 billion in imports, Chinese policymakers could take other steps to retaliate.
- a currency depreciation could be used to offset some of the effect of tariffs.
- Chinese authorities could sell some of its large official-sector holdings of US Treasuries, which would lead to a tightening of US financial conditions.
- Chinese authorities could limit access for US companies to the Chinese domestic market, particularly in the services sector, where the US exports $56 billion in services annually and runs a $38 billion surplus.
Well overnight, Bloomberg was out reporting that China is “evaluating the potential impact of a gradual yuan depreciation.” It’s not hard to see when that headline crossed initially:
Obviously, nothing has been decided on this and as Bloomberg writes in the full piece, the move would of course require Xi’s approval.
The risks are clear. China has been doing their best to support the yuan (i.e. create appreciation pressure) for quite sometime and that effort included a brutal short squeeze last summer when the PBoC adopted the laughably opaque “counter cyclical adjustment factor”, leading directly to a historic rally in the yuan versus the dollar that ran so far, so fast Beijing ultimately had to put the brakes on the situation in early September by relaxing rules on forwards put in place following the 2015 devaluation.
Here’s an annotated chart that shows you how things have played out for the yuan. Note the (successful) attempt to engineer a short squeeze last summer, the (initially) successful attempt to put the brakes on that by relaxing rules on forwards in September, and the (not so successful) effort to put the brakes on post-September yuan strength by sidelining the counter-cyclical adjustment factor that was used to start last summer’s short squeeze.
Of course it is likely lost on Donald Trump that China has actually been trying to engineer currency appreciation for quite a while – you’ll recall that the yuan has risen against the dollar for five consecutive quarters. If they move to devalue the yuan, he’s not going to take that into consideration. Rather, he’s just going to call them a currency manipulator and that will only exacerbate the situation. Further, a move to devalue would have other undesirable side effects, not the least of which is risking the type of market volatility that followed the August 2015 deval that ultimately triggered a harrowing bout of flash crashing madness that culminated in Black Monday on August 24. Here’s Bloomberg from the same piece linked above:
While a weaker yuan could help President Xi Jinping shore up China’s export industries in the event of widespread tariffs in the U.S., a devaluation comes with plenty of risks. It would encourage Trump to follow through on his threat to brand China a currency manipulator, make it more difficult for Chinese companies to service their mountain of offshore debt, and undermine recent efforts by the government to move toward a more market-oriented exchange rate system.
It would also expose China to the risk of local financial-market volatility, something authorities have worked hard to subdue in recent years. When China unexpectedly devalued the yuan by about 2 percent in August 2015, the move sent shock-waves through global markets.
“Is it in their interest to devalue yuan? It’s probably unwise,” said Kevin Lai, chief economist for Asia ex-Japan at Daiwa Capital Markets Hong Kong Ltd. “Because if they use devaluation as a weapon, it could hurt China more than the U.S. The currency stability has helped to create a macro stability. If that’s gone, it could destabilize markets, and things would look like 2015 again.”
Yes, “things would look like 2015 again” and no one wants that. Ken Peng, an investment strategist at Citi Private Bank in Hong Kong had a more colorful take:
Using yuan depreciation is like sacrificing 800 soldiers of your own to kill just 1,000 enemies.
As Barclays wrote on Sunday, “the PBoC has not [yet] retaliated by steering the CNY weaker, augmenting our view that China will prefer to respond to US tariffs proportionately, while keeping CNY on a stable path”. Here’s the fixings versus estimates for 2018 (i.e., a way of gauging how the PBoC is steering the currency on a given day):
“China is on the back foot in the trade spat with the U.S. as an attempt to devalue the yuan would imply the Asian nation propping up its dollar reserves and buying USD assets such as Treasuries,” Nordea’s global currency strategist Andreas Steno Larsen said on Monday, adding that “there are no good ways to retaliate for China” as there is “no leverage on the ‘dumping Treasuries story.”
But just to underscore the second chart above, the yuan has appreciated a lot since last year, so there’s some room for “market-driven” weakness.
That said, Bloomberg’s Anchalee Worrachate notes that “the yuan has depreciated against most of its peers since the 2015 deval despite this year’s advance versus USD, and a further and sudden weakening could draw the ire of its trading partners.”
So as Trump would say, “we’ll see.” I guess one thing that’s worth remembering (or maybe “ren”membering is better here), is that they could always just throw caution to the wind with an overnight deval and then mitigate any bets on a further weakening of the currency by selling Treasurys as they did in late 2015. That would kill two birds with one stone although it would be a disaster in terms of capital flight, instability, etc.