Good news: the offshore yuan rallied the most in three weeks on Thursday, snapping a six-day losing streak in the process, thanks to a variety of factors, including the apparent restart of trade negotiations between Beijing and Washington.
On Wednesday evening, the Chinese Ministry of Commerce said the U.S. has invited a Chinese delegation to Washington for talks in “late August”. It’s far from clear that’s anything to get overly excited about and indeed, the Ministry’s statement sounded a cautious tone.
“The Chinese side reiterated that it opposes unilateralism and trade protectionism and does not accept any unilateral trade restrictions, [but] China welcomes dialogue and communication on the basis of reciprocity, equality and integrity”, the statement reads. That’s a nice way of saying “please don’t make us fly halfway around the world for nothing like you did in May.”
Still, any news that doesn’t involve an escalation is good news. The tentative thawing in relations comes just a week ahead of the imposition of duties on $16 billion in Chinese goods and also ahead of public hearings scheduled for August 20-23 on Trump’s proposed tariffs on an additional $200 billion in imports.
Traders also cited a stronger than expected yuan fixing.
But it looks like the real catalyst for yuan strength on Thursday is this, from Reuters:
China’s central bank has restricted commercial banks from using some interbank accounts to deposit or lend yuan offshore through free trade zone schemes, two sources with direct knowledge of the matter said on Thursday.
The move was aimed at tightening offshore yuan liquidity and making shorting the Chinese currency more expensive, traders said.
This is yet another attempt to squeeze shorts, and it precipitated a rather dramatic move in CNH forwards as 12-month forward points jumped from ~400 to 830. That’s the biggest jump since January of 2016.
That comes less than two weeks after the PBoC reinstated rules requiring a reserve ratio of 20% for financial institutions engaged in forwards trading to arrest the yuan’s slide at ~6.90, which looks like the proverbial line in the sand. It also comes just days after the PBoC’s guidance to banks to avoid “herd behavior“.
Speculation that the yuan would approach the 7-handle has risen this week amid the sharp selloff in emerging market FX and the ongoing deceleration in activity data out of China. Here’s BNP’s Ji Tianhe with some color on what comes next:
Will there be a replay of the December 2016 squeeze, when 1-year USDCNH shot to 3700pips? We think this is unlikely in the near future or indeed this year, as RMB net outflows are currently quite contained (CNY 43bn in June 2018). In November 2017 RMB net outflows were CNY 229bn, followed by a cut-off of RMB supply to offshore, resulting in a mere CNY 6bn of net outflows in December 2017. We don’t expect RMB cross-border flows to be impacted this time; arbitrage flows from corporates could even increase cross-border flows.
Going forwards, the three channels of downward pressure on the RMB are now restricted: corporate-buying of FX forwards has eased, onshore banks have stopped selling the RMB, and with today’s guidance on offshore banks, we think the USD will be the main driver of USDRMB. Given the expected Federal Reserve rate hikes and general sentiment being USD-positive, we think the pair could rise to 7.0. The PBoC may not want to push the pair down significantly, as this could further complicate domestic economic and financial issues. However, the recent measures suggest to us that the RMB index, now close to 93, is reaching a bottom.
The implication there is that there’s only so much China can do to stop the slide as long as the Fed continues to hike. Late-cycle fiscal stimulus in the U.S. is putting the Powell Fed in a position where the committee has to hike in order to guard against the possibility that the Phillips curve suddenly reasserts itself, as it’s prone to doing in late-stage expansions. When you pile tariffs on top of that, you put the central bank in a real bind. Powell has been steadfast in his commitment to a data-driven policy regime, and he’s been even more adamant about expressing his upbeat take on the U.S. economy. That’s all dollar-positive, and speculative positioning in the greenback reflects those dynamics.
China cannot tighten policy materially at a time when economic activity continues to moderate. So, the policy divergence with the U.S. will continue to grow and pressure on the bilateral rate will continue to build, up to and until there’s an EM crisis acute enough to force a Fed pause or until there’s a meaningful thaw in China-U.S. relations.
Of course the weaker the yuan against the dollar, the more insulated the Chinese economy is from the trade war, but the problem, as ever, is balancing that against the threat of capital flight. FX reserve data for July showed China’s war chest actually rising by $5.8 billion to $3.118 trillion. The median estimate was $3.107 trillion, so that was an upside surprise that seemed to send a benign message about capital flight and also suggested China did not resort to rampant intervention to arrest the yuan’s slide.