“With our belief that China is unlikely to make further concessions unless the US offers compromises, the latest developments suggest our Standoff scenario is materializing and the Escalation scenario is becoming increasingly likely”, Barclays Jian Chang writes, in a note dated Friday.
Chang, you’re reminded, was the only economist who predicted the last round of PBoC benchmark cuts.
Over the past two weeks, it’s become clear that the Trump administration is keen to corner Beijing. The blacklisting of Huawei and the apparently imminent ban on Chinese surveillance companies suggests Trump is prepared to squeeze China on the assumption Xi will eventually crack. If you go by state media, that may be a miscalculation.
Although Beijing is constrained mathematically in terms of proportional tariff responses to US levies on an additional $300 billion in Chinese goods (which now seems like the base case), China has a virtually limitless set of non-tariff retaliations it can lean on.
The two “nuclear” options are obviously a steep yuan devaluation and the dumping of US Treasurys. On May 13, state media teased the Treasury nuke. “Many Chinese scholars are discussing the possibility of dumping US Treasuries”, an unverified Twitter post by the editor-in-chief of the Global Times read.
Posturing aside, there are myriad reasons to believe Beijing wouldn’t risk going “nuclear”, including the fact that a steep devaluation would risk capital flight while dumping US Treasurys en masse would not only be counterproductive, but also risk kicking off a global meltdown.
That said, China is well prepared to keep capital flight in check, having learned from the 2015 experience and I continue to insist that one strategy might well be to let the currency fall and then cite “irrational market behavior” as an excuse to sell Treasurys in defense of the yuan. That would kill two birds with one stone. Of course, it would also kill a lot of other birds in the process because, again, there would be collateral damage from China “going nuclear”.
Now, though, we may be moving closer to a situation where Beijing feels like it has no choice. The Huawei situation cannot go unanswered and the populace has been whipped into a nationalist frenzy by the Party. That’s a double-edged sword. On one hand, it means domestic support for relatively drastic measures is probably running high, but on the other hand, it increases the visibility of the trade conflict and thereby makes it obligatory that Beijing take action, lest Xi should appear weak in the face of an increasingly belligerent Trump.
It’s with all of that in mind that Barclays Jian Chang says the odds of China resorting to measures that “previously looked very unlikely” have risen.
“We think in the event of further escalation of the tariff war, China would allow measured weakness in CNY, although we think the Chinese authorities would be unlikely to tolerate a very sharp and sudden depreciation”, she writes, adding that “it is interesting to note that while Reuters reported that ‘China’s central bank will not let yuan decline past 7 to the dollar’ on May 17, the time horizon initially reported was ‘in the immediate term’, which was revised in a later version to ‘in the near term.'” Maybe other folks noticed that too, but I surely didn’t, and the nuance is indeed “interesting”, as Chang puts it.
She goes further, noting that Beijing could look at export restrictions, including, of course, rare earths, a subject that’s been good for a lot of headlines this week. She also notes that “restricting sales of certain US products and services in China, based on national security concerns or for regulatory or legal violations”, is an option. “The restrictions could apply to US smartphones, servers, autos, pharmaceuticals, or distribution of Hollywood movies and series, as long as the action would not incur significant domestic economic and employment costs”, Chang says.
And there’s more. China may “intensify shipping inspections and prolong customs checks, apply greater scrutiny or delay approvals of licenses and permissions for doing business in China, and tighten regulatory discretion of investment by US companies”, Chang writes. Beijing may also impose travel restrictions.
Meanwhile, BofA says that while there’s no evidence yet that China is actively trying to weaken the yuan (indeed, until Friday the fixes had been on the strong side) depreciation is still “an acceptable policy option if required.”
“Even though Chinese officials have stated a move above USD/CNY 7.00 is not desirable and the evidence so far suggests they have not pushed for this, there is scope for this policy option”, the bank writes, in a note dated Thursday. “The logic and motivation for this is twofold”, BofA says:
First, there is no overt sign of FX stress or domestic capital flight. Second, China has limited policy options to retaliate with that offer the same flexibility. Chart 3 shows an FX pressure index that is widely used in academic literature to gauge the depreciation/appreciation pressure on a currency. As of April, the balance of pressure on CNY was for appreciation and we are still some distance away from the devaluation stress periods of 2008, 2013 and 2015. Chart 4 also shows that our estimates of capital outflows using balance of payments data and the official PBoC statistics of onshore USD (FX) demand are not elevated as far as March data is concerned.
BofA goes on to lay out a series of options when it comes to Beijing’s capacity to retaliate.
In a “brinksmanship” scenario, the bank says the yuan could fall to 7.13. In a “full trade war” situation, the number is 7.70. Here are the pros and cons as described in the note:
Pros: An appropriate market based response to a negative trade shock. Can be managed up to a point and closely monitored. It can also be walked back if trade deal happens. PBoC has macro-prudential tools, counter cyclical component in daily CNY fixing to help manage process.
Cons: Could trigger beggar-thy-neighbor devaluations in Asia, notably KRW and also domestic capital flight. We have made conservative estimates that USD/CNY 7.91 would be required to offset further tariffs that may still be insufficient to offset tariffs and clearly potentially destabilizing given our fair value estimate of USD/CNY 7.54.
As for the Treasury “nuclear” option, BofA thinks the dumping of China’s vast holdings is highly unlikely.”This nuclear threat has limited mileage [as] USD global funding status arguably means that China requires USD reserves to meet its own potential USD financing needs in a crisis situation, shortage of safe-haven assets means that China escalation of tensions would be met by ready safe-haven buying [and] the Fed could neutralize any disruption.”
Finally, it’s worth noting that BofA thinks a rare earth ban would be used only in a “limited” fashion. “The US imports 80% of its rare earth needs from China and it is a vital component of tech manufacturing and electric batteries”, the bank reminds you, adding that an export ban “would result in temporary disruption of supply chain, higher production costs to competitors and expansion of production/mining facilities in US and Australia.”
Whatever route China chooses to go, the bottom line is that Beijing is going to have to do something relatively soon. That doesn’t mean an overnight devaluation or some kind of dramatic pronouncement of all-out economic war is in the cards. But what it does mean is that if there’s no break in the stalemate in the coming days, you can expect a barrage of incremental news stories detailing what will initially sound like a piecemeal approach, but what, in hindsight, will surely be recognized as a coordinated, non-tariff counteroffensive.