Three weeks ago in Armchair Trader – Conservative FX markets testing (some) extremes, we warned that based on precedent a resumption of the trade war with the United States would likely result in Chinese policy-makers retaliating by weakening the Renminbi. Seemingly the thinking from China’s side in the past 18 months has been that a weaker Renminbi serves as a warning to the United States that China can retaliate in more ways than one. It also makes Chinese exports more competitive, which can at least partly compensate for any downturn in exports triggered by US import tariffs.
Figure 1: After weeks of relative stability Chinese Renminbi has slowly but surely depreciated
Source: 4X Global Research, BIS, CFTES, investing.com
It is indeed important to remember that the People’s Bank of China (PBoC) fixes the daily USD/CNY central parity rate around which spot can trade 2% either side. If USD/CNY spot hits either the strong or weak end of the band the PBoC has to intervene in the FX market (buying or selling Dollars). So the PBoC in effect dictates the Renminbi’s direction, taking into consideration the broader economic costs and benefits of an appreciating or depreciating currency in the context of underlying demand for the Renminbi and thus China’s balance of payment flows. The United States of course does not have this ability to control its currency, with the Dollar’s weakness or strength largely the by-product of market forces – arguably a great source of frustration for President Trump who has regularly advocated a weaker Dollar.
While the US and China have not gone as far as re-introducing or increasing tariffs on each others’ imports, the war of words has clearly escalated with Hong Kong caught in the middle. China said it plans to impose national security legislation on Hong Kong and US Secretary of State Mike Pompeo told Congress on 27th May that the US administration no longer views Hong Kong as an autonomous Chinese region. President Trump could issue an executive order removing some or all of Hong Kong’s special status under US law and this week he hinted at possible sanctions against China. In such a scenario China could retaliate against US companies by placing them on an “unreliable entity list” to restrict trade or by throwing up other obstacles. Similar tits-for-tats in 2018 and 2019 led to a full-blown trade war between the two trading giants.
Given this backdrop it is perhaps no surprise, in our view, that since 7th May the PBoC has fixed USD/CNY 0.5% higher (i.e. fixed the Renminbi weaker) – see Figure 1 – and allowed the Renminbi to depreciate over 1% versus a weakening Dollar (see Figure 2). As a result the Renminbi Nominal Effective Exchange Rate (NEER) has depreciated over 2%, despite today’s small rebound, and remains within touching distance of yesterday’s 11-week-low (see Figure 1). In comparison the Renminbi (and the Dollar) had been range-bound between end-March and early May.
Figure 2: PBoC has fixed Renminbi weaker against a slightly weaker Dollar…which is telling
Source: 4X Global Research, Federal Reserve, investing.com
Implications of a resumption in trade war would reach far beyond Renminbi exchange rate
So while the Renminbi’s depreciation has so far been modest in the greater scheme of things, it does suggest in our view that Chinese policy-makers are sending the United States a clear, even if still subtle message that in the event of a full-blown trade war they can once again retaliate in more ways than one. The implications of the resumption of a full-blown trade war between the US and China of course reach far beyond a possible acceleration in the pace of Renminbi depreciation.
Figure 3: Asia-Pacific currencies on the whole are, in relative terms, highly correlated with Chinese Renminbi
Source: 4X Global Research, investing.com
Note: Red indicates low correlation, green high correlation. Correlations are derived from closing (spot) exchange rates versus US Dollar.
For starters any sustained weakness in the Renminbi would likely increase the odds of other Asian currencies also depreciating versus the Dollar, in our view, with policy-makers keen to maintain their countries’ export competitiveness vis-à-vis China, particularly at this current economic juncture. Given that the economies of Australia, and to a lesser extent New Zealand, are also closely tied to China’s we would expect Renminbi weakness to eventually feed through to the Australian and Kiwi Dollars. The correlation between daily percentage changes in the Renminbi and daily percentages changes in Asia-Pacific currencies indeed remains reasonably high (see Figure 3). Should the Renminbi and the currencies of other major trading partners to the United States weaken in tandem versus the Dollar this would of course increase the odds of the Dollar appreciating in NEER terms.
Moreover, the introduction of new import tariffs would, again based on precedent, likely have a material and negative impact on global trade at a time when global economic activity has only just started to very slowly recover from a very low base. Put differently, any further headwind to global trade would likely delay any meaningful recovery in global demand and supply and cast further doubts on whether global GDP growth can forge a V-shaped path of recovery in the second half of the year. For example if the market is a net-seller of Renminbi (and the currency under depreciation pressure) the PBoC has to sell Dollars (FX reserves) in order to stop the Renminbi from weakening. Conversely, if market demand for the Renminbi is strong, the People’s Bank of China has to buy Dollars (and sell Renminbi) to stop the currency from appreciating, which may in turn contribute to domestic inflationary pressures.
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