Caixin View: How Mnuchin or U.S. Midterms Could Push Yuan Over Its Red Line

The yuan has fallen 9% against the U.S. dollar in the past six months and is within a whisker of a key psychological level of 7 per dollar. On Oct. 9, for the first time since 2008, the People's Bank of China (PBOC) fixed the currency's daily reference rate at above 6.9 per dollar, and has set the rate weaker every day since then. On Monday, the fixing was 6.9154, the lowest since January 2017.

The main reason for the rapid depreciation over the last few months has been the dollar's strength — the Dollar Index has risen steadily since April on the back of a string of interest rate hikes by the U.S. Federal Reserve, strong U.S. growth, and major tax cuts implemented by the Trump Administration. The index is currently at around 95, having risen to almost 97 in August, the highest since mid-2017. Consequently, we think that developments in the U.S. are going to be a major driver of whether and when the yuan breaks through the 7 per dollar barrier.

The first driver will be the release of the U.S. Treasury's semi-annual report on the exchange rate policies of its main trading partners this week, likely today. There has been speculation the report would label China a currency manipulator — essentially, claiming that China is trying to gain some advantage in the trade war by depreciating its currency. If this happened, then the yuan could potentially fall past 7 to the dollar, as it would significantly escalate bilateral tensions. We think this is an unlikely scenario, and our view is backed up by a recent Bloomberg report. But it's also possible that U.S. Treasury Secretary Steve Mnuchin could ignore the report's conclusion and still label China a currency manipulator.

The second driver will be the pace of rate hikes in the U.S. The Federal Reserve is due to raise interest rates again later this year, probably in December, but China is unlikely to follow suit given its shifting priority toward supporting domestic economic growth. In an interview with Caixin last week, PBOC Governor Yi Gang said the Chinese central bank will "focus on the domestic economy" when making adjustments to its monetary policy. This indicates that the PBOC’s decision-making will be influenced less than before by changes in the external environment, including interest rate increases by the Fed. This policy was already clear — while the Fed has raised interest rates every quarter since December 2017, the PBOC has only hiked money-market rates twice and each time by less than the Fed, so spreads between the cost of U.S. and Chinese government debt have narrowed.

To avoid increasing the cost of borrowing for the debt-ridden corporate sector, China is choosing to keep rates low — but at the cost of yuan depreciation as the narrower spread contributes to capital outflows and less demand for the Chinese currency. With China "currently facing the pressure of slowing economic growth," Yi said, "the interest rate is appropriate." But although the Fed's next rate hike will help support the dollar in the long run, the move is already largely priced in to the current exchange rate, so we don't expect a significant impact.

Finally, we have the U.S. midterm elections on Nov. 6. We don't know what the results are going to be, but we can make some assumptions on what would happen to the exchange rate under various outcomes. Healthy economic growth in the U.S., supported in part by the Trump Administration's business-friendly policies, has contributed to the dollar's recent strength. If the Democrats win back control of the House but not the Senate, then the U.S. government's ability to push through more legislation — for example, "Tax Reform 2.0", a plan to extend the significant tax cuts that were implemented in January — will face a significant setback. So we expect this outcome to bring the dollar down against the yuan — but only slightly, as this outcome, being the most likely according to most major U.S. polls, is already largely priced in. If the Democrats manage to gain a majority in both the House and Senate, then the dollar could see a significant drop. But if the Republicans retain control of both the House and the Senate, then we think a jump in the dollar is likely — and this would perhaps be enough to push the yuan through the 7-per-dollar barrier.

Caixin View is coming to Singapore

Our research partner CEBM is an instrumental part of Caixin View. CEBM’s Chief Economist, Dr. Zhong Zhengsheng, formerly with the People's Bank of China, will be visiting Singapore from Nov.19 to 23. Readers are welcome to schedule a meeting with Dr. Zhong, by contacting him at zhongzhengsheng@cebm.com.cn, or with CEBM's chief macroeconomic analyst Zhang Lu, at lzhang@cebm.com.cn, to discuss topics of interest or potential cooperation.

Calendar

October 16: National Bureau of Statistics (NBS) releases consumer price index (CPI) and producer price index (PPI) for September

October 19: NBS releases Q3 GDP data, September industrial production and retail sales, January-September fixed-asset investment, and real-estate investment and sales, end-September surveyed urban unemployment rate

People's Bank of China may release money supply and total social financing data for September this week

Ministry of Commerce may release foreign direct investment (FDI) and outbound investment (ODI) data for September this week