Caixin View: The Unbearable Lightness of a ‘Stable’ Yuan
China’s currency is back in the spotlight as the talks between Washington and Beijing to end a damaging trade war appear to have yielded an agreement in principle over one key irritant for President Donald Trump — the yuan.
Citing “productive talks,” U.S. President Donald Trump tweeted on Sunday that an impending March 1 tariff hike on Chinese imports would be postponed, and that he would meet President Xi Jinping in Florida to conclude a trade agreement if more progress is made. The yuan jumped to a seven-month high in onshore trading on Monday in response to the news.
China’s exchange rate policy has been a key point of contention in its relations with the U.S. Trump has accused China of deliberately devaluing the yuan to make its exports cheaper and gain an unfair advantage in trade. His Sunday comments on Twitter mentioned there had been progress made on currency issues although he didn’t give specifics and said details would be announced at a later date. A statement from the Chinese side communicated through the state-backed Xinhua News Agency also mentioned “exchange rates” as one of the areas where substantial progress had been made — a change from the last round of talks in Beijing, where only the statement from the U.S. side mentioned currency matters.
In an exchange at the Oval Office on Friday, Treasury Secretary Steven Mnuchin said currency was an area where Chinese and U.S. negotiators had reached an agreement, describing it as “one of the strongest agreements ever on currency,” although U.S. Trade Representative Robert Lighthizer said there was “a lot more work to do” over the weekend.
There are no official details on what the agreement may entail, but Bloomberg News reported last week that the U.S. wants China to guarantee a “stable” exchange rate. Given that an overriding concern of President Trump is to reduce the U.S.’s trade deficit with China, what this may mean in practice is that the U.S. wants China to guarantee a strong yuan.
But there are two key structural sources of downward pressure on the yuan that will continue in 2019 and beyond. First, China’s economic growth will likely continue to slow, which may make investing in yuan-denominated assets less attractive. Second, the country may run its first full-year current account deficit in more than 25 years after its surplus plummeted in 2018. Large surpluses have meant there’s been a steady flow of capital into China, and have given the country a war chest of foreign-exchange reserves with which to support the yuan. The end of surpluses erodes this important backstop, and deficits mean net outflows, which will reduce demand for the yuan.
Under these conditions, a demand from the U.S. that China’s currency remains strong seems a big ask.
That’s not to say that there are no sources of support for the yuan in 2019. The main ones include:
• The U.S. Federal Reserve seems to have ended its cycle of interest rate hikes for now. That lays to rest a key source of downward pressure on the yuan as investors will be less incentivized to shift capital out of China and toward U.S.-denominated assets.
• Sentiment is an important driver in the forex markets, and if a trade agreement is reached, the yuan will likely see at least a short-term boost. And more broadly, although China’s growth is slowing, it was still 6% in 2018 — most major economies would be very happy with such a rate.
• Increased flows of foreign capital into China this year, helped by greater inclusion of mainland stocks and bonds in major global indexes like MSCI Inc.’s Emerging Markets Index and the Bloomberg Barclays Global Aggregate index
But pledging to maintain a strong yuan would involve China’s central bank managing the currency even more tightly, running against years of demands from other countries that it make its currency more market oriented. It would also put limits on the amount of monetary stimulus that the country could unleash if economic growth were to slow much faster than expected — although top policymakers are insisting such a stimulus is not going to happen.
Rather than giving any such guarantees, perhaps the best outcome would instead be if China agrees to improve the transparency of its managed exchange rate. Although the U.S. Treasury has for years declined to label China a currency manipulator, and stuck to that stance again last year, Treasury Secretary Steven Mnuchin has voiced concerns about the country’s opaque exchange rate system.
The criticism was not surprising. Under current rules, the People’s Bank of China (PBOC) sets a daily parity rate for the onshore yuan against the dollar, from which it can deviate by a maximum of 2% up or down over the course of the day. The PBOC decides the daily rate based on a mixture of market demand and a mysterious “counter-cyclical factor” which it uses sporadically if it needs to. Such mechanisms invite criticism from suspicious trade partners, although ironically enough, the “counter-cyclical factor” seemed in 2018 to be largely used to strengthen the yuan, rather than weaken it.
Another area that could benefit from greater transparency is the PBOC’s direct intervention in the foreign-exchange markets, where it buys or sells yuan to affect its price and movement. Such interventions can only be inferred when PBOC publishes data mid-way through the following month, including the size of its foreign-exchange reserves and foreign-exchange purchase positions. A more transparent mechanism could help assuage critics’ concerns and would also tally with demands in the Trump administration’s other trade agreements — one of the clauses in the Canada-U.S.-Mexico Trade Agreement was that all parties should declare monthly interventions in the currency markets no later than seven days into the following month.
We don’t know the details of the agreement yet. Will this be a binding deal, or a loose voluntary commitment? If it’s the former, how would it be enforced? Will “stability” refer to the dollar-yuan exchange rate, or to the yuan’s level against a basket of currencies of its trading partners? Getting all this sorted out could take a long time beyond the initial framework agreement.
China may well want a strong yuan, to attract much needed foreign capital into its bond and stock markets, and also to project an image of a powerful, resilient economy. A strong currency would also make imports cheaper, helping to reduce its massive trade surplus. But it remains to be seen whether China is prepared to be strong-armed into a binding currency arrangement with the U.S., one that could hinder its ability to run its own monetary policy suited to domestic economic conditions. Markets shouldn’t be cheering too loudly yet.
Feb. 28: National Bureau of Statistics releases manufacturing Purchasing Managers Index (PMI), nonmanufacturing PMI, and Composite PMI Output Index for February
March.1: Caixin releases Caixin China General Manufacturing PMI for February
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