Chinese Yuan: Currency Manipulation or Market-Induced Depreciation?
By: Henri Kouam
Tags: Currency, FX, Treasury, Usd, China

What happened at G20?

The truce agreed by both superpowers at the G20 appeared shallow. As the trade war rumbles on, the challenge is not identifying trade-related issues such as forced technology transfers, intellectual property theft, subsidies to state-owned enterprise and other non-tariff barriers designed to provide domestic Chinese companies with an unfair advantage. However, implementing such an encompassing trade deal was always unlikely by the Trump administration whose intransigence and preference for short-term and election-centric wins has focused on agricultural products rather than longterm structural changes to China’s economic model. Rather, the implementation of any trade agreement should have been the main point of contention for any administration, but this was always unlikely under the Trump administration.

Chinese Yuan hits new lows?

Following the recent escalation, the Chinese Yuan reached news lows, prompting further worries in global stock markets as well as U.S. claims of currency manipulation. Prior to 2005 when China moved to a managed exchange rate, the Yuan was fixed, which allowed the Chinese economy little room for its currency to serve as a shock-absorber and ease structural adjustments to economic shocks. Following calls by more advanced economies, it liberalized its current account and moved to a free-floating exchange rate. This not FX fixing explain the recent depreciation in the Yuan above the key and what is being seen as a psychological 7.00 level.

Meanwhile, the Chinese Yuan fell below its key and psychological level of 7.00 against the dollar following the recent tariffs on $300bn worth of Chinese products. This puts the total Chinese products under U.S tariffs to $550bn. It is only normal that the Chinese Yuan depreciates as economic theory dictates that currencies tend to act as shock absorbers during periods of financial or economic stress. China is no different, not least because of its less rigid exchange rate.

Furthermore, the Chinese economy grew by 6.2% in Q2, its lowest level in 27 years, compounded by a structural slowdown as it transitions from an investment to a consumer-driven economy. This is only normal, as the economy matures and more advanced exports and the service sector drive its competitiveness going forward. Hence, the trade-induced depreciation and other structural factors explain the recent Yuan weakness, making claims of currency manipulation grossly overstated and incomplete.

Compounding to China’s problems is its current account surplus, which shrank from 10% to 0.5% of GDP. As a result, a weaker currency is unlikely to be sought by the Peoples’ Bank of China as this will cause capital flight and raise the cost of dollar-denominated debt. Not only this bode ill for Chinese lenders, but it will also make debt sustainability concerns grow louder. Furthermore, China will need to tap international debt markets to fund its current account, a weaker Yuan will complicate this as it makes foreign-denominated debt more costly.

The Dollar strength is explained by a variety of factors

Meanwhile, the U.S. dollar is justifiably strong. Despite lowering interest rates at its most recent meeting, interest rates in the U.S. are higher than most Central Banks in the World, bar the emerging world. Furthermore, the U.S. economic activity is strong, albeit slowing, unemployment is at a record low and the impact of the procyclical fiscal stimulus continues to linger. This is compounded by the IMF’s recent World Economic Outlook, which revised up U.S. GDP growth by 0.3 ppt to 2.6% for 2019 and 1.9% for 2020.

The U.S. economy has performed favorably throughout its trade dispute with China, in spite of U.S stock indices hitting new lows on Monday. Furthermore, a twin deficit has done little to hamper the dollar’s status as a safe-haven asset, and this is palpable following its trade dispute with China. Additionally, the USD has also strengthened is also compounded by concerns on global growth. Prior to the 2008 crisis, investors fled into dollar assets in preparation for the GFC, so the FED’s position as the global lender of last resort has provided shielded any trade-induced corrections.

Can this change?

It can be argued that an aging population, current account, and fiscal deficit, as well as a more multipolar trading environment, will test this. Despite interregional trade supporting globalization, intra-regional trade continues to account for a significant portion of total trade. China, for one, trades substantially with its Asian neighbors whose digital and physical infrastructure it continues to build. As trade becomes increasingly cleared in the Yuan, Euro, Pound, Yen, it is difficult to see its safe-haven properties persist, at least to the same extent.

Meanwhile, the Yen, Swiss Franc and Gold remain important hedges for investors looking to insulate their portfolios against global financial, economic and political risk. The extent to which these assets price-in geopolitical uncertainty depends on a range of other factors such as the probability of a recession. When the latter looks less unlikely, the dollar can usually see more consistent flows.

The Chinese economy is more exposed to the trade war in the short term.

As the currency depreciation and economic slowdown in China have shown, Chinese businesses such as Huawei and ZTE are more exposed to the trade war over the short term as their supply chains rely on technologically-advanced chips, semiconductors, and software from the U.S. Meanwhile, U.S. companies rely on China’s ever-growing and wealthy middle class to buy their products. Apple and Tesla are prime examples of companies who rely on Chinese consumers. This explains why the bulk of 0.3% downward revisions in the IMF’s recent global outlook accrue to emerging markets, whose markets and supply chains are increasingly linked with China.

A weaker Yuan can support bilateral trade, only somewhat

It might be easy to view a weaker yuan as the trigger for greater Chinese export competitiveness, but debt servicing cost will be more costly for dollar-denominated debt. This explains the recent stock market turmoil in Shanghai. Nevertheless, a transient boost to trade is not unlikely for Asian and some Latam economies who trade closely with China, which will serve as a substitute for goods, services or intermediate products that were previously purchased from the U.S. Furthermore, slower GDP in the two largest economies suggest lower import demand, which is unlikely to change significantly vis-a-vis a weaker yuan.



The dollar exchange rate is particularly salient for global trade, and a stronger dollar will hurt global exports. This is owing to a substantial portion of global trade being invoiced in dollars, which tend to be sticky as most countries currencies react more slowly to a weaker dollar than the reverse. Meanwhile, short-term competitiveness for Chinese stock indices and exports is not unlikely in the near term.

Can the U.S. treasury intervene?

Despite the U.S. treasury wrongly labeling China a currency manipulator, it is unlikely to redress what it sees as a competitive devaluation from China. Even though this view directly contravenes the economic reality facing both economies. The challenge for the U.S treasury is how to temper the affinity for the dollar as investors balance geopolitical risks against yields. Intervening in FX markets is, however, possible but will certainly be financially costly and counterproductive owing to the reasons outlined below.



1) Despite having twin deficits, the dollar is still the main reserve currency, supported by its characteristics as the lender of the last resort. As such, it is difficult to see how it can depreciate in recent months despite the Federal Reserve lowering interest rates.



2) Secondly, a significant portion of trade is invoiced and cleared in the dollar, which gives it significant “hold properties” during uncertain times such as a trade war or geopolitical uncertainty.



3) The dollar continues to hold safe-haven properties, whether underpinned by a higher interest rate differential or not remains to be determined. Its safe haven properties are particularly salient during periods f geopolitical uncertainty, compounded by concerns on global trade.

Currency manipulation claims are overstated and oblivious to other drivers.

The Chinese are unlikely to allow a significant depreciation of their currency as this will compound concerns of debt sustainability. Meanwhile, FX related debt and the cost of self-insurance suggest emerging markets central banks will have to perform a fine balancing act. The recent decision by the Fed to lower interest rates was the bell-weather for other central banks to follow suit, this might no longer be the case as trade-induced currency depreciation in emerging market currencies will cause inflation to rise. At the very least, Emerging Market central banks might rethink their presupposed easing paths following the FED’s easing bias. As I argue here, Central Banks might not be converging just yet, but the uncertain nature of the trade war might test this assertion.

Based on strong U.S. economic activity, higher interest rates than most central banks and the dollar’s safe-haven properties, it is incomplete and somewhat misguided to label China a currency manipulator. All the evidence suggest that market forces, rather than central bank FX intervention drove the recent depreciation. The dollar’s safe-haven properties, its seemingly strong economy, and interest rate differential explain its strength, and tariffs, as well as the structural slowdown in the Chinese economy, explain a weaker Yuan.