China and the US this week finalized plans to hit each other with a 25% tariff on an additional USD 16bn in imports, further inflaming trade tensions. This period of strained relations has been marked by notable CNY weakness: The yuan has tumbled more than 8% against the dollar since 3 April, when the US detailed its USD 50bn list of targeted Chinese imports.
Yuan depreciation is not unreasonable in this deteriorating trade environment, especially with further 25% tariffs on USD 200bn worth of Chinese imports threatened by the US. Downward pressure on the CNY looks likely to linger, given a deteriorating current account balance, a softening domestic economy, and a shrinking yield advantage over the US.
But there are several reasons why investors shouldn't expect the relatively steep pace of yuan depreciation to persist:
- The CNY weakness reflects more than just trade troubles. The 5.5% decline in the CNY trade-weighted index (TWI) over the last eight weeks came alongside a surprise negative turn in Chinese economic data. With a softer macro picture now priced in, the scope for a serious negative surprise has narrowed.
- Though a weaker currency can help offset tariffs and act as a form of domestic stimulus, there is a tipping point at which expectations become unhinged, ultimately causing more harm than good. A seriously weaker yuan would also draw further ire from the US, which could tweak its tariffs higher.
- The Chinese central bank squarely targeted speculative yuan selling on 3 August by reintroducing a 20% reserve requirement for buying USDCNY FX forward contracts. We view this as a clear signal of only limited official tolerance for further depreciation from current levels.
So we have adjusted our USDCNY forecasts to 7.0 over three, six, and 12 months (previously 6.7, 6.6, and 6.5, respectively) to reflect a more negative stance on the yuan against the dollar. Uncertainty over how US-China trade tensions could unfold in the months ahead may add to two-sided volatility to our USDCNY call, though we believe the bias is to the upside.
Short-term interest rate differentials between China and the US have collapsed
SHIBOR vs. LIBOR, in %
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