The Chinese yuan’s rapid slide of almost 6% against the dollar since mid-June has sparked fears of a potential “currency war.” Last week, President Donald Trump complained the yuan was “dropping like a rock,” and US Treasury Secretary Steven Mnuchin revealed that the Treasury is investigating whether China has manipulated its currency.
A deliberate and explicit policy by China to depreciate the yuan against the dollar is one of the options we consider in our 5% probability risk case for a full-blown trade war, which would also include substantially higher tariffs and aggressive non-tariff actions. The latest developments still fall short of this scenario, in our view:
- The CNY slide, we believe, has been led by the markets rather than the People’s Bank of China (PBoC). Allowing some yuan depreciation is just one of a number of policy tools being deployed to help offset economic deceleration. We believe China will not want the yuan to depreciate too much because of the risk of undermining confidence in the currency and sparking capital outflows.
- The US Treasury potentially labeling China a currency manipulator (in October) does not, in itself, create an escalation in trade tensions. Under a 2015 law, designating China as a manipulator is meant to trigger up to a year of negotiations to resolve the issue. Since Trump has already used his presidential powers to go beyond negotiations and impose tariffs, the "currency manipulator" label is somewhat moot.
Our base case, to which we assign a 60% probability, is for the US to complete enacting the 25% tariffs on USD 50bn of Chinese goods, introduce a 10% tariff on a further USD 200bn of imports from China, and levy duties on as much as USD 350bn of auto and auto-parts imports. We assume the Chinese will retaliate, potentially with non-tariff measures.
The risk remains that, regardless of whether the yuan’s slide is the result of deliberate policy or passive neglect by the PBoC, Trump will react to the weaker Chinese currency by raising tariffs even further. Such uncertainty and the risk of a retaliatory cycle underpin our recent decision to reduce our global equity overweight and to maintain a long position in 10-year US Treasuries.