Reports of a potential agreement on exchange rates as part of US-China trade negotiations lifted the Chinese yuan on Thursday, which rallied as much as 0.55% against the USD in offshore markets, to trade below the 7.1 mark.
In August, the US labelled China a currency manipulator. According to Bloomberg, the White House is now considering proposing a currency deal with China, which the US says was agreed in February prior to talks breaking down, as part of an agreement to suspend a scheduled increase in tariffs slated for 15 October. The report comes amid a flurry of both negative and supportive headlines on trade as China’s top negotiator Liu He meets with Robert Lighthizer in Washington later today.
If a deal were reached on currencies we would expect the yuan to strengthen. But we don’t think China would agree to something that could lead a significantly stronger yuan.
- A stronger yuan would be inconsistent with a slowing Chinese economy, adding to already significant headwinds. It would also be costly, considering that China might need to draw down their foreign exchange reserves in order to prop up the yuan. During the last major economic slowdown in 2015/16 China’s FX reserves declined to near USD 3trn, nearly a trillion dollars below their mid-2014 peak.
- Chinese policymakers are well aware of the consequences of the 1985 Plaza Accord on Japan’s economy
and will not want to repeat it. (Under the Plaza Accord, France, West Germany, Japan, the UK, and the US agreed to intervene in currency markets to weaken the US dollar against the Japanese yen and German Deutsche mark. The yen strengthened by 50% versus the USD between 1985 and 1987). Committing to a currency pact would be equivalent to China partially restricting its ability to ease monetary policy, since currency weakness typically occurs hand-in-hand with monetary easing.
- Even if a deal on exchange rates were to be struck, it would likely focus on stability rather than yuan appreciation, and may come in the form of an informal agreement. For instance, China could reiterate past pledges that it would not actively devalue the yuan. We note that capital controls are currently stricter than in the past which should also help stability.
Going into the trade talks, we hold a baseline case for only modest progress. With that in mind, we forecast USDCNY at 7.4 over the next three and six months, and 7.3 over the next 12 months. With heightened trade tensions and a slowing Chinese economy, we continue to advise investors to hedge CNY long exposure versus the US dollar. If a deal on US-China were to be reached at this week’s talks that suspended indefinitely or even rolled back tariffs, we would expect the yuan to strengthen, irrespective of whether a specific currency agreement is part of the deal.
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