The market views the USDCNY 7.0 mark as a symbolic threshold. The previous two peaks in USDCNY near 7.0 (in late 2016 and late last year) and the managed nature of the exchange rate have given the 7.0 level a psychological significance for investors. So any break above it would likely weigh on sentiment. This week, for example, the Financial Times ran a story titled “Why ‘cracking seven’ is a big deal for China’s currency.”
But we see reasons why 7.0 should be viewed as just another number:
- We think the People’s Bank of China (PBoC) is likely to treat 7.0 in the same way as any other exchange rate level. If it doesn't, its monetary policy flexibility would be heavily constrained, which would be counterproductive. So we think policymakers won't prevent the CNY from breaching this psychological barrier if it is about to do so, especially if the US moves to impose tariffs on all Chinese goods. Recent PBoC comments point in this direction. Last week central bank governor Yi Gang said that no specific yuan level was important.
- Yuan depreciation is unlikely to be used as a weapon to mitigate trade issues. While a weaker yuan clearly offsets the economic impact of tariffs, we don’t expect the PBoC to pursue a policy of deliberately managing the currency downward. Such a policy risks sparking capital outflows and also would likely worsen relations with the US further. Last month the US Treasury Department refrained from labeling China a currency manipulator, but comments at last weekend’s G20 finance ministers meeting by US Treasury secretary Steven Mnuchin suggest the currency remains a live issue.
- Slowing growth and trade tensions will likely push USDCNY to 7.0 over the next three months, but we don't expect the exchange rate to stay above it for long. We expect USDCNY to stabilize and drift lower toward 6.7–6.8 over the next 6–12 months for three reasons. First, a trade deal – our base case is for an agreement to be reached by the end of the year – would put downward pressure on the exchange rate. Second, improving balance-of-payment flows should support the yuan. And third, we expect the USD to weaken broadly in 2H19.
So we do not believe USDCNY 7.0 is a line in the sand. To manage near-term currency risks, we reiterate our guidance to hedge CNY long exposure over the next three months.
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