Reluctantly, the People’s Bank of China set a soft fix for the onshore yuan this morning which allowed the pressure of the offshore traded yuan to filter into local markets, resulting in a breach of the 7.00 level in USDCNY. The move transgressed the psychological line in the sand for the first time in more than a decade.
Chart 1: The Chinese have many good reasons to keep the currency stable, which is why it has taken a decade for the USDCNY cross to reach this level, despite coming dangerously close two times before; at the end of 2016 and at the end of 2018.
The fact this level has been broken for the first time in a decade, after two serious attempts at the end of 2016 and 2018, demonstrates that the PBOC will struggle to have the yuan serve two different masters for the coming period.
On one hand, it does want to signal it stands ready to do “whatever it takes” against the US tariffs, despite running out of US export goods to slap extra tariffs upon, to combat the impact US measures are having on a slowing Chinese economy.
While on the other hand, capital outflows and the political repercussions of a weaker yuan give reasons to believe that this may not be the start of a systematically weaker yuan.
This is why we think the yuan will indeed continue to weaken, but in a managed and gradual way – a feat not managed by the PBOC in the past.
The simplistic argument is that China weakens its currency to gain an advantage in export markets, however, this ignores China’s recent financial history and strategic long-term goals.
First, an unstable currency may lead again to capital outflows just like in 2015-2016. Back then, Chinese authorities spent a large proportion of their foreign reserves to defend the yuan and prevent the Rmb7.00 from falling.
Secondly, China is in the middle of opening up its bond markets for foreign investors via trading in Hong Kong, with the goal of making more investable funds available for economic activity in China. Once again, a volatile currency is not supportive of this goal while foreign bond issuance should provide a level of stability as it soaks up USD liquidity.
Thirdly, as the current trade war with the US demonstrates, the Chinese economy is very dependent on the manufacturing sector which at the moment accounts for 40% of its Gross Domestic Product.
The vulnerability of the manufacturing sector to swings in global demand is one of the reasons why China wants to move more to a consumer-based economy.
A continually weaker yuan erodes this transition because it maintains the competitive nature of exports. Further, it erodes the purchasing power of Chinese consumers as many high-quality consumption goods continue to be imported.
For now, the PBOC appears to be managing these often mutually exclusive goals by softening the onshore fix, while it gives verbal signals it is committed to a stable yuan to avoid mass capital outflows.
This, to some extent, is consistent with monetary policy expectations in markets. A full percentage point cut by the Federal Reserve over the 12-month period is baked into market pricing, while expectations point towards no move by the PBOC.
Should this play out, yuan depreciation should support the Chinese economy without USDCNY rising further. The trade-weighted depreciation as the US dollar softens was implemented as recently as a month ago, and should trade wars begin to impact the greenback, it may re-emerge again.
This is why we consider that further weakening of the yuan will be managed and gradual as it seems the best compromise between signalling to the US it’s is willing to use all means to fight back, while also long term strategic goals are honoured.
Meanwhile, for now a currency war between the US and China remains out of scope, even with recent calls from the Whitehouse for Treasury intervention in markets.
Chart 2: The spread between onshore and offshore yuan rates dragged CNY above 7 following a soft fixing by the PBOC.
While it remains a risk, as does everything in this day and age of unpredictable policy, the odds are significantly stacked against the US in the game of “winners and losers”. China’s FX reserves dwarf that of the US, suggesting this is not a game of brinkmanship the Treasury wants to embark upon.