The yuan has long been viewed to have been manipulated by the authorities in a move to support and place the Chinese economy in a more favourable position. It has now raised our concern as to whether China has enough ammunition to retaliate against any potential tariffs imposed by the US. China exports more to the US than it imports. Hence, the trade war could potentially favour the US and risk China running out of ammunition.

The worry is whether China will increasingly let the yuan slide further against the USD. As at now, the yuan has fallen by 5.8% against the USD partly due to the trade war and also other factors such as rising US interest rates and the Chinese central banker injecting more cash into the banking system.

Should China let the yuan slide further, it will further strain the bilateral tension between the US and China, raising the risk that China has clearly shifted in its currency policy, suggesting that it is running out of ammunition, heightening the risk of a global market panic as what happened in 2015. A cheaper yuan would likely push other emerging-market currencies to fall, including the ringgit against the USD and hit hard on those who have large exposure of USD debt. Besides, the cheaper yuan would anger Japan and the EU which have sought to join the US administration in a unified response to China’s trading practices in general.

• The yuan has long been viewed to have been manipulated by the authorities in a move to support and place the Chinese economy in a more favourable position. In today’s trade tension between the US and China, the Chinese has thus far responded to US President Donald Trump’s measures with tariff attacks of its own on US goods, especially agricultural products.

• In late September, the US levied 10% tariff on a whopping US$200 billion worth of Chinese goods, and the tariff is scheduled to rise to 25% in January 2019. Trump has also threatened additional tariffs on US$267 billion worth of Chinese products, adding up to essentially everything China ships to the US.

• It has now raised our concern as to whether China has enough ammunition to retaliate against any potential tariffs imposed by the US. China exports more to the US than it imports. Hence, the trade war could potentially favour the US and risk China running out of ammunition. The worry is whether China will increasingly let the yuan slide further against the USD.

• As at now, the yuan has fallen by 5.8% against the USD. It has made Chinese exports cheaper and help offset some of the impact of US duties. But the current weakening of the yuan is not purely due to the US-China trade war; it is also a result of other factors. The Fed’s raising of its policy rate has widened the interest rate differential. The Chinese central banker injected more cash into the banking system by loosening selected liquidity ratios with the aim of supporting growth and weakening the yuan which in turn gives its exports a better comparative advantage.

• Meanwhile, what happens if the US further slap tariffs on China? There is ample room for China to further let loose its currency. Such a scenario is likely to escalate a currency war apart from the trade war. By letting loose the yuan, it will spook investors’ confidence on the current Chinese leadership’s control on this trade war. However, the Chinese authorities have stepped in to stabilize the yuan from surpassing the 7.00 critical psychological level against the USD. Had the yuan surpassed the 7.00 level, it would be unclear where the next level will be.

• In the meantime, the risk for the yuan to fall further as we move ahead in 2018 cannot be ruled out. Should that happen, it will further strain the bilateral tension between the US and China. But further devaluation would be a risky play for China. And the move to let loose the yuan will clearly suggest a strong shift in the currency policy.

• If we recall in 2015, the Chinese authorities devalued the yuan that caused panic in the global markets. A similar scenario is possible this time around should that happen. Besides, a cheaper yuan would likely push other emerging-market currencies to fall including the ringgit against the USD. It will hit harder on emerging market with large exposure of USD debt, even if it does reduce to some degree the Chinese comparative advantage by having a cheaper yuan. Besides, a cheaper yuan would anger Japan and the EU which have sought to join the US administration in a unified response to China’s trading practices in general.

• Hence, it remains unclear if China is more afraid of the trade war that will hurt the economy or move to a cheaper yuan that will cause spook capital as well as confidence.

Source: AmInvest Research - 4 Oct 2018