On the Minds of Investors
30/05/2019
Q: Could the trade war force a weaker CNY?
The Chinese yuan (CNY) has weakened by 3.2% since the end of April 2019, following an escalation in trade tensions with the U.S. This prompted many investors to worry that the CNY could depreciate further, as the Chinese authorities look for ways to offset the negative effect of higher U.S. tariffs on Chinese exports. It is important to consider the costs of such depreciation, as well as potential benefits. Overall, Beijing is likely to desire a stable currency, as reiterated by senior central bank officials in recent weeks.
A weaker currency, in theory, would help to keep Chinese exports competitive, offset the negative impact from higher tariffs imposed by the U.S., and protect Chinese companies’ profitability. A recent International Monetary Fund Blog has shown that specific categories of Chinese exports to the U.S. contracted sharply after tariffs were raised, likely due to the stockpiling of these products ahead of tariff increase. Moreover, U.S. consumers seem to be absorbing much of the tariff, not Chinese producers. Hence, from China’s perspective, strong U.S. demand reduces the necessity for the CNY to depreciate to boost exports, considering the negatives associated with a weaker currency.
Potential easing of Chinese monetary policy to support growth could also pressure the CNY weaker. However, the interest rate differential between the U.S. and China has widened in favour of the CNY in recent months. The U.S. Federal Reserve is not expected to raise rates in 2019. This would allow the People’s Bank of China to ease monetary policy moderately without creating extra pressure on its currency.
There are also costs to engineer a weaker currency to support growth. An obvious problem would be higher import costs that would offset the gain in competitiveness, as well as introducing imported inflation. This would also make negotiation with the U.S. more challenging, especially when the Treasury Department is looking to expand the penalties on economies that it believes are engaging in currency manipulation to subsidize their exports.
More importantly, like many emerging markets, currency depreciation could prompt more capital outflows and deter inflows. Even though the CNY is still not a fully convertible currency and there are still capital controls in place, outflows and the subsequent decline in foreign exchange reserve can still be substantial. This was clear in 2015 and 2016 (right chart on the next page). Meanwhile, China is trying to attract more foreign investors into its equity and bond markets, in preparation for a gradual decline in current account surplus. China onshore markets’ presence in both emerging market equity and fixed income indices are expanding. Currency depreciation could undermine international investor confidence.
EXHIBIT 1: China: Exchange rate and foreign reserves
Chinese yuan weakens as u.s. – china trade tension re-escalates
Source: FactSet, J.P. Morgan Asset Management; (Left) China Foreign Exchange Trade Center, J.P. Morgan Economic Research; (Right) People’s Bank of China.
*CFETS RMB index is the China Foreign Exchange Trade System basket of 24 currencies traded against the Chinese renminbi. Past performance is not a reliable indicator of current and future results. Guide to the Markets – Asia. Data reflect most recently available as of 28/05/19.
Investment implications
Weighing up the pros and cons of currency depreciation mentioned above, and taking into account official comments in recent weeks, a deliberate attempt to weaken the currency by the Chinese authorities seem unlikely. However, the CNY is managed by the People’s Bank of China on a trade-weighted basis (left chart above). This means if the U.S. dollar go through another round of strengthening against major currencies, such as the euro, Japanese yen and the British pound, the CNY would need to weaken against the U.S. dollar to maintain stability against its currency basket, given the large weight of the U.S. dollar in the basket.
For investors in China, we believe international diversification is important regardless of CNY’s exchange rate trend, given the low correlation of onshore assets (both equities and fixed income) with international assets.
For investors in broader Asia, prospects of more monetary policy support to the economy should favour Chinese fixed income, especially in sovereign, or quasi-sovereign bonds. Corporate bonds could offer higher yields, but understanding their corporate fundamentals is important for risk management, especially those companies with high level of debt.
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