On the Minds of Investors
06/08/2019
Breaking “7” and currency manipulation
Following the deterioration in trade relationship between the U.S. and China last week, the Chinese yuan (CNY for onshore, and CNH for offshore) depreciated significantly against the U.S. dollar (USD) on 5 August. The onshore USD/CNY exchange rate broke above the psychological threshold of 7 for the first time since 2008. USD/CNY traded 1.3% higher by the end of Monday versus market close on August 2. Then after markets closed on Monday, the U.S. Treasury department has determined that China is a currency manipulator.
The recent resurgence of the USD meant that the CNY needs to weaken against the greenback in order for the trade weighted basket to remain stable. More importantly, for the central bank opting to allow USD/CNY to break above 7 is seen by many investors as a warning shot over the ongoing trade spat with the U.S. Following last week’s trade negotiation between senior officials in Shanghai, U.S. President Donald Trump tweeted on Thursday night that the U.S. will impose 10% tariff on 1 September on the remaining Chinese exports that is currently not affected by the 25% tariff. This reportedly came as a surprise to the Chinese negotiators. The latest measures from both sides are likely to make the upcoming trade negotiation much more challenging and tougher to reach an agreement.
These considerations are echoed by People’s Bank of China’s response to the Financial Times. It cited market expectations against ‘protectionist measures’ in driving the currency weaker, and highlighted the relative stability of CNY’s trade weighted exchange rate. The central bank downplayed the importance of the ‘7’ threshold and reiterated the two-way risk for the CNY going forward.
We believe that currency depreciation is a double-edged sword for the economy. It helps to offset some of the negative impact from tariffs, and counter the decline in current account surplus. However, a weakening Chinese yuan also raises import costs and deter capital inflow. Then there is the worry over capital outflow by domestic investors, which has led to a sharp drop in China’s foreign exchange reserve in 2014 and 2015. This was less of a challenge in 2018 when the CNY weakened against the USD by 10%, as the authorities enforced stricter capital control measures to limit capital outflow. It is also worth noting that the falling yields globally against CNY yields increase the opportunity costs to sell CNY and buy the USD.
Labelling China as a currency manipulator is another major setback for the two sides to reach an agreement. The immediate threat of additional punitive measures on China is low, as U.S. Treasury Secretary Steven Mnuchin is expected to engage with the International Monetary Fund to “eliminate the unfair competitive advantage”. Yet, the latest move is likely to concern the global business sector on future path of trade.
EXHIBIT 1: CHINA: EXCHANGE RATE AND FOREIGN RESERVES
USD / CNY AND CHANGE IN FX RESERVES
Source: FactSet, People’s Bank of China, J.P. Morgan Asset Management.
Guide to the Markets – Asia. Data reflect most recently available as of 05/08/19.
Investment implications
A weaker CNY’s immediate impact is on the region’s currency market. The Korean won (-1.5% against the USD on Aug 5) and Taiwan dollar (-0.7%) have underperformed relative to southeast Asian currencies due to their supply chain link. Along with the growth concerns, risk aversion could put pressure on Asia’s risk assets in the near term. In China, investors can also be concerned about companies with high USD liability exposure, especially in the real estate sector.
The escalation of trade tension between the U.S. and China will keep business investment subdue, which is the main challenge to global growth. Meanwhile, investors could start to worry about the possible spillover towards personal consumption, which has been resilient thus far. Tariffs on a broader range of Chinese exports would raise prices for U.S. consumers and squeeze companies’ profit margin.
Nonetheless, investors should remain calm. While Asia’s trade cycle is likely to be under pressure, domestic demand in China and southeast Asia are still supported by structural and demographic factors. Moreover, Asia’s central banks are now embracing rate cuts, which is a positive for Asian fixed income especially in sovereign debt. Although the short-term focus would be on currency risks, the global search for yields would bring investors’ interests back in the region. Global equities have started to correct in recent days and the latest exchange between Washington and Beijing could prolong this adjustment. A silver lining is that this correction would make equity valuation more attractive, which would attract long-term investors.
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