The currency markets changed on 5th August when the People’s Bank of China (PBOC) devalued the Chinese yuan and fixed the USDCNY rate above $7.00.
The shift saw the PBOC move away from defending the psychologically important level and declare a preference to use currency to counteract the effect of the new round of US tariffs that come into effect on 1stSeptember.
The hard devaluation caught the markets off-guard and now some days on, it continues to bring about a re-evaluation of the forex markets. One major change is that the daily fixing by the PBOC will, for a while at least, be centre stage and give traders an indication of what the next 24-hours holds for them and their positions. The coming week will give clues to what the short-term ‘new-norm’ looks like, but traders and analysts should be primed to expect the unexpected.
The US has introduced and adjusted tariffs like someone running a bath. There are significant changes and then slight adjustments – the intention being to find the right temperature for China to concede ground on the wider trading issues. China’s move looks to be more structural. The devaluation that took place Monday 5th – Thursday 8th August is the fourth largest devaluation of the yuan (against USD) on record.
The previous large devaluation – from 6.3 to 6.9 – took place in 2018 and occurred over a period of around 200 days. In that instance, the 11% price change was slow and steady, and didn’t cause any market instability. The move of last week was smaller (in the 2% region) but it was the rapidity of the move that is the key factor.
The PBOC’s approach may well have been intended to alarm the markets. The devaluation has after all come about due to the US-China trade dispute. Whereas the US is putting tariffs in place with every intention of withdrawing them at a later date, the pre-emptive devaluation by PBOC is now being seen by many as more permanent in nature rather than a position to be ceded at a future date. Pointing to the, albeit more gradual, devaluation of 2018 there is clear evidence that the trend is moving above the $7.0 level.
In fact, some analysts are predicting the next move could be a further weakening of the yuan. Previous devaluations since 2016 have typically been within a range of 8–10% and if the move of last week is the start of a full-scale move, then USDCNY would ultimately end up at the $7.4–$7.5 level.
Houze Song – research fellow at Paulson Institute think tank, MacroPolo – takes the opinion that China will show restraint due to two concerns. The first is the risk that further action draws the European Union and Japan into the dispute. The second is the chance it could increase the amount of capital outflows.
The eurozone and Japan both have base interest rates at around zero, so have limited scope for reducing rates any further. Further yuan devaluation that is met by US rate cuts would see JPY and EUR strengthen against the US dollar. The problems for Japan and the eurozone that are caused by this ‘triangulation’ would increase the likelihood of unified action against China. Song shared opinion notes in MarketWatch:
“Given how relatively weaker the EU and Japanese economies are compared to the United States… those economies will struggle to cope with any drastic yuan depreciation. This isn’t likely to sit well with Brussels and Tokyo – which is already feeling added economic pain because of a heated trade spat with its neighbour South Korea – and could easily become politicised.”
The devaluation of 2015 saw Chinese and global investors withdraw considerable capital from the Chinese economy. Beijing’s has over the last four years moved its economy to be less reliant on credit-based economic growth, but there would still be significant pain associated with any capital outflow.
Drawing on comments made by Yi Gang, governor of the People's Bank of China, Steven Englander, global head of G10 FX research at Standard Chartered Bank in New York, said subsequent comments from the Chinese administration suggest the yuan’s rise to current levels would be contained.
“The bad news is that this was kind of unexpected in the market, the break of seven (yuan)… The good news is that it seems to be a controlled break and the Chinese authorities are making comments that they are not trying to use the currency as a trade negotiating tool or for competitive reasons.”
Source: South China Morning Post
The ball is back in the US court. President Trump is well known for his impulsive decision making, which makes his approach harder to predict, but he is one of the now many proponents of the US talking about further action.
White House trade advisor Peter Navarro spoke with CNBC’s ‘Closing Bell’ on Friday 9th August:
“Clearly, they are manipulating their currency from a trade point of view… They’re going to, and we’re going to take strong action against them.”
Demonstrating the US administration’s willingness to fight on several fronts, Navarro said every American farmer will be “made whole” and insisted US consumers will not suffer financially.
“China will bear virtually the entire burden… China is the one that suffers far more harm than what might be inflicted on us,” he said.
Trading note – the emphasis now placed on the daily yuan fixing announcements is likely to increase price volatility at those times. Whipsawing and ‘gapping’ will both be more likely to occur.