The trade war between Washington and Beijing has tipped China’s currency onto a path of destabilization. If hostilities escalate, China may let its renminbi (RMB) fall further. For investors, that could mean more volatility and tighter financial conditions.
The renminbi depreciated sharply against the US dollar in June after President Trump announced that he would potentially seek tariffs on virtually the whole of the US’s inbound trade with China, worth about US$450 billion a year.
More recently, Trump threatened to increase the size of the tariffs on goods worth nearly half that amount, unless China makes certain concessions.
China’s Growth Has Slowed
To be fair, it isn’t only the trade war that’s weighed on the RMB. As the display shows, the RMB has broadly tracked the US dollar for the last two years or so, becoming in the process a source of global currency stability. [Display]
But that relationship began to change earlier this year, before any tariffs were officially announced. At the time, the outlook for China’s economy had begun to deteriorate, while the US economy performed well. As the interest-rate differential between the countries was also changing in the US’s favor, there seemed to be fundamental reasons for a revaluation of the RMB against the dollar.
The RMB remained closely correlated to the US dollar, however, even as the latter strengthened. In April and May, the RMB faced further challenges as emerging-market currencies weakened and the US dollar appreciated further. Still, it was slow to respond.
These fundamental factors, in our view, would have been quite sufficient in themselves to justify much of the weakness of the RMB that followed in June. Had the US never announced tariffs on Chinese goods, the RMB weakness would have been characterized as the currency “catching up” with macroeconomic reality.
As it turned out, the US tariffs sparked an even faster depreciation of the RMB, largely because reduced trade will hurt Chinese economic growth. This is why it’s important to understand how the trade-war rhetoric and China’s economic fundamentals interact with each other. How they do so could have significant policy implications for China.
Earnings in the Firing Line
Under normal circumstances, for example, the People’s Bank of China (PBOC) would respond to the fundamental outlook by taking a measured approach to the currency, trying to keep it relatively stable but allowing it to depreciate gradually as the outlook dictated.
Now, however, if trade hostilities reach a point where they seem likely to cause further deterioration in fundamentals―a risk that China’s policymakers almost certainly began considering in June―it’s quite possible that the PBOC will allow the RMB to depreciate more quickly.
Corporate earnings will be a trend to watch. We expect next year to be challenging for the Chinese economy, and the outlook for the RMB will be weak on fundamentals alone. If the trade war causes fundamentals to deteriorate further, earnings will almost inevitably be adversely affected.
This is likely to prompt a response from the PBOC across a range of policy options, not just the RMB.
Tipping Point Looms for RMB
What are the implications for investors? Of the potential US$450 billion worth of goods to be targeted, tariffs have so far been announced in respect of US$50 billion. Tariffs on another US$200 billion could follow in September (action on the remaining US$200 billion will depend on how China responds).
On fundamentals alone, we would expect USD/RMB to depreciate toward 7.00 RMB over the medium term. If the US does extend tariffs in September, the RMB would be under pressure to depreciate well beyond that level.
That could have implications for global financial conditions, as it likely would coincide with an even stronger US dollar at a time when central banks, led by the Federal Reserve, are starting to drain excess liquidity from the financial system. A weaker RMB and stronger US dollar would also likely add to pressure on other emerging-market currencies, which could put more pressure on local bond markets.
While the PBOC’s ability to manage the RMB is not in question―particularly given its range of policy options, including fiscal measures and capital controls― the task has undoubtedly become more complicated due to the need to assess the impact of US trade policy on China’s currency and economy.
Perhaps the biggest change for Chinese policymakers managing the currency is that―for the time being, at least―they are on the defensive, whereas not so long ago their focus was on smoothing the RMB’s path to becoming a global currency.
Global investors may find themselves on the defensive, too. Our advice: keep an eye on exchange rates and expect more volatility as the year wears on.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.