China will send a weaker Yuan to the Trump front

Beijing’s long-standing line has been a commitment to keep the yuan stable.

In the strong-dollar policy’s heyday in the late 1990s, Treasury Secretary Robert Rubin would often be probed for nuance in the doctrine. He was loath to change; even the smallest deviation or difference of interpretation could cause huge ructions in foreign-exchange markets. Journalists would push on whether prolonged strength furthered American interests. The scrutiny was fair; the former Goldman Sachs boss wasn’t averse to the occasional shift. There were rare instances when it served Washington to allow the dollar to soften, or even to sell it. Rubin was aided by a long boom that sucked money into the US. Conditions matched the stance. Pragmatism ruled.

Chinese officials today can relate.

Beijing’s long-standing line has been a commitment to keep the yuan “basically stable.” With Donald Trump’s return to the White House, traders are about to find out how much steadiness can be maintained amid threats of dramatically increased tariffs. Might it mean a pronounced but gradual weakening over the next few years that doesn’t risk too much disruption or increase the danger of capital flight? The People’s Bank of China has also mentioned the merits of a “reasonable equilibrium level.” What’s fair or common sense can, of course, depend on the situation. China would need some way to absorb the shock if 60% tariffs on its exports are truly levied. FX is a great place to start — and the terrain justifies it.

Allowing the yuan — already weaker than when Trump first triumphed eight years ago — to retreat is likely one of the first lines of defense. It’s down about 3% this quarter and has fallen against the dollar most days since the election. It was trading around 7.2 by the end of the week.  A majority of economists polled by Bloomberg News
expect the PBOC to let it slip further, probably in conjunction with other shields like a few interest-rate reductions and bigger budget deficits. Opinions were divided on the extent of the likely yuan move, but a level beyond 8 per dollar is considered unlikely.

President Xi Jinping won’t want anything resembling a freefall. The central bank limits daily fluctuations at the best of times. Market forces have some say; cooler growth and lower borrowing costs would push most currencies down. But very little happens that officials won’t tolerate. An early sign that the PBOC is wary of one-way traffic came Wednesday when officials set the daily fix, roughly the starting point for trading, higher than dealers anticipated. The exercise was repeated the next day. The aim appears to be a measured descent, not engineering an abrupt devaluation. (Such a dramatic event did happen in 2015, roiling world markets. That was a sobering experience for Chinese authorities and beyond.)

Why is 8 yuan per dollar so significant, aside from being a big round number? It’s rich in symbolism because before July 2005, the currency had been fixed at around 8.3 for more than a decade. When China retired the peg in favor of a regime that was looser but not loose, it was seen as a concession to US pressure. Then-President George W. Bush was keen to stymie bills aimed at sanctioning trade that were floating around Congress. To return to 8 now might amount to saying flexibility was a mistake. Unless China has given up on making the yuan a serious global currency, it will be careful of such optics.

Whenever FX and trade are discussed, the prospect of some kind of grand bargain is never far from the conversation. The Plaza Accord of 1985, in which Germany and Japan were persuaded to let their currencies appreciate significantly, came up at a seminar in Singapore last week hosted by Gavekal Research. A sweeping agreement now would be tough to reach, suggested Louis-Vincent Gave and Arthur Kroeber, but a more modest “deal” is plausible. Neither Trump nor Xi will benefit from sky-high tariffs and punitive tit-for-tat exchanges. Trump was elected in part because of unhappiness with inflation, yet that is what really high tariffs would produce. Xi is contending with a slowdown and doesn’t desire being completely shut out of the world’s biggest market. Some kind of transaction where Trump shows restraint in return for more Chinese purchases of agriculture and merchandise might work. Both sides could declare victory and move on.

This makes the big assumption that they’d stick to the plan, and each would need to convey to their audiences that they negotiated from a position of strength. Another reason that something as comprehensive as Plaza is a stretch is the belief in Japan and China that Tokyo suffered from the pact. Also to be remembered: Governments have little sway over markets today compared with four decades ago. Better to aim for something modest and, of course, transactional. That’s preferrable to a protracted, intensified trade conflict.

Meantime, Beijing could do worse than encourage — or nudge — the yuan down. Ultimately, Rubin concluded in his memoir, underlying economics drive currencies more than state meddling. The stars are aligning for some kind of yuan retreat. It may even be in China’s interest.

Credit: Bloomberg