My Baby, Xi Wrote Me A Letter

With the trade war heating up, we have been getting more questions about yuan policy. Despite renewed US-China tensions being a headwind for the mainland economy, we do not see the yuan being used as a weapon in this trade war.


Headlines regarding the tariffs have been all over the place, making it truly difficult to get a handle on the situation. President Trump got the optimism rolling by claiming yesterday that President Xi had written him a “beautiful” letter just as Chinese negotiators were arriving in Washington. Today, Trump tweeted that there is “absolutely no need to rush” the negotiations.

At 12:01 AM ET today, the US increased tariffs on $200 bln of Chinese goods from 10% to 25%. This increase was originally scheduled to go into effect on January 1 but was delayed after a truce was called at the December G20 summit in Buenos Aires.

Back when the 10% tariffs were first announced last fall, China imposed retaliatory tariffs on $60 bln of US imports on the same day. Then, the US threatened tariffs on a further $267 bln of Chinese imports if China were to retaliate. Now, Trump has upped that additional amount to $325 bln, which would basically cover all Chinese imports into the US.

Press reports suggest that China was emboldened to backtrack on its previous promises due to Trump’s attacks on the Fed. That is, China believed Trump was concerned enough about the US economy that he would take a quick trade deal. Instead, Trump announced these tariffs and both sides appear to be dug in.

An interesting twist is that these tariffs will not apply to Chinese goods that are already in transit. This may give the two sides a little breathing room before the tariffs actually bite. However, even though talks continue today, we do not hold out hope for a quick deal.

Trump has now pledged that the government would buy up to $15 bln in farm goods to offset any lost demand from China. In turn, those purchases would be sent as humanitarian aid to “poor and starving” countries. This is a tacit acknowledgment that the trade war is hurting agricultural states in the US, states that went overwhelmingly red in the 2016 election. Trump must contend with an electorate. Xi does not, and so we expect China to play hardball and not give in to US demands.

Senior China officials continue to downplay risks of weaponizing the yuan. We take them at their word. Premier Li has promised not to weaken the yuan to stimulate exports. He has also acknowledged that a devaluation will do more harm than good to China, and we concur (see section below on the 2015 yuan devaluation).



Renminbi and yuan are often used interchangeably to describe China’s currency. Renminbi translates roughly as “the people’s money,” while yuan is the base unit. A useful comparison would be sterling and pound; the first is what the UK refers to as money, while the pound is the base unit.

The renminbi was introduced in 1948 by the People’s Bank of China (PBOC), almost a year before the founding of the People’s Republic of China. As the Communists gained control of greater and greater portions of the country, they replaced the various regional currencies that were circulating with the renminbi. For most of the early years, it was pegged at 2.46 per dollar but was sporadically revalued until the rate reached 1.5 per dollar in 1980.

While there were several minor devaluations during the 1980s, China upended the global economic order with its massive 33% devaluation in January 1994. Coupled with an aggressive export-led development plan, China saw its GDP quadruple in size from 1993 to 2008. GDP growth averaged 10.5% per annum during that period. The yuan remained pegged at roughly 8.3 per dollar until 2005. Indeed, during the Asian Crisis of 1997, China policymakers steadfastly maintained the peg.

Official policy changed with the de-pegging of the yuan in July 2005. A managed float followed, but this stalled during the Great Financial Crisis, when the PBOC re-pegged the yuan at around 6.83 per dollar in July 2008 in order to inject stability into an otherwise chaotic global backdrop. The yuan was unpegged again in June 2010 and continues to be run as a managed float.

The yuan was last devalued in August 2015. The move unsettled global markets and led to significant capital outflows from China. Foreign reserves fell from $3.7 trln in July to $3.2 trln in early 2016. This necessitated the tightening of capital controls, and foreign reserves stabilized.

Currently, spot CNY is allowed to trade 2% on either side of the daily fix. The fix itself is a bit of a black box, especially with the re-introduction of the so-called “counter-cyclical factor” last August. This allows the quoting banks to use non-market factors in submitting their fix rates.

Offshore CNH was first introduced in July 2010. The PBOC and the Hong Kong Monetary Authority (HKMA) made a joint announcement then that the RMB would be made deliverable in Hong Kong. This offshore program has since been expanded to major financial centers such as Singapore, Taiwan, and London.

CNH is freely tradeable but is still influenced by the PBOC via liquidity conditions. Last fall, China announced that it plans to work with Hong Kong to sell yuan-denominated bills offshore. This would allow the PBOC to better control offshore liquidity and therefore influence the offshore CNH rate.



The mainland economy is likely to resume slowing. GDP growth is forecast by the IMF at 6.3% in 2019 and 6.1% in 2020 vs. 6.6% in 2018. GDP rose 6.4% y/y in Q1, matching the cycle low in Q4. In light of the tariff risks as well as building global headwinds, we see downside risks to the growth forecasts. For now, our base case remains that China muddles through. That is, growth may slow more than desired due to the trade war, but we do not foresee a hard landing.

Both official and Caixin PMI readings for April fell back to earth. Official manufacturing PMI fell to 50.1 from 50.5 in March, while Caixin manufacturing PMI fell to 50.2 from 50.8 in March. Those March readings were the highest since Q3 2018 and had generated some optimism that the mainland economy had turned a corner. Not yet, it would seem.

Price pressures are rising. CPI rose 2.5% y/y in April, the highest since October. The PBOC does not have an explicit inflation targeting framework, though the government is aiming for 3% inflation this year. Still, policymakers are clearly focused on supporting growth, not fighting inflation.

The fiscal outlook bears watching. Prime Minister Li vowed last year to cut taxes and administrative fees further in order to support the real economy. This, along with increased state spending, will put upwards pressure on the budget deficit. The deficit was -2.2% of GDP in 2018, and the OECD sees it widening to -3.3% in 2019 and -3.5% in 2020. We see upside risks given the renewed emphasis on fiscal stimulus.

The external accounts have deteriorated. The current account surplus was 0.4% of GDP in 2018, and the IMF expects it to remain at 0.4% this year before narrowing to 0.3% in 2020. Compare this to 10% in 2007 and 4% in 2010. China’s exports remain vulnerable and suggests downside risks to the current account forecasts. Indeed, market consensus is more pessimistic at 0.1% and 0.0% for this year and next, respectively.

Foreign reserves have stabilized but remain well below record highs. At $3.095 trln in April (vs. the all-time high near $4 trln in mid-2014), reserves cover over 16 months of imports and are nearly three times the stock of short-term external debt. Thus, the country is not very vulnerable to shifts in sentiment and so-called hot money. China’s Net International Investment Position (NIIP) has fallen to 12.5% of GDP from a peak near 35% back in 2007 but remains a respectable number.



There has been no 100% predictable relationship between CNY and CNH. While the two are highly correlated (at 0.84 currently vs. 0.90 in December), the spread tends to oscillate. There have been extended periods when CNH trades below CNY, and vice versa. However, since CNH’s inception, its under- and overvaluation with regards to CNY has basically been symmetrical in terms of the probability distributions.

We note that there have been two periods of significant CNH deviation from CNY, and both times saw USD/CNH trade above USD/CNY. The first took place from September 2011 to January 2012. The second took place from August 2015 to February 2016. This second phase was a particularly turbulent period for Chinese markets, as the August 2015 devaluation led to a significant spike in volatility and capital outflows.

USD/CNH is currently above USD/CNY and is moving higher. The divergence is the greatest since early February. If US-China trade tensions persist, we suspect that this divergence will intensify and may become the third period of significant CNH deviation from CNY. Stay tuned.

CNY is outperforming after a so-so 2018. In 2018, CNY was -5.5% vs. USD and was right in the middle of the EM pack. So far in 2019, CNY is 0.8% and behind only the best performers RUB (+6.7%), THB (+3), MXN (+2.4%), PEN (+1.6%), CLP (+1.2%), ZAR (+1%), and PHP (+0.9%). Our EM FX model shows the yuan to have VERY STRONG fundamentals.

We believe recent CNY weakness is simply reflecting broad-based EM FX weakness. The correlation between CNY and MSCI EM FX is around -0.77, which is near all-time highs around -0.80. It appears that PBOC is simply allowing CNY to trade more in line with wider EM FX. USD/CNY is trading at the highest level since early January. The pair is currently testing the 200-day moving average near 6.82 and is on track to test the December 20 high near 6.9170.

Chinese equities are outperforming after underperforming last year. In 2018, MSCI China was -21.2% vs. -17.4% for MSCI EM. So far this year, MSCI China is up 14.1% YTD and compares to 7.7% YTD for MSCI EM. Our EM Equity Allocation Model puts China at VERY OVERWEIGHT, and so we expect Chinese equities to continue outperforming.

Chinese bonds have underperformed. The yield on 10-year local currency government bonds is +17 bp YTD. This is ahead of only the worst performers Turkey (+429 bp), Argentina (+264 bp), Hungary (+25 bp), and Poland (+19 bp). With inflation likely to remain low and the central bank to maintain its dovish stance, we think Chinese bonds will start to outperform.

Our own sovereign ratings model shows China’s implied rating fell a notch to A/A2/A this past quarter. The secular slowdown is taking a toll on the economy and we see growing downgrade risks to actual ratings of A+/A1/A+. This suggests that S&P’s downgrade last year to A+ may not be the last.