Semiannual US Treasury FX Report Suggests Trade Hawks Hold Sway

The US Treasury finally presented its semiannual report to Congress on “Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States.” The delay was due to a change in the criteria for being named a currency manipulator as well as for being included in the report, suggesting the trade hawks continue to drive US policy. Yet while more countries came under scrutiny amidst heightened trade frictions, China was not named as a manipulator.

POLITICAL OUTLOOK

Starting with this Treasury report, the US will now assess all trading partners whose bilateral trade with the USD exceeds $40 bln per annum. Before, Treasury assessed the 12 largest trading partners plus Switzerland. Using 2018 data, this new group contains 21 countries that account for more than 80% of US goods trade. The eight new countries to be assessed are Ireland, Vietnam, Malaysia, Thailand, Singapore, Belgium, the Netherlands, and Hong Kong. They join the previous group of thirteen that included China, Mexico, Japan, Germany, Italy, India, Korea, Canada, Taiwan, France, the UK, Brazil, and Switzerland.

As reports suggested, Treasury did indeed adjust the criteria for being named a manipulator. The threshold for the current account surplus was lowered from 3% of GDP to 2%. The criteria for persistent, one sided intervention was also modified. A country will now be flagged if net purchases are conducted in at least 6 out of 12 months (vs. 8 previously) and these net purchases total more than 2% of GDP over a 12-month period.

We believe that these adjustments reflect the growing clout that the trade hawks have within the Trump administration. With this latest Treasury report, the US is basically putting all its trading partners on notice that scrutiny on trade imbalances will get even stronger. As it noted, “Treasury’s goal in adjusting the coverage of the Report and these thresholds is to better identify where potentially unfair currency practices or excessive external imbalances may be emerging that could weigh on US growth or harm US workers and businesses.” Bottom line: trade tensions are likely to remain high this year.

Under the new criteria and expanded coverage, the Monitoring List expanded significantly. It is now made up of China, Japan, Korea, Germany, Italy, Ireland, Singapore, Malaysia, and Vietnam. India and Switzerland were dropped in this latest report after both met fewer than two of the three criteria for two straight reports. Korea now only meets one and if this is the case when the next report is prepared, it too will be dropped from the Monitoring List.

As the table below suggests, Vietnam seems to meet all three criteria and should have been named a manipulator. However, the Treasury noted that “The Vietnamese authorities have credibly conveyed to Treasury that net purchases of foreign exchange were 1.7 percent of GDP in 2018. These purchases came in a context in which reserves remained below standard adequacy metrics and there was a reasonable rationale for rebuilding reserves.” This compares to our own calculations that suggest FX intervention in excess of 4% of GDP.

Given the current trade frictions, many were wondering if China would be named a currency manipulator. Fortunately, the answer was no. However, it was kept on the watchlist. Indeed, China has been on the watchlist since its inception even though it has only met one criteria the entire time. Why? “Treasury will carefully monitor and review this determination over the following 6-month period in light of the exceptionally large and growing bilateral trade imbalance between China and the United States and China’s history of facilitating an undervalued currency.”

 

 

A BRIEF HISTORY LESSON

The Treasury report to Congress was mandated by the “Omnibus Trade and Competitiveness Act of 1988.” This legislation originally stemmed from an amendment proposed by Representative Dick Gephardt that would require the US to examine the policies of countries that had large trade surpluses with the US. To put it bluntly, the legislation was a response to the deteriorating trade position of the US. Many politicians blamed foreign trade barriers rather than domestic factors for this deterioration.

The initial report to Congress on “International Economic and Exchange Rates Policy” was meant to fulfill the process set forth in the legislation. Under Section 3004 of that act, “The Secretary of the Treasury shall analyze on an annual basis the exchange rate polices of foreign countries, in consultation with the IMF, and consider whether countries manipulate the rate of exchange…..for purposes of preventing effective balance of payments adjustment or gaining unfair competitive advantage in international trade.”

At that time, Treasury examined five areas of concern to decide if a country was guilty of currency manipulation: 1) external balances, 2) exchange restrictions and capital controls, 3) exchange rate movements, 4) changes in international reserves, and 5) macroeconomic trends.

The Treasury report was later amended in section 701 of the “Trade Facilitation and Trade Enforcement Act of 2015.” “The 2015 Act requires that Treasury undertake an enhanced analysis of exchange rates and externally‐oriented policies for each major trading partner that has: (1) a significant bilateral trade surplus with the United States, (2) a material current account surplus, and (3) engaged in persistent one‐sided intervention in the foreign exchange market.” Treasury noted that “Because the standards and criteria in the 1988 Act and the 2015 Act are distinct, it is possible that an economy could be found to meet the standards identified in one of the Acts without being found to have met the standards identified in the other.”

In the April 2016 report on “Foreign Exchange Policies of Major Trading Partners of the United States,” Treasury laid out the specific thresholds for the three new criteria regarding currency manipulation: “(1) a significant bilateral trade surplus with the United States is one that is at least $20 bln; (2) a material current account surplus is one that is at least 3% of gross domestic product (GDP); and (3) persistent, one-sided intervention occurs when net purchases of foreign currency are conducted repeatedly and total at least 2% of an economy’s GDP over a 12-month period.”

No trading partner was found to satisfy all three criteria in that April 2016 report and so none were named currency manipulators. However, Treasury created a Monitoring List of the countries that fulfilled any two of the three criteria. This list initially contained China, Japan, Korea, Taiwan, and Germany. The October 2016 report added Switzerland, while the October 2017 report dropped Taiwan. Lastly, India was added to the monitoring list in the April 2018 report.

 

INVESTMENT OUTLOOK

Trade tensions continue to weigh on global financial markets. China just put its purchases of US soy on hold. Those so-called goodwill purchases were seen after the December trade truce. Rhetoric in China media remains heated. Elsewhere, press reports suggest a deal with Europe looks more difficult than ever, especially with new EU leadership coming in just as the November US tariff deadline hits.

Press reports suggest the Trump administration is studying tariffs on goods coming from countries that have undervalued currencies. That pretty much describes all of EM. It would allow US companies to seek countervailing duties against the subsidy-like impact of a weak currency. Commerce would reportedly defer to Treasury in terms of determining which currencies are deemed to be undervalued. However, this appears to be an entirely different angle of attack than the Treasury report.

This is yet another example of the trade hawks’ undue influence on US trade policies. Reports suggest Ross and Lighthizer have been pushing for this since the beginning of Trump’s term.   While China remains the focus for the US, this latest move opens up potential trade battles with most of the US trading partners. And it’s not just EM. The OECD estimates the euro, sterling, and yen to be significantly undervalued now.

Senior China officials continue to downplay risks of weaponizing the yuan. We believe them. 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 (consider what happened after the 2015 yuan devaluation).

The yuan fix has basically flat-line around 6.90 since May 20. This occurred despite continued and persistent weakness across EM FX, which means that the PBOC has been discouraging yuan weakness rather than encouraging. The so-called counter-cyclical factor in the CNY fix is the culprit here.

Yet we don’t want to overstate the case that China is “defending” the 7 level. It’s clear that this is an unsustainable position if EM FX continues to weaken. Indeed, there is nothing special or magical about the 7 level beyond the usual round-number syndrome. The correlation between CNY and MSCI EM FX is around -0.78, which is near all-time highs. While the PBOC wants to discourage capital outflows by keeping the yuan stable, there are limits to this strategy if policymakers intend to allow market forces to have a greater role in the exchange rate.

MSCI EM FX has basically given up all of this year’s rally. With global trade tensions still ratcheting up, we think EM weakness will continue. Next up is the December low near 1597, followed by the November 13 low near 1588 and the October low near 1582. That last level represents another 2% loss from current levels. If the recent correlation holds up, this should push USD/CNY above that 7 level.