Some Thoughts on a Possible US-China Currency Pact

There has been increased talk about a possible “currency pact” from China as a key component for a partial trade deal. The notion was first discussed in February, when Treasury Secretary Mnuchin touted that the US and China had agreed on a currency pact that was “the strongest ever.” No details were ever divulged, as US-China talks broke down in May over the deeper structural reforms that China was unwilling to commit to. So what can we expect of a trade pact this time around?

POLITICAL OUTLOOK

Many believe that the currency pact will be something along the lines of the currency chapter of the USMCA. The United States-Mexico-Canada Agreement (USMCA) includes provisions forbidding any of its members manipulating their respective currencies. Here’s the relevant section, which is Article 33.4 of Chapter 33 of the USMCA: Each Party confirms that it is bound under the Articles of Agreement of the IMF to avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage. Each Party should: (a) achieve and maintain a market-determined exchange rate regime; (b) refrain from competitive devaluation, including through intervention in the foreign exchange market; and (c) strengthen underlying economic fundamentals, which reinforces the conditions for macroeconomic and exchange rate stability. Furthermore, the agreement includes a requirement to inform the other countries if it has undertaken an action with regard to the other country’s currency.

If a currency pact is based on the USMCA, then it would be a low-cost pledge for China to make. China’s current account surplus has already fallen significantly, and policymakers have already been moving towards a more market-determined CNY. Furthermore, PBOC actions this year have been oriented towards preventing excessive currency weakness, not strength. During times of broad EM weakness, the PBOC has typically fixed the yuan stronger than what models would suggest, thereby leaning against the wind a bit.

There appears to be no clause in the USMCA with regards to enforcing exchange rate compliance. We would expect the US to insist on some sort of enforcement mechanism, but it would have to be vague enough to make it acceptable for the Chinese. This also means that the US Treasury FX report (See A Brief History Lesson below) could take on a greater degree of importance, perhaps acting as a report card of sorts about how the administration sees China’s FX regime.

 

A BRIEF HISTORY LESSON

China was named a currency manipulator in August by the US Treasury. Press reports suggested that President Trump made the choice to name China, leaving it to his staff to complete his directive. Treasury did so officially by citing the Omnibus Trade and Competitiveness Act of 1988. This unilateral decision apparently supersedes the three criteria set forth in section 701 of the Trade Facilitation and Trade Enforcement Act of 2015. China only met one of the three criteria needed to be named a manipulator, which simply confirms that the designation as a currency manipulator has become purely politicized.

After being named a manipulator, US Treasury must engage with the IMF to determine what steps will be taken next. If there is no progress within a year, China would face possible sanctions. The Trade Facilitation and Trade Enforcement Act of 2015 “establishes a process to engage economies that may be pursuing unfair practices and impose penalties on economies that fail to adopt appropriate policies.” The US can then 1) prohibit OPIC financing for projects in the offending country, 2) prohibit the US government from procuring any goods or services from that country, 3) call for greater IMF oversight, or 4) instruct the USTR to negotiate bilateral trading arrangements with that country to address currency undervaluation.

The Treasury FX 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 by 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.”

 

INVESTMENT OUTLOOK

Markets have seized on the possibility of a partial trade deal. It’s worth noting that the optimism is hitting all the markets: FX, equities, bonds. EM and the growth-related majors (dollar bloc and Scandies) are outperforming, while global equity markets are rallying. Asian stock markets are likely to run with this optimism tonight. US yields are rising and the US 3-month to 10-year curve is flat and no longer inverted for the first time since July 30. The thinking goes that even a partial trade deal reduces US recession risk and we would have to agree, at least for the near-term.

Yet we warn investors that a partial deal simply prevents things from getting worse. Our understanding is that in return for the currency pact and increased purchases of US goods by China, the US in turn would refrain from enacting any more tariffs and lifting sanctions on Huawei. Existing tariffs would remain in place and until those are removed by a broader trade deal, we think risks to global growth and trade remain in place. So enjoy this current risk-on bounce in sentiment for now, as we doubt it will last.