Some Thoughts on the Upcoming Semiannual US Treasury FX Report

The US Treasury will soon release its semiannual report to Congress on “Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States.” As well as adjusting the criteria for being named a currency manipulator, more countries will reportedly come under scrutiny. Yet despite the current trade frictions, we do not think China will be named as a manipulator.

POLITICAL OUTLOOK

The US Treasury presents its semiannual “Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States” report to Congress this month. It is later than usual, as the report is typically issued every April and October. No date has been set but as we await the report, we thought it would be helpful to look at the history of the report and what might happen this month.

Given the current trade frictions, many are likely wondering if China will be named a currency manipulator? If so, it would be the first time any country has been named since 1994. Our short answer is, no. By our calculations, China appears to only meet one ($20 bln bilateral surplus with the US) of the three criteria currently used (see A Brief History Lesson below). Foreign reserves have been falling even as the once-significant current account surplus moves closer and closer to balance.

The report from April 2018 was renamed “Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States.” The Treasury report now focuses on the 12 largest trading partners of the US, which account for more than 70% of the trade in US goods. These countries are China, Mexico, Japan, Germany, Italy, India, Korea, Canada, Taiwan, France, the UK, and Brazil. It also covers Switzerland, which was previously among the top 12.

Reports suggest that Treasury will lower the threshold for the current account surplus from 3% of GDP to 2%. It has also been reported that the number of major trading partners to be covered will expand from 13 currently to around 20. This would likely bring the following countries under greater scrutiny: Ireland, the Netherlands, Singapore, Vietnam, Belgium, Malaysia, and Thailand.

In the October 2018 report, China was found not to be a currency manipulator. However, it remained on the Monitoring List of countries that merit “close attention” to their FX policies because two of the three criteria are met. In that most recent report, China was on the Monitoring List by Japan, Korea, India, Germany, and Switzerland.

As the table below suggests, Germany, Japan, and Switzerland are likely to remain on the Monitoring List. Along with China, we believe the data justify India and Korea being dropped from the List. India foreign reserves have been falling recently, whereas Korea’s trade surplus dropped below the $20 bln threshold in 2018.

Of the likely new seven countries to be added, all but Ireland and Vietnam are unlikely to be put on the Monitoring List. Ireland meets two of the three criteria and so should be put on the List. Vietnam meets all three criteria and so it could become the first country to be named as a currency manipulator since 1994.

 

 

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.

After the “Omnibus Trade and Competitiveness Act of 1988” was passed, Treasury wasted no time in naming names. In the first report in October 1988, Korea and Taiwan were both identified as currency manipulators. Treasury “determined that Taiwan and Korea, within the meaning of Section 3004 of the Omnibus Trade and Competitiveness Act” were manipulating their exchange rates. The April 1989 report upheld these findings. However, Taiwan was absolved in the October 1989 report and Korea in the April 1990 report.

The May 1991 report first saw China come on Treasury’s radar screen. The report noted that China’s growing trade surpluses “chiefly reflect China’s generalized and pervasive controls over the external sector, including both import restrictions and the allocation of foreign exchange. These controls, in conjunction with China’s administrative determination of its exchange rate and sustained real effective depreciation in 1990, raise concerns and indicate a shift in policy may be occurring aimed at reinforcing China’s attempts to generate significant external surpluses.”

The May 1992 report quickly crystalized Treasury’s growing concerns. Due to “continued devaluation of the administered exchange rate and control of swap center rates, in conjunction with pervasive trade and exchange controls, as an effort by China to frustrate effective balance of payments adjustment,” China was named as a manipulator. Taiwan was named again too, while Korea got a pass this time.

The December 1992 report found that Taiwan and China continued to manipulate their currencies. Korea was still found not to, but Treasury expressed concerns over “pervasive” exchange and capital controls there that “significantly constrain market forces in the currency market.”

The July 1994 report was noteworthy, as it came after some significant currency moves by China. In January of that year, China unified its dual exchange rates at the weaker of the two. While Treasury welcomed that move, it still viewed China as a manipulator. Elsewhere, both Korea and Taiwan were found not to be manipulators this time around. However, Treasury remained “concerned about certain financial and foreign exchange policies in both countries, particularly capital controls, which discourage investment and impede the operation of market forces in exchange rate determination.”

The December 1994 report no longer found China to be manipulating its exchange rate. Taiwan and Korea were also given a clean bill of health, though Treasury wanted to see further liberalization in all three countries. It is important to note that in every Treasury report since this one, neither these three nor any other trading partners have been identified as currency manipulators.

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.”

Note that “the 2015 Act establishes a process to engage economies that may be pursuing unfair practices and impose penalties on economies that fail to adopt appropriate policies.” Basically, currency manipulators are given a year to try to solve the issue through negotiations. If no solution is reached, the US can 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.

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 made up of countries that fulfilled two of the three criteria. This list initially contained China, Japan, Korea, Taiwan, and Germany. The October 2016 report added Switzerland to this Monitoring List, but no country met all three criteria. The October 2017 report dropped Taiwan from the Monitoring List. Lastly, India was added to the monitoring list in the April 2018 report and that is where we stand now.

 

INVESTMENT OUTLOOK

Trade tensions are feeding the negative tone of global financial markets as the week begins. Talks ended Friday with no breakthrough, and no date has been set for the next round. Despite constructive spin from both sides, we remain pessimistic near term. Reports suggest the US is giving China one month to reach an agreement before the second phase of US tariffs kicks in on another $325 bln of Chinese imports.

Indeed, rhetoric from both sides over the weekend suggest things will get worse before they get better. This has weighed on global equity markets whilst boosting core bond markets. JPY, CHF, and JPY are bid to start the week as risk-off sentiment returns after a brief absence Friday. This has come at the expense of the dollar bloc, Scandies, and EM. This trend should continue.

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 (consider what happened after the 2015 yuan devaluation).

We believe recent CNY weakness is simply reflecting broad-based EM FX weakness. The correlation between CNY and MSCI EM FX is around -0.80, which is near all-time highs. It appears that PBOC is simply allowing CNY to trade more in line with wider EM FX. USD/CNY is making new highs for the year. The pair is currently testing the January 3 high near 6.8830 and is on track to test the November 30 high near 6.96. After that is the October 31 high near 6.98.

Despite rising US-China trade tensions, we think that will be settled in a totally different arena from the Treasury’s FX report. Specific criteria have been formulated to identify currency manipulators, and China simply doesn’t fit the bill. Rather, we believe the US will continue to rely on tariffs and tariff threats to address what it sees as unfair China trade practices, rather than relying on the Treasury FX report.

MSCI EM FX is leading this move down and has given up over 75% of this year’s rally. Broke below the 200-day moving average near 1619 today and is on its way to testing the January low near 1610 and then the December low near 1597. MSCI EM has given up a bit more than half of this year’s gain. The 62% retracement objective of that move comes in near 1004, and a break below would set up a test of the January low near 945.50.