Some Thoughts on the Upcoming 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.” Speculation has grown that China will be named a currency manipulator, which would be the first time any country has been named since 1994. We do not think China will be named, which would be positive for Chinese assets as well as the wider EM.

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 week. 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 week.

Speculation has grown that China will be named a currency manipulator, which would be the first time any country has been named since 1994. Press reports suggest that Treasury staff have recommended to Secretary Mnuchin that China not be named a manipulator. We concur. Yes, CNY is trading near multi-year lows but so are many other EM currencies. CNY is -6% YTD and is in the middle of the EM pack. As such, Chinese policymakers could argue that DNY weakness is simply reflecting broad-based EM FX weakness.

IMF Managing Director Lagarde weighed in on this issue on the sidelines of the IMF/World Bank meetings in Bali. She noted that “If you ­compare the position of the renminbi relative to the US dollar, it has a lot to do with the strength of the dollar.” This is very similar to our take on the matter.

The most recent report from April 2018 was renamed “Macroeconomic and Foreign Exchange Policies of Major Trading Partners of the United States.” Currently, the Treasury report 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 Treasury noted was previously among the top 12 but is now number 15. Treasury said it is considering whether to expand the number of countries covered in the future.

 

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 in order 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 1998, 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.

In the October 1989 report, Taiwan was absolved but not Korea. Treasury “concluded that there were no clear indications Taiwan was manipulating its currency within the meaning of the legislation, but that there were indications of continued exchange rate manipulation by Korea.” It reversed this judgment on Korea in the April 1990 report, noting that “while there is a lack of evidence of direct government manipulation of the exchange rate, we remain concerned about the won’s depreciation.”

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 also named 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 “remains 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, or 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.

 

ECONOMIC OUTLOOK

In the April 2018 report, Treasury noted that global growth accelerated to its fastest pace since 2011 and led by the US. With the IMF recently cutting its global growth forecasts, we believe the October 2018 report will also have to acknowledge the cloudier outlook. Global growth is now seen by the IMF at 3.7% in both 2018 and 2019, same as in 2017. Both forecasts were marked down by 0.2 percentage points.

The US external accounts are likely to continue worsening. The current account deficit is seen by the IMF at -2.5% of GDP in 2018 and -3.0% in 2019, up from -2.3% in 2017. As Treasury pointed out in April, “the US trade deficit widened in 2017, mainly because domestic demand growth in our major trading partners lagged domestic demand growth in the United States, trade and investment barriers persist in many economies, and several surplus economies continue to have currencies that are undervalued per estimates by the International Monetary Fund (IMF).”

 

INVESTMENT OUTLOOK

At this point, it’s anyone’s guess whether China is named as a currency manipulator this time. We lean towards no. Why? For one thing, China does not meet all three of the criteria. Indeed, it only meets one, which is a persistent trade surplus with the US over $20 bln. China’s current account surplus has shrunk significantly to 1.3% of GDP in 2017. The IMF sees it shrinking further below the 3% criteria to 0.7% in both 2018 and 2019. Lastly, the PBOC has not engaged in one-sided FX intervention and foreign reserves have risen only $18 bln over the last 12 months.

Furthermore, there may be a thaw in US-China relations. Press reports suggest Presidents Trump and Xi will try to meet on the sidelines of the G20 meetings next month in Buenos Aires. Tensions between the two nations are already the worst they’ve been in decades, and so we may see some efforts at fence-mending by the US. Not naming China a manipulator would be a good start.

If China is not named, then we would expect Chinese equities and the yuan to rally. This would be due in large part to the improved prospects of a trade deal that would allow both sides to start dismantling tariffs. This would also be a net positive for EM, since China is such a huge part of global trade and the global supply chain.