Some Thoughts on the Yuan

China flag

Many observers are warning that China’s devaluation of the yuan may be a way that it is pushing back against the threatened US tariffs.  We are skeptical and note that nearly all the major currencies fell to this year’s lows recently, and the yuan is off less than 0.5% in H1 18, outperforming most major and emerging market currencies.

The Chinese yuan extended its slide and finished the mainland session at its lowest level of the year.   It is one of the weakest in the region this month.  The onshore yuan has depreciated 1.9% against the dollar so far, and the offshore yuan has fallen slightly more (2.1%).  Only the Korean won and Thai baht fell more (3.5% and 2.9%, respectively).

While many if not most economists and business journalists are critical of the US claim that Canada, the EU, and Japan steel and aluminum exports are threatening US national security, and tend to think tariffs more broadly are counter-productive, the move against China seems to enjoy widespread support.  The disagreement is over tactics.

Napolean warned of the dangers of China awakening.  Well, it has awoken, and it is disruptive to the trade and financial relationships that prevailed.  Many American politicians and journalists attribute it China’s disregard for the rules of engagement laid out by the WTO.  There is merit in this claim, but it is exaggerated on two grounds.

First and foremost, even if China played by the rules, the US would still feel threatened by its rise, as its share size makes it a major player and rival.  The fact of the matter is it is not good enough for many Americans that the economy has never been larger.  Many find it irksome if not threatening that its share of the world economy is shrinking.

Second, China is not the only country that bends the rules when possible and breaks them when it can get away with it.  Is that the all the large powers behave, gaming the rules to their benefit.  China may be egregious than other developed countries, but the US nor more than China can have it both ways.  Many Americans want to hold China to the standards of developed countries when it suits, but at the WTO, the US insists China is not a market economy.  China wants to be a market economy for WTO purposes but given consideration for being a developing country in other respects.

Often it seems that what ails America can most clearly be seen in China.  For example, during the weekend Barron’s, the argument was made that the US trade conflict with China emanates from the class struggle in China.  Among the factoids cited to demonstrate this was the between 1980-2010, the share of income that went to China’s top 1% rose by nine percentage points.

We are told this is the result of the dictatorship of the Chinese Communist Party which tolerates no rival power center.  Who can disagree?  Research by Emmanuel Saez found that the share of income commanded by the top 1% in the US rose from almost 9% in 1980 to 22% in 2015.

The war camp has steady drum beat.  The adversary has to be vilified.  It has to be made dangerous.  Some suggest China could sell its $1 trillion of Treasury holdings.  How scary.  But those familiar with reserve management and the challenges of finding an alternative discount this scenario, and not only now but consistently in recent years as it has often been recycled.

Maybe China will allow the yuan to fall to offset the US tariffs.  It is possible, but this too seems unlikely.  The yuan is falling against the dollar because the dollar is trending higher against most of the world’s currencies.  A significant force lifting the dollar is the US policy mix, which includes the most aggressive monetary policy in the world, and a large dollop of fiscal stimulus that provided in 2008-2009.

US and China’s monetary policy is diverging.  The PBOC cut reserve requirements, which is a channel to ease monetary policy.  It liberalized the collateral rules for one of its operational facilities (MLF).  The motivating factor behind the easing of policy is not so much the slowing of the economy, evident in the last official data, but the financial challenge.  Officials want to facilitate deleveraging and bring shadow banking assets on to bank balance sheets.

The yuan is not the only currency that is at lows for the year.  Last week, the euro, sterling, the dollar-bloc currencies all made set to new lows.  It also depends on when you want to begin the story.  Year-to-date, the yuan is the second strongest emerging market currency in Asia, behind the Malaysian ringgit and virtually matching the pegged-Hong Kong dollar’s 0.4% decline.

China is unlikely to weaponize the yuan.  It would risk renewing the vicious cycle of currency weakness, capital outflows,  and equity slump.  It would aggravate China’s challenges.  As we have seen, however, countries sometimes take actions that are self-defeating.  The yuan’s recent weakness is explainable without resorting to malevolent intentions.

There is a fundamental clash between the US and China.  Graham Allison called it the Thucydides Trap,  a rising power challenges an existing power.  Programmatically, Made in China 2025 is running into an equally powerful expression of nationalism in America First.  It is not communism vs. liberalism, as the US President celebrates and supports the rise of illiberalism.

Deeper still is the different strategies to absorb the surplus savings.  The US leads the development of the financial markets and letting paper assets house the savings.  The Great Recession began off as a crisis in the financial markets.  China has under-developed its capital markets, partly intentionally, as it focused on the market for goods.  It surplus savings is expressed in the form of excess capacity and surplus production.  This alone would lead to trade frictions as foreign demand was sought to absorb the surplus.