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Beidaihe, and the shifting sands in trade, CNY and economic policy

First published: 24/07/2018

Beidaihe, a famous Chinese summer seaside resort, popular with tourists, is situated southwest of the port city of Qinhuangdao in northeastern Hebei province, about 300 kilometres east of Beijing. China watchers know it, though, because every year around the beginning of August,  it hosts a top brass Chinese Communist Party meeting to discuss and define key policies. Since Xi Jinping came to power, and especially as he has consolidated his own controlling position in a Communist Party that itself has become more controlling, Beidaihe may have less significance from the standpoint of  collective decision making than used to be the case. Regardless, the rumour mill is already in full swing with regard to the fate of senior officials, and there is no question that the leadership has important issues to debate. Few will figure as prominently as Trump’s trade war and broader Sino-US divisions at a challenging time for the economy, which is losing traction in the wake of the 18-month old financial and credit clampdown.

China’s currency is again in focus…

The Chinese currency, or CNY as it is labelled in global fx markets, faced a torrid time during the financial crisis of 2015-16, hitting a low point of 6.96 to the US dollar towards the end of 2016. Following billions of dollars of currency intervention, the loss of nearly $1 trillion of reserves, and a considerable tightening of capital controls, the currency stabilised. Aided and abetted by the global economic recovery, stronger Chinese exports and a weak US dollar, CNY rose back to 6.28 in April 2018.

Sine then, however, it has been falling within the limits prescribed by the People’s Bank of China. It has fallen back to close to 6.80 against the US unit, or about 7.5 per cent less than its recent high. The CNY is also lower now in trade weighted terms than it was at the height of the 2015-16 crisis, and while the government can claim it is managing the currency against the basket, and not focusing on the US dollar rate,it is the US dollar rate that really matters. 

To some extent, the fall in China’s currency has been part of a general US dollar rise in the wake of the US economy’s robust performance, and the parallel shift in expectations of rising US interest rates. The trade weighted US dollar measured by the DXY index, and also the more broadly based index recorded on the St Louis Fed database, has risen by a little more than 5, and 4 per cent respectively. To the extent, though, that the fall in CNY has gone further, and against the background of the escalating tension with the US over trade, and technology, questions are being raised as to whether China is using its exchange rate as a tool with which to offset the effect of Trump’s tariffs, and hit back at the US.

…. as trade row builds

The fall in CNY has certainly not been lost on the US Administration. President Trump tweeted on 19th July:

‘China, the European Union and others have been manipulating their currencies and interest rates lower, while the US is raising rates while the dollar gets stronger and stronger with each passing day – taking away our big competitive edge. As usual, not a level playing field…’

And Treasury Secretary Mnuchin told Reuters the same day that the Treasury is closely monitoring China’s currency markets for ‘signs of manipulation’.

We have heard these charges from the White House before but they take on a more ominous ring in the context of a trade row that shows few signs of ending, and to which there doesn’t seem to be any obvious long-term escape route. Trump’s trade war, if anything, is getting more serious. By the end of July, the US will have levied a new 25 per cent tariff on $50 billion of imports from China, which the latter is going to match.  The White House had already threatened China with a 10 per cent tariff on a further $200 billion of imports if it did so, but at the end of last week President Trump – perhaps eager for a distraction from the Helsinki summit fiasco – said he was ready to impose tariffs on the entire $500 billion of goods imported from China. (I have noted elsewhere that as things stand, and taking into account the US spat with Europe, Canada and Mexico, and others over steel and in all likelihood cars, over $1 trillion of world trade could be on the tariff rack before long, or about 7 per cent of world trade –

Is China likely to ‘weaponise’ its currency in the way described and alleged? My own view is no, or at least not in current circumstances.It cannot want to risk a recurrence of the turbulence unleashed in 2015-16, and of renewed capital flight. In its international relations, it has cosied up to the EU as a partner with which to stand up against Trump’s trade war, come out in support of the recently concluded EU-Japan free trade agreement, and tried to present itself as a stable and reliable economic leader. Playing fast and loose with the exchange rate is a sure way to shatter that image.

But with that said, there is little doubt that the Chinese authorities will have to show its hand soon if they want to assure global foreign exchange markets that they are not pursuing a policy of covert depreciation. The closer the market gets to CNY7 to the US dollar, the more important that will be. 

….and as domestic conditions become more compatible with a weaker currency

The problem for China is that, leaving side trade and tariffs, domestic  economic and financial circumstances are changing in ways that lead almost naturally to a weaker currency, regardless.  In a nutshell, monetary and fiscal polices are gradually being loosened.

The financial clampdown has been in situ for about 18 months, resulting in a significant slowdown in the underlying rate of officially recorded credit expansion and in both fixed asset investment and retaIl sales. Defaults in the Chinese bond markets remain relatively small in number and affect a modest volume of debt, but they are rising (to the extent they are allowed). To deflect the negative economic consequences, the central bank has been injecting large volumes of liquidity, lowered banks’ reserve requirement ratios three times this year, and boosted funding for loans. It has also encouraged banks to buy bonds with low credit status, and pressured them to negotiate work-outs with weak borrowers.

The question about how to react to the economic slowdown has manifested itself in a public disagreement between the People’s Bank and the Finance Ministry, with the former appealing for greater fiscal accommodation so that it does not succumb to a significant reversal of its own strategy. The State Council has weighed in with the central bank. The People’s Bank has numerous facilities that it deploys to add and take away liquidity, but while it is hard to gauge in real time just how generous it is being, we can see other real time measures of accommodation. Interest rates, which never came close to peaks reached during past monetary tightening cycles, have come down since the beginning of the year. The 3-month Shanghai interbank rate, for example, has dropped from over 4.9 per cent last December to about 3.5 per cent. Other short-term rates have fallen too, though from lower levels and by smaller amounts.

There has not been any marked reversal of fiscal strategy, or any announcements detailing new projects and infrastructure spending, but it is significant that the government is showing some signs that it is willing to ease the overall stance and pursue a more proactive fiscal policy. This is likely to be realised through local and provincial government activities as well as other off-budget vehicles rather than through central government initiatives, per se,

In any event, the stage is being set, even if modestly at the moment, for an overall easing of policy. In my forthcoming book, Red Flags: Why Xi’s China is in Jeopardy, I argue that the main risk to then lower growth/orderly debt reduction/ deleveraging scenario in China was a high sensitivity to weaker economic growth that would then trigger policy easing and kick the debt and deleveraging can down the road to a more awkward resolution.  It looks as though this is where China has arrived.