Submitted by Michael Every of Rabobank
You thought Monday was dramatic in markets? Welcome to Tuesday!
Fortunately, last night Hong Kong did not see the PLA move in but still recorded widespread anarchy on its streets showing the government is clearly not in control: a fresh statement from Beijing is due today, and one wonders what it can add. Will it be as helpful as the statement from the PBOC yesterday that said they are not weakening their currency due to US trade measures, before qualifying that the weaker CNY--which has shocked markets--was “due to the effects of unilateralist and trade-protectionist measures and the expectations for tariffs against China.” (So, yes, they are weakening the currency due to US measures.)
On the back of that this morning we awake to find that US President Trump--after crying out to the Fed about weaker CNH and CNY--has officially labelled China “a currency manipulator”. Naturally this is already seeing already-reeling markets reel further.
The last time China was assessed by the US Treasury on those grounds was a few months ago, where it was found not to be a currency manipulator as it didn’t meet all three of the US’ own criteria (large bilateral trade surplus – tick; current account surplus as % GDP – no tick; persistent intervention to weaken the currency – no tick). Yet now the CNY is finally moving lower in line with its real fundamentals, it IS labelled a manipulator. The irony!
What this US labelling step means in practical terms is unclear as the Treasury’s guidelines state the US must now work with the IMF to address the problems causing the offending currency to be too weak. In this case, of course, the IMF will point out that while China WAS guilty of currency manipulation for years in the past, and the US said nothing “because free trade”, now that CNY is finding its own level, it clearly isn’t guilty – or at least not of that. Indeed, even if the IMF did put forward some policy suggestions, these would probably be listened to by Beijing as much as they are by Berlin,…which might still be next in line to be designated at the rate we are going.
So what will the US do? If you think the answer is nothing then I have a Chinese-funded bridge to sell you. Far more likely they will move forward with more tariffs or countervailing duties, which we discussed a few months ago as being in the works based on US estimates of what the Real Effective Exchange Rate of country should be. If one looks at the principles involved in the new Counter-Veiling Duties (CVD) policy being mooted by the US, all Washington has to do is say they think CNY should be at 6, or 5, and hey presto! They can slap a further crippling set of duties on China based on the difference between that level and where it is actually trading. Even if it doesn’t work quite like that, we are still going to see far greater protectionism via China.
And what will China do? Well, the CNY fix today makes that clear: at 6.9683 vs. 6.9225 (a 458 pip cut): it is going to push the currency even lower. That obviously opens the door to the nightmare scenario of a downwards spiral in Chinese FX and simultaneous upwards spiral in US tariffs - which I have long flagged as all too possible for under the Cold War scenario I believed was playing out between the US and China (rather than the “trade deal soon!” scenario so many neo-classical economists had been plugging, wrongly, on TV all year).
And what will markets do? Crash. Equities are slumping. They will slump more. Bond yields are tumbling. They will tumble far more. 10-year US Treasuries are at 1.67% at time of writing and are possibly going to test through their global financial crisis low as soon as this week: would you want to bet against a 20bp move over the next four sessions at this rate? At the same time, Aussie 10s are through 1% for the first time, putting pressure on the RBA today, who had only just started to feel smug that their blatant institutional spruiking has at least temporarily stabilised house prices. And that’s just one example.
Worry most about the Chinese property developers who have borrowed heavily in USD unhedged. Worry about other EM USD borrowers too, as EM FX tumbles vs the greenback. And worry about global trade flows, as a stronger USD rumbles through the real economy and US-China divorce smashes supply chains. Of course, JPY is up, and EUR too – which sends its own signal: Europe is indeed turning into Japan in more ways than one!
And worry about whether China can stay in control of this process or not. Yes, it “gains” from a weaker Renminbi. For example, you can argue that with USD500bn of exports to the US, putting a 10% tariff on USD300bn of new Chinese exports, meaning a USD30bn “loss”, can be offset by a 6% depreciation in CNH as 6% of USD500bn is USD30bn: we are already over half way there given CNH is trading at 7.13 today vs. 6.88 a few weeks ago. (Of course, it doesn’t work quite as smoothly as that in reality.)
Yet China can lose a lot here, and more quickly than people think. After all, it has a USD2.2 trillion FX debt pile, half of which is short term; a current-account bill of around USD3 trillion annually (on the total outflow side); far less than USD3.1 trillion in liquid FX reserves to access; and a banking system with USD40 trillion in largely CNY-denominated assets that can technically be switched into USD by all involved (capped at USD50,000 per person per year). They already have draconian capital controls in place, but things could get far, far worse ahead. How long until we see FX rationing, both for individuals and firms? Who would be a priority and who wouldn’t, hypothetically?
That China would take such a risk at the same time as there is pushback against Huawei, against the Belt and Road, and against its claims to the South China Sea, to say nothing of Hong Kong, points to the stress it is under and the cul-de-sac it finds itself in. Yet how a “can’t lose face, won’t lose face” China would react to its own EM FX crisis that humbles it leads us on to other, darker scenarios. And none of them say higher bond yields or higher equities.
And it’s still only Tuesday