Perceived currency fight may force trade war truce

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Beijing’s tolerance of a soft renminbi may exert devaluation pressure on the currency market and create volatility that could hit US stocks. It could thus turn out to be a catalyst for a truce in the Sino-US trade conflict.

My view that China will not devalue the renminbi to fight the trade war remains unchanged. However, it is likely that market forces will do the job under the prevailing market conditions and sentiment. The People’s Bank of China (PBoC) will almost inevitably intervene, but only to slow the pace of any decline.

The recent escalation of the Sino-US trade conflict is negative for risk assets in the near term. That includes Chinese stocks: the trade skirmishes will hurt Chinese growth expectations and revive fears of an economic hard landing. To limit the damage, Beijing is likely to step up its policy easing measures.

While it should help support domestic demand, such easing – combined with the impact of higher US tariffs on China’s exports – will add downward pressure on the renminbi. Ironically, renminbi weakness may be a force driving the US and China towards a trade deal. The unintended consequence, however, may be a bout of currency war by stealth!

Lighter FX intervention could hit market sentiment in China

While there is no evidence of Beijing devaluing the renminbi to fight the trade war, and devaluation is still not on the policy agenda, the PBoC may increase its tolerance of a renminbi driven weaker by market forces. This would mean it would intervene less heavily on the foreign exchanges. But that would also hurt market sentiment: Chinese equities could correct, Chinese bond yields could fall and the renminbi could risk weakening towards or even beyond 7 per US dollar in the near term.

The PBoC’s greater tolerance of a soft renminbi may exert competitive devaluation pressure in the FX market and create volatility. This could also hurt the US stock market, as recent market volatility has shown. A US equity sell-off may not trouble Washington’s trade and national security hawks. But it would likely annoy president Trump, who sees the US stock market’s performance as a gauge of his approval rating.

Weaker US stock prices may lead to trade truce

If a weaker renminbi hits US stock prices, it may create sufficient financial pain to persuade the US president to call a truce and seek further negotiations. Anything else would portray him as failing to deliver on his promise to “tame China” and make America great again.

If the effects of renminbi depreciation do prompt the two sides to come to a trade agreement, the eventual impact on market sentiment, especially in China, would be hugely positive. Given the expectation that additional easing by Beijing would accelerate liquidity growth, such an outcome of renminbi weakness would support Chinese stocks after some knee-jerk negative reactions.

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

Chi Lo

Senior Economist for China

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