The Threshold of 7 Yuan per Dollar has been Exceeded

Is China using the exchange rate as a tool to react to the increase in American tariffs?

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The week just ended opened with the depreciation, on August 5, of the Yuan. On Monday People's Bank of China (PBOC) set 1 the Yuan midpoint to 6.99, accepting that it actually exceeded the threshold of 7 yuan per dollar. During the day, the Chinese currency reached 7.04. In the following days the Yuan continued to weaken, closing the week at 7.06.

Trump's interpretation is that of an intentional act ("currency manipulation") by China, in response to the American tariff policy.

The relationship between trade war and Yuan depreciation has been widely analyzed in this magazine: see US-China: the trade war saga (May 15, 2019) and Chinese Yuan is gauging trade war tensions (May 17, 2019).
However, Trump's interpretation leaves some doubts, for the following reasons:

  • Devaluation is a much weaker instrument of international competition than duties. Devaluations increase the competitiveness of a country but also "import" inflation and transfer resources out of the country. The increase in duties generates more public resources that can be put back into the economy by reducing taxes or increasing transfers. The increase in duties is a strategy that can therefore be carried out much more aggressively than devaluation.
  • The chronology of events that suggests that PBOC only anticipated values towards which the market would have gone anyway, maintaining the semblance of a monetary authority still able to set the exchange rate.

Understanding whether the Yuan devaluation is the main Chinese reaction to the American trade war is important for two reasons:

  1. To measure the medium-term exchange rate risk associated with the Yuan
  2. To foresee the possible evolution of the ongoing trade war

The chronology of recent events

  1. On July 31, at the end of the 12th round of trade meetings between the US and China, held in Singapore, Trump announced via Twitter that, on September 1, a 10% duty on $300bn worth of US imports from China would be applied.
  2. A few minutes after Trump's tweet, many emerging market currencies began to depreciate: first of all Mexican Peso, followed by Brazilian Real and South African Rand. Among these, the Chinese Yuan showed a weakening, as well.
  3. On July 31, the FED cut rates by 25 basis points. This decision, read by many commentators as favorable to emerging economies, did not interrupt the weakening of emerging markets currencies, signaling the strength of the factors driving towards their depreciation.
  4. In the following days, more and more currencies were involved in the depreciation against the dollar. Only safe-haven currencies (Swiss Franc and Yen), the strong currencies (Israeli Shekel and Thai Baht) and the Turkish Lira exception, resisted the strength of the dollar.
  5. On August 5, the PBOC took note of the direction of the market and decided to devalue its currency, bringing the midpoint for the exchange rate to 6.99.

1. On a daily basis, the People's Bank of China sets a midpoint for the yuan/dollar exchange rate and then intervenes in various forms on the various markets to contain fluctuations in the effective exchange rate within a +/-2% range. This mechanism is similar to the European Monetary System (EMS), which at the end of the last century anticipated the creation of the euro. Setting a central parity does not mean that the currency will keep those values. On 16 September 1992, the pound and lira were forced out of the EMS, because the system of European central banks was no longer able to intervene in the foreign exchange market to keep the pound and lira within the fixed band. In the presence of a high degree of freedom in capital movements, central banks may not have sufficient instruments to contract the direction of the market, if this is "compact" in its expectations.