The Yuan to the Rescue

The global outlook is looking like it's going from bad to really messy as the trade war looks to be spilling over into a currency war.

The Chinese Yuan weakened considerably today against the dollar and according to an AP report out recently it has weakened below the politically sensitive level of 7 and to its lowest level in over a decade, which observers take as an important threshold that could signal disruptions in global markets, and disrupt it has.

But what is the link between trade and currency?

Let's start with a primer. Generally speaking when you import a good from abroad say from China, the good has to be paid for in Chinese yuan, but normally what we hold here in the US is American dollars, so we have to exchange our currency for theirs in order to finalize that purchase. In most cases we do not carry out the currency exchange ourselves but this is done through financial intermediaries that facilitate the transaction when we pay, say using our debit or credit cards. The dollar-yuan exchange rate is what determines how much in dollars we have to give up for each yuan we indirectly obtain in order to buy the good that is denominated in Chinese yuan.

Managed Float

The Chinese yuan is managed by the country's monetary authority, the People's Bank of China (PBOC). The PBOC sets the exchange rate daily but generally allows the yuan to float, that is move freely in response to market dictates, with the dollar, but within a 2% band. It would otherwise intervene through monetary policies or directives to keep it within that band should market pressures force it to fall or rise higher than the band.

Notice that even though a bilateral exchange rate takes two to tango, I have stated that the rate is set by the PBOC. This is because the US dollar is allowed to float freely against other currencies. This means that the dollar-yuan exchange rate we face is determined by the Chinese government's or PBOC policy. The US monetary authority - the Fed - can intervene through similar monetary policy actions to move the rate in a direction it prefers, but as a major global and reserve currency, the US dollar is left to float freely.

For those who have watched global markets closely you would know that China's managed float is an exchange rate policy that has often been criticized by western countries, especially the US, as helping to boost Chinese exports at the expense of our exports. This is because the policy has tended to see the PBOC deliberately weaken the yuan against the dollar and make their exports therefore relatively cheaper.

Intuitively, a weaker yuan makes it easy for holders of US dollars to buy the yuan and therefore to buy Chinese products denominated in yuan, so Chinese exports increase. However the stronger dollar means it is expensive to buy and therefore expensive to buy our products which are denominated in US dollars so our exports fall. The 2% band does provide it a little bit of leeway in manipulating the exchange rate in its favor and this is what has drawn criticism from the West, whose currencies float freely.

Trump Tariffs

This now brings up the current situation. The Chinese economy depends heavily on exports and the squeeze from Trump's tariffs has seen a drop in its exports and resulting slowdown in its growth. This is also not been helped by the fact that China has also responded with its own tariffs on US exports and because generally tariffs hurt the countries imposing them, while inflicting harm on US exporters, it also harms Chinese consumers as well.

While we tend to discuss the impacts of tariffs in terms of the volume of exports and imports, because the exchange rate is actually the price of foreign currency that makes these international transactions possible, they would also be affected, but so far this has taken a back seat until now.

If the Chinese yuan was allowed to float freely against the dollar, the impact of the US tariffs on China should see the yuan weaken: the resulting fall in Chinese exports from the tariffs reduces their net exports and this reduces Chinese GDP. This will cause the Chinese interest rates to fall in their money market and lead to a depreciation of the yuan through financial capital flight as investors take advantage of arbitrage.

The Chinese yuan has effectively weakened by about 5% since the imposition of tariffs by the Trump administration on Chinese imports last year to date. In fact it could very well have weakened further if China had not in turn imposed retaliatory tariffs on US exports. Intuitively, because China's retaliatory tariffs would have led to a reduction in their imports, the impact on their net exports was only smaller than it would have been, leading to a smaller than expected fall in Chinese interest rates, and a resulting smaller depreciation in the yuan against the dollar.

This current slide in the Chinese yuan to below the sensitive rate having weakened to about 7.02 yuan per dollar (as of this morning) is therefore expected, being driven by investor expectations that the fresh 10% tariffs on more than $300 billion worth of Chinese imports, will have the effect described above - this temporary overreaction is the exchange rate is what in the literature is called exchange rate overshooting.

Currency Manipulation?

It is hard to tell for sure if this is a deliberate action by the monetary authorities in letting the yuan slide, since while the Chinese monetary authority has explicitly stated that it is not deliberately weakening the yuan, it does set the rate that then tells us the 2% band within which it is allowed to fluctuate. That rate while below 7, permits a fluctuation above 7 within that band.

In any case, a significant weakening of the yuan against the dollar is an expected outcome that should not surprising. The Chinese economy is heavily dependent on its exports, and as explained as the money market adjusts to the resulting fall in output, the currency is expected to weaken significantly to restore asset market equilibrium.

The outcome we are seeing may simply be China's response to letting it play out in the financial markets, which would serve, without explicit monetary policy to lower the boost their economy, to act like an automatic stabilizer in boosting their exports through a market driven weakening of their currency.

The reason this could get messy is because the current US reaction to this may be both to put pressure on the Fed to weaken the dollar through more expansionary policy and what started as a trade war with its overall growth reducing implication would spread to a currency war, with its own even more dire outcome.

There is a lesson that is lost on politics in all of this... you cannot attempt to manipulate market prices and not get hurt by doing so, as all markets tend to be connected - if you impose tariffs, then be happy to entertain the implications of a resulting stronger dollar.