Preparing for the worst

Plotting the Great Fall of China?

Xi Jinping, the Chinese leader, is threatening to “punch back” if Donald Trump’s administration persists in putting tariffs on his country’s goods.

But the people taking the greatest pummelling this week were investors in China’s currency, which has been lurching lower against the dollar as trade war looms with the US.

Talk of tariffs has been ratcheting up the pressure on the yuan, which has dropped against the dollar and experienced its longest losing streak in four years. Critics of China’s currency policies are also predicting that the authorities could choose to drive it down further in a bid to make the country’s exports cheaper once US tariffs are enforced.

Perhaps that’s what was being signalled when the People’s Bank of China (PBoC) guided the yuan to six-month lows against the dollar, dropping the reference rate progressively lower as the week progressed (the central bank sets a daily price around which the currency can move by up to 2%). By Thursday the renminbi had fallen for 11 consecutive days and was down 4% against the dollar in that period.

In fact it is only in the last few weeks that the yuan has depreciated and its year-to-date performance has been relatively strong compared to other G20 currencies. Earlier this year Yi Gang, the central bank governor, also said that he wouldn’t deliberately weaken the yuan in the event of a trade conflict and Beijing must know that a too-obvious devaluation will only embolden its opponents overseas.

Paul Mackel, head of global emerging markets forex research at HSBC, says that the Chinese are already moving towards a “clean floating” regime in which the exchange rate is more market-determined and intervention is kept to a minimum. Accelerating that process would probably prompt a sharper fall against the dollar in the short term, perhaps. Beijing could also make a case that a weaker currency is inevitable if the row results in the smaller trade deficits that Donald Trump is demanding.

In the meantime the yuan is running into headwinds because investors see more prospect of monetary easing from the Chinese authorities, including an announcement from the PBoC last Sunday that it is cutting the capital big lenders need to hold as a backstop.

The changes in reserve requirements will release about Rmb700 billion ($108 billion) of liquidity and some commentators have been linking the move to the row over tariffs because the reductions are planned to come into effect just one day before trade duties are applied.

The broader context is that China’s economy was already showing signs of slowing, in part because of the government’s efforts to reduce excessive debt. The authorities are trying to deleverage the corporate sector and one of the outcomes is that the shadow banking activities have been shrinking (hurting the smaller firms that rely on it more for funding). About Rmb200 billion of the reserve cut is supposed to be redirected in loans to small enterprises.

Another priority for policymakers is debt-for-equity swaps at larger companies. Less debt has been swapped than the authorities had hoped, however, with the banks asking for more support to put the programme into fuller effect. The remaining Rmb500 billion freed up by the reserve reductions is supposed to give them room to act.

Bigger picture, the fear for bearish investors is that the confrontation over tariffs could coalesce with the deleveraging campaign to trigger some kind of domestic credit crunch, despite the efforts to cushion the companies more exposed to the deteriorating mood. A leaked report by the National Institute for Finance and Development, a government-backed think tank, has warned of a potential “financial panic” in China, according to Bloomberg. In particular, it raised concerns over the recent stock market sell-off.

Of course, the monetary easing from the PBoC is also a stark contrast to the rate hikes at the Federal Reserve, which is piling more pressure on the yuan in the currency markets.

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