The Implications of Trump's Decision Not to Label China a 'Currency Manipulator'
Zhou Ailin
/SOURCE : Yicai
The Implications of Trump's Decision Not to Label China a 'Currency Manipulator'

(Yicai Global) April 14 -- Days after Chinese President Xi's US visit, President Trump told The Wall Street Journal China was not a "currency manipulator," thus assuaging market angst over a trade war between the world's two largest economies.

Less downside pressure on yuan

The yuan has remained stable this year despite the recent strong rally of the dollar index.

"Expectations of long-term devaluation of the yuan remained remarkably low last month, with the implicit depreciation margins deducted from one-year and two-year offshore forward contracts standing respectively at approximately 3 percent and 5.5 percent," Wu Houwei, monetary and financial expert and assistant professor at the Institute for Advanced Research of SUFE, told Yicai Global.

Low expectations reflect structural changes in domestic foreign exchange transactions, a market insider noted. "The deficit in (spot and forward) foreign exchange settlement and sales processed by banks for their customers plunged 90 percent to just USD1.9 billion in February. Judging by the USD4 billion increase in China's foreign reserves last month and daily fluctuations in the sport market since February, the deficit in foreign exchange settlement and sales will remain at an extreme level, or a balance between settlement and sales may have already been achieved," said Han Huishi a foreign exchange (forex) expert.

Supply and demand has a direct impact on the yuan's exchange rates. A rally of the dollar places pressure on the yuan through the currency baskets, but given the balanced forex settlement and sales in China, the 'closing prices' pricing principle means that not all the currencies included in the basket can form downside pressure on the yuan, making one-way devaluation of the yuan much more difficult.   

That said, the yuan is still threatened by rate hikes by the Federal Reserve and unwinding of its balance sheet.

"Unwinding the Fed's balance sheet means that the US will remove currency from circulation by selling Treasury bonds and mortgage-backed securities (MBS), and the monetary base will shrink, thus resulting in a sharp fall in broad money (M2) supply. It may lead to a rise in capital outflow for China," commented Xia Chun, research director at Noah Holdings (Hong Kong) Ltd.

However, most market players believe that the US will not shed Treasury bonds or MBS until next year. Some scholars even argue that the Federal Reserve (Fed) lacked the motivation to unwind its balance sheet. "The household sector deleveraged after the financial crisis, but the US government's deficit kept growing, and at the end of the day they need to find buyers for the new debts," said Zhou Hao, chief Chinese economist at Commerzbank AG, adding that "Purchasing more debts by the Fed can boost market confidence, so it doesn't need to unwind its balance sheet."

Stable rates conduce forex reform

Establishing a free float or clean float system for the yuan remains a main objective for China. Stable exchange rates create a favorable environment for the Chinese government to push forex and other financial reforms.

"Capital outflow is expected to decrease to USD40 to USD58 billion (CNY300 to CNY400 billion) this year, thanks to stabilizing exchange rates and tightening control on capital movements. Unless some unexpected policies are introduced in the US, China's forex reserves will remain above USD2.9 trillion at year's end," predicted Ding Shuang, head of economic research at Standard Chartered Bank Greater China.

"China must adapt itself to free float exchange rates for its currency. It will send out a price signal about the Chinese economy. If economic growth slows and the yuan weakens, the foreign trade sector will benefit. Naturally, free-floating exchange rates may lead to temporary overshooting, but it'll eventually wear off if the market is stable and has sufficient liquidity," advised Lorenzo Bini Smaghi, chairman of Societe Generale.

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Keywords: TRUMP , Forex , Currency , Trade