China isn't weaponising its currency (yet)

China’s currency took a dive against the dollar late last week, just hours after US President Donald Trump called out the renminbi for “dropping like a rock.”

While large state banks stepped in to stem the slump, it has declined more than 7 per cent against the dollar in the past three months, and in doing so has become Asia’s worst-performing currency.

Given the pace of weakening and the US's stated desire to slap tariffs on all $505.5bn of its annual Chinese imports, many contend that Beijing is weaponising the renminbi as it runs out of US goods to tax.

A weaker currency, the argument goes, makes China’s exports cheaper than global manufacturers' and its imports pricier. This not only gives Chinese tariffs on US products more bite, but it could also blunt the impact of those piled on by the Trump administration. A 10-per-cent depreciation in the real effective exchange rate raises net exports by an average 1.5 per cent of GDP, according to the IMF.

But at the moment, China does not appear to be doing this.

The recent depreciation, says Marc Chandler of Brown Brothers Harriman, is more about the dollar than the renminbi. The greenback has strengthened against emerging markets and most major currencies like the euro, British pound, Japanese yen and both Aussie and Canadian dollars. Federal Reserve Chairman Jerome Powell's upbeat assessment of the US economy and his nod to continued (if gradual) rate hikes this year and next has supercharged this dynamic.

And because the renminbi has strengthened relative to virtually every other emerging markets currency since January, a correction was due, points out Robin Brooks of the Institute of International Finance.

Other market forces played a part, adds Chandler.

“China's economy has weakened, debt worries are growing, and they have eased monetary policy while forcing some deleveraging. Add to that tightening from the Fed, and for any country, the currency is probably going to fall."

The only issue with that argument is that China manages the value of its currency, of course. Officials have had the ability to intervene at any point during the renminbi’s recent drop, which means they essentially chose to let it touch 12-month lows. But Calvin Tse of Citigroup writes that he does not expect Beijing to adopt a policy of using the renminbi to offset trade tensions.

“Authorities have deep scars from the 2015/2016 experience, where a rapid pace of currency depreciation drove excessive capital outflows, which net resulted in a large tightening of financial conditions.”

Weaponising the renminbi through a managed depreciation could resume this flight. Brooks believes it could lead to a repeat of the panic in 2015 and 2016. Worse, it could foil Beijing's plans to put its financial system on firmer footing.

2015 redux?

But if China chooses to escalate a trade war using its currency, it has the ammunition to do so, says Brad Setser of the Council on Foreign Relations. Using China’s balance-of-payments data from the first quarter of 2018 (the most recent available), Setser finds that the Middle Kingdom added about $100bn to its foreign assets, the fastest growth of official assets since 2014.

Reserves increased by about $25bn, while state banks extended their overseas lending some $55bn. Chinese financial institutions snapped up about $30bn of foreign bonds and equity, too.

Portfolio inflows also surged, topping $150bn—two-thirds of which came from foreign investors purchasing Chinese bonds. What flows in can also flow out, so the volume of capital flight could be higher if things take a turn for the worse this time around. That being said, China can also impose capital controls whenever it sees fit.

Just because China can initiate a currency war does not mean that it will. And it almost certainly will not make such a move lightly, given the very real risk that depreciation could run away from authorities and lead to a broader loss of confidence in domestic assets.

Still, some concern may be warranted if the currency makes further declines against the dollar, says Setser, because “it's quite possible that the tariffs have changed China’s calculus.”

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