March 07, 2019

Where Will the CNY Go?

The market is waiting for the U.S.-China trade talks to come close to an end — one that has been going on for close to a year. The two largest nations in the world are trying to agree on freer and fairer trade practices. While the majority of the focus is on tariffs and tax laws, the U.S. dollar/yuan (CNY) exchange rate value also matters, as Treasury Secretary Mnuchin has even said that the yuan is the most important aspect of the talks with China.

The question is, after the trade talks come to a conclusion, will there be any changes to the CNY outlook?

The standard answer is, probably not, as China continues to hold on to its quasi-fixed peg system. China’s nightmare is to agree to a ‘Plaza Accord’-like deal, similar to the one that Japan agreed to in 1985. The Japanese yen was revalued by 200 percent within two years of that agreement, ending with Japan in a boom-and-bust cycle that meant many lost decades.

China, in this situation, would prefer a weaker CNY, citing its slowing economy and huge debt pile.

Since the People's Bank of China has already led the CNY stronger this year, to avoid criticisms of currency manipulation during trade talks, there may even be a relief devaluation of the yuan after the talks conclude.

Incidentally, the U.S. dollar/yuan non-deliverable forward markets, which reflect the onshore market in China, may be reflecting this already, as they are showing a weaker CNY in the forward rates.

The more appropriate answer for the CNY outlook is that it should reflect true economic fundamentals. The trade balance would result in a stronger CNY, as we just reported another widening of the trade gap between the U.S. and China. Capital flows are also supporting the yuan because of China's ongoing capital controls, restricting money to go out from China.

Purchasing Power Parity (PPP), a way to compare the currencies of various countries, reflects that the CNY is still about 20 to 30 percent weaker on consumer prices. So the longer-term target seems to be for a stronger CNY. Meanwhile, the USD/CNH offshore market - traded outside of China - is showing yuan forwards as being slightly stronger than the current spot, at least in the shorter-end of the forward market.

My View: Beyond the uncertainty of the trade talks, this dichotomous view of the CNY, together with the fact that the yuan cannot immediately correct to its fair value, could explain why the recent foreign exchange market has not been very responsive to economic fundamentals, such as interest rates, commodity prices or economic numbers. President Trump has recently said that the U.S. and China have reached a deal on currency manipulation.

For an economy that is the world's second largest and has an influentially large trade surplus, it seems like it is a matter of time before the CNY value will be determined by global investors correcting any unfair values, rather than China unilaterally having the ability to fix its own exchange rate.

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