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What a Difference a Week (or a Weekend) Makes

May 14, 2019

Editor’s note. Brad Setser discusses his take on the exchange rate implications of the US-China trade skirmish.

Whither the yuan.

[Brad W. Setser | May 10, 2019 | Council on Foreign Relations]

Until this past week, it looked like the United States and China were heading toward a deal. Not a great deal, but a deal. China would roll back its tariffs on U.S. agricultural goods and oil (and, as importantly drop the guidance to state import giants to avoid U.S. goods); the U.S. would rollback (sooner or later) the 10 percent tariffs on $200 billion. There would be modest progress on a host of long-standing irritants. But no fundamental changes to China’s state capitalist model, and no real change in the system of subsidies and local preferences that China is using to try to displace imports of aircraft, semiconductors, and medical equipment.

Trump was tweeting about how a great deal was likely.

China was importing a few more U.S. soybeans as an "early harvest" on an expected deal (that helped close the spread between U.S. beans and Brazilian beans).

Preparations were supposedly starting for a signing summit.

It seemed that USTR was quietly letting a host of industries know that, well, they wouldn’t get everything they were asking for in the negotiations.

And China’s currency was stable. A bit too stable arguably against the dollar—it was drifting up a bit against the basket (if you squint).

China, it seemed, was delivering on at least one of the commitments it made in Buenos Aires.

Maybe China really miscalculated and pulled back its offer during the negotiations in Beijing last week and thus provoked Trump’s tweet storm. Or perhaps Trump, influenced by concerns that the deal that seemed on offer wasn’t going to be viewed as a “great” deal, changed his mind and decided to go forward with additional tariffs even if it means a sell-off in the U.S. stock market. At some point Trump will have to decide whether he wants to run for re-election as the "tariff" man who disrupted world trade, or as the defender of a reformed status quo (after a great deal, that inevitably would involve a lot of messy compromises that don't change many Chinese trade practices). As David Fickling notes, if Trump is fixated on the bilateral deficit, it isn't entirely obvious that Trump really wants a deal.

The implementation of the full threatened set of new tariffs (in a month?), incidentally, would also result in a modest fiscal consolidation—putting 25 percent tariffs on close to $550 billion in imports would, if importers cannot substitute away from Chinese goods in the short-run, put something like $140 billion into the U.S. Treasury (as Trump likes to note).* Realistically, it might be more like $100 billion in new tariff revenue, given opportunities to substitute away from Chinese goods in some sectors—but that’s still a half point of GDP fiscal consolidation, all else equal.

That's big enough to notice but, as Dr. Krugman notes, not big enough to generate a recession on its own. Especially as some of the impact of Trump's tax cuts and his decision to go along with higher levels of spending will likely be felt this year (so there is a bit of an offset).

It is also a much smaller drag than the drag from the dollar’s 2014-15 appreciation, which knocked at least a percentage point off economic growth (and probably more).**

And if Trump goes ahead with all the threatened tariffs, it raises a basic question: Will China continue to want to keep its currency stable, or would it want to try to offset the (substantial) trade impact of “full” U.S. tariffs with a weaker yuan?

UBS estimates that 25 percent tariffs on all of China’s exports to the United States, plus Chinese retaliation against U.S. imports, might knock 1.5 percentage points off China’s GDP growth (exports to the United States are a bit over 4 percent of China’s GDP, or, on a value added basis, somewhere around 3 percent of China’s GDP).

China has other ways of retaliating. Cutting off the limited purchases of soybeans is a given (now that South America’s harvest is hitting the market, that’s what China would normally do this time of year). China could raise its tariffs to a uniform 25 percent and extend them across all U.S. trade. It could squeeze GM China. Or give a lot of orders to Airbus even if Airbus doesn’t locate an A330 line in China.

But letting the yuan weaken has always been, in my view, the logical “asymmetric” Chinese response to a trade war.

The market would certainly test China’s resolve—so if China didn’t want the yuan to weaken, it would need to take action—intervene, manage the fix, tighten controls—to signal that China wanted stability in its currency amid tariff instability.

And if China let the yuan depreciate, China would also—at some point—need to decide when to step in to set a new floor under the yuan (e.g. signal this far but no further).

That’s all China’s choice. In my view, China has the firepower it needs to continue to manage its currency (concerns about China’s foreign currency debts are overstated in aggregate, though there are a few indebted real estate companies—and China has no shortage of dollars either at the central bank or in the banking system*).

Indeed, I thought much of the criticism of China’s reported commitment to currency stability in the (now aborted?) trade deal was overdone. “Stability” more or less is China’s current policy.

The reported commitment did imply that China wouldn’t cut interest rates below those in the United States in the near term—but with the Fed now on hold, that’s not a huge burden. And, well, I didn’t mind the resulting pressure on China to use fiscal policy rather than monetary policy to stimulate its economy.

China’s manufacturing surplus has stayed around $1 trillion even as its current account surplus has come down, and I for one don’t think an even larger Chinese manufacturing surplus would improve the global economy. It would also fan populist pressure from the “left behind” manufacturing regions of the United States and Europe.

But behind this view is a broader view—as long as China’s currency stayed stable, its balance of payments, in my view, also would remain stable.

China’s reserves, it is true, haven’t been growing that fast recently—

But looking only at reserves misses the real action in China’s balance of payments these days.

China’s bank lending abroad has soared over the last 9 years (call it Belt and Road lending if you want, but the increase in the pace of lending predated the launch of the Belt and Road—initially it went to support Chinese firms going out and especially Chinese energy investments abroad). Every indicator I have found suggests the state banks now have a substantial (and growing) net foreign asset position. The BIS data (which shows global banks exposure to China) isn't that different from China's own data.

That outflow has been supported by increased bank borrowing from the world—and by $150-200 billion (call it around 1.5 percent of GDP) in portfolio inflows into China’s bond and equity market.

China’s trade surplus, while reduced, is still sufficient to cover China’s tourism imports and the “error” term in the balance of payments. Everything, more or less, balanced. In a good quarter, China might add a percentage point to its net external assets. In a bad quarter, China might have to dip modestly into its reserves.

But there hasn’t been sustained pressure in either direction.

That shows up clearly in the data that I (and much of the market) use to track China’s intervention. There have been months when China's state banks have sold foreign currency, but also months when China's state banks have bought.

Why does this recent history matter?

Well, because it lends itself to two different interpretations of what China can and should do in response to the increase in U.S. tariffs.

One view, more or less, is that China has no need to upset the apple cart. The yuan’s recent stability hasn’t required heavy intervention (at least so long as the financial account remains controlled) or forced China to raise interest rates, and China has shown that it can stabilize its domestic economy by relaxing lending curbs and a more expansionary fiscal policy. Letting the yuan move too quickly could upset the restoration of domestic confidence in China’s economic management, and, well, force China to dip into its reserves to keep any move limited…

I suspect that China has more than enough firepower to maintain the yuan in its current band if it wants to even with U.S. tariff escalation. The tariffs—plus the Iranian and Venezuelan oil sanctions—might be enough to push China’s current account into an external deficit (China is the world’s largest oil importer, so the price of oil matters for the overall balance as much as U.S. tariffs). But if China signaled that the yuan would remain stable, portfolio inflows would likely continue—and a modest deficit need not put any real strain on China’s reserves (especially if Xi insists on a bit more discipline in Belt and Road lending to avoid new debt traps).

The other view is that China has shown that it is firmly in control of its exchange rate and balance of payments, and thus it is in a position to let its currency weaken without putting its own financial stability at risk. Controlled depreciations are hard—the market (even a controlled market like the market for the yuan) obviously has an incentive to front run any predictable move (as China learned in 15 and 16). But I suspect China could pull that off —it would just need to signal at some point that once the yuan had reset down, China would resist further depreciation. The goal, in effect, would be to reset the yuan’s trading range around a new post U.S. tariff band, not to move directly to a true free float.

That would let Chinese firms (who have already started to complain) cut their dollar prices (offsetting some of the impact of the tariff) without reducing their yuan revenues, and help China make up for lost exports to the United States with additional exports to the rest of the world…

Basically, it is China’s choice… it won't be forced into an option it doesn't like.

But it is a choice that obviously matters enormously for the entire world. Other Asian economies, setting Japan aside, would likely let their currencies depreciate along with the yuan to avoid losing out to China in global markets. Other manufacturing exporting and oil importing emerging economies (like Turkey) might face a bit of unwelcome pressure on their currencies as well. Not all currencies though would depreciate along side the yuan. And a weaker yuan against the euro and the yen would hurt European and Japanese exports (China exports a lot of capital goods these days, it isn't just a producer of consumer goods). A weaker yuan, in effect, redistributes some of China's trade pain globally, and thus poses a challenge to those parts of the world that have relied on exports rather than domestic demand to power their own economies.

Oh, and Trump would also have to decide if he would raise the tariff rate above 25 percent in response to China’s depreciation (or move quickly to extend the tariffs to all trade with China), as he has threatened in the past.***

That's why my best guess is that China limits any near-term move as it tries to see if there is still time (and will) to cut a deal that avoids further escalation.

* This is the estimated effect of going from zero to 25. Some of that effect has already happened, as Trump had already introduced a 25 percent tariff on $50 billion of Chinese imports and a 10 percent tariff on another $200 billion in imports.

** The gap between the extensive coverage that trade policy shifts receive relative to the limited coverage typically provided to the impact of exchange rate moves is a pet peeve of mine.

*** The game theory here is probably interesting. Too big a move now risks provoking Trump into the kind of broad tariffs that China likely wants to avoid. I suspect the optimal time for a major depreciation would be once Trump has extended the tariffs fully.

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