China Studying Yuan Devaluation As Retaliation To Trade War; CNH Slides

Last week, with the tit-for-tat Chinese trade war escalating following Trump's threat to raise Chinese imports tariffs by another $100BN, we said that it is time to buy some Yuan puts, ahead of a potential Chinese devaluation.

Overnight we got a clear lesson why this highly convex trade would be prudent in the current trade war environment, when Bloomberg reported at 3am EDT that China is "evaluating the potential impact of a gradual yuan depreciation" citing people familiar with the matter said, as the country’s leaders are weighing their possible responses in the escalating trade war with President Trump.

As a reminder, a devaluation was one of the "nuclear" retaliation options listed here on Friday, and is certain to provoke an even harsher response by the US. Still, this appears not to have spooked senior Chinese officials who are reportedly studying a "two-pronged analysis of the yuan that was prepared by the government": one part looks at the effect of using the currency as a tool in trade negotiations with the U.S., while a second part examines what would happen if China depreciates the yuan to offset the impact of any trade deal that curbs exports.

Still, the analysis doesn’t mean officials will carry out a devaluation, which would require approval from top leaders.

In kneejerk response, both the onshore and offshore yuan weakened as much as 0.2% to 6.3186 per dollar in onshore trading and 6.3211 for the offshore pair.

At the same time, the dollar climbed against the yen and other EM currencies in response: "USD seems to be regaining some ground on the back of the headline" said Valentin Marinov, head of G-10 FX research at Credit Agricole. “The story seems to suggest that the Chinese are discussing the idea of FX depreciation rather than work on an imminent change in FX policy."

Ironically, while Trump has bashed China on the campaign trail and more recently on Twitter, for keeping its currency artificially weak, the yuan has gained about 9% against the greenback since he took office and has been steady in recent weeks despite the escalation of trade tensions between the world’s two largest economies, prompted by a weaker dollar. The Chinese currency touched the strongest level since August 2015 last month.

That said, w\hile a weaker yuan could help President Xi Jinping shore up China’s export industries in the event of widespread tariffs in the U.S., a devaluation comes with plenty of risks, according to Bloomberg:

  • It would encourage Trump to follow through on his threat to brand China a currency manipulator,
  • it would make it more difficult for Chinese companies to service their mountain of offshore debt,
  • It would undermine recent efforts by the government to move toward a more market-oriented exchange rate system.
  • It would expose China to the risk of local financial-market volatility, something authorities have worked hard to subdue in recent years. When China unexpectedly devalued the yuan by about 2 percent in August 2015, the move sent shock-waves through global markets.

“Is it in their interest to devalue yuan? It’s probably unwise,” said Kevin Lai, chief economist for Asia ex-Japan at Daiwa Capital Markets Hong Kong Ltd. “Because if they use devaluation as a weapon, it could hurt China more than the U.S. The currency stability has helped to create a macro stability. If that’s gone, it could destabilize markets, and things would look like 2015 again.”

Which is why many are unconvinced China will actually follow through.

China is unlikely to resort to a devaluation unless it exhausts its other trade-negotiation tools, said Frances Cheung, head of Asia macro strategy at Westpac Banking Corp. in Singapore. The more likely scenario is that the two countries will reach a compromise and China will continue to liberalize its capital account, added Zhou Hao, senior Asia emerging markets economist at Commerzbank AG.

“There are many measures they can take before resorting to this tool,” said Ken Peng, an investment strategist at Citi Private Bank in Hong Kong. “Using yuan depreciation is like sacrificing 800 soldiers of your own to kill just 1,000 enemies.”

Perhaps, although as we noted yesterday, one of the measures suggested by China's Global Times is to attack the US stock market. It is not clear if that is necessarily a "better option." It also doesn’t mean market-driven yuan weakness is off the table. The average forecast among analysts tracked by Bloomberg calls for the currency to drop slightly by year-end to 6.38 per dollar.

“There is room for a near-term yuan correction given how much the currency has gained since last year,” said Ken Cheung, a currency strategist at Mizuho Bank Ltd. in Hong Kong. “China would allow market-driven yuan weakness if sentiment fluctuates on trade war concerns. But it’s unlikely for the authorities to engineer another round of significant one-off devaluation.”

Speculation aside, a key event will take place in under 24 hours when traders looking for clues on President Xi’s thinking will get an opportunity to hear him speak personally. On Tuesday he’s scheduled to address the Boao Forum for Asia - China’s answer to Davos - on the tropical island of Hainan.

Meanwhile, courtesy of Bloomberg, here are several research analyst responses to the story that China may devalue its currency:

Citi Private Bank (Ken Peng, investment strategist)

  • China likely won’t devalue the yuan, as further weakness would lead to significant capital outflows, which the government tried to rein in over the past few years
  • Cost of such a measure outweighs benefits; using yuan depreciation is like sacrificing 800 soldiers of your own to kill just 1,000 enemies
  • There are many tools the government can take before resorting to yuan depreciation, such as more tariffs, canceling orders from American companies and even selling U.S. Treasuries
  • The yuan may weaken due to market forces, as it’s rallied too quickly recently and the U.S.-China interest-rate gap has narrowed

Westpac Banking Corp. (Frances Cheung, head of Asia macro strategy)

  • China is unlikely to target a certain level for the yuan in response to the trade conflict when other options aren’t exhausted
  • A stable yuan is in China’s interest, it helps promote foreign interest in yuan assets
  • Response pretty much focuses on trade, though this may be extended to other bilateral flows as China doesn’t import that much from the U.S.
  • Prudent for policymakers to carry out studies such as this from time to time

Daiwa Capital Markets (Kevin Lai, chief economist for Asia ex-Japan)

  • Would be unwise for China to devalue the yuan, as that could hurt China more than the U.S.
  • Currency stability has helped create macro stability; if that’s gone, it could destabilize markets, and things would look like 2015 again

Mizuho Bank (Ken Cheung, strategist)

  • There’s room for near-term yuan correction given how much the currency has gained since last year
  • It’s unlikely China will engineer another significant one-off devaluation -- the cost would be too big as it would spark depreciation concerns and go against China’s target to open its market and globalize the yuan

Commerzbank AG (Zhou Hao, economist)

  • Yuan depreciation is a measure China would have to prepare, and there’s nothing unusual for it to be considered in a trade war
  • If China and the U.S. fail to strike a deal, China would definitely weaken the yuan
  • More likely scenario is for the two countries to compromise and China to liberalize capital account