In A U.S.-China Currency War, Who Wins?

US-ECONOMY-NYSE
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Trade tensions are entering a new phase. The U.S. has accused China of mobilizing its currency, the yuan, to gain the upper hand in trade. The threat of currency wars isn’t novel. In any trade skirmish, currency adjustments are often a natural consequence of tariffs, blunted growth or central bank action to soften the impact.

So when President Trump threatened to levy tariffs on the remaining $300 billion of Chinese imports, economists expected a weakened yuan and a stronger dollar. But when the yuan moved according to expectations, Trump demanded China be branded a currency manipulator and urged the International Monetary Fund (IMF) to get involved. Despite his protestations, the evidence doesn’t meet the IMF’s checklist to suggest that China has been unscrupulous.   

But regardless of the political posturing, this move will result in winners and losers. Any significant currency escalation could elevate market risk and usher in a significant default cycle in China.

Cheap Yuan Benefits American Consumers

As the Chinese currency depreciated and broke through seven yuan to each U.S. dollar, markets got nervous, fearing a rerun of 2015-16. Back then, as the global economy was in the midst of an energy recession, capital flows out of China spiked as investors turned bearish.

But much has changed since the 2015-16 tantrum. China has tightened its capital controls and limited speculation against the yuan. This gives the central bank greater control over the currency, as it fixes the target for its daily exchange rate.

Ironically, while the U.S. fears that China is undervaluing its currency, the hard data suggests it has been propping it up over the last several years. As China looks to rebalance its economy from manufacturing to services, it has focused on improving consumer buying power through wage increases and a bias towards a strong currency.  

Measures such as the Real Effective Exchange Rate (REER), from the Bank of International Settlements, suggest the yuan is 13.4% above its 15-year average while the dollar is up 10.3%. In other words, the yuan seems to have appreciated more than the dollar over this period.

The big winner from the recent depreciation is the American consumer. Chinese imports are now cheaper, blunting the sting of tariffs. U.S. companies that import from China also benefit.

The other winner is the U.S. dollar. The dollar tends to be a counter-cyclical currency. If growth in the rest of the world is accelerating relative to the U.S., the dollar tends to dip. However, if the U.S. economy leads, then the dollar strengthens - just as we see today.

Therefore, while Trump pushes tariffs, global growth will be under siege and geopolitical risk will be elevated. That excites demand for dollars, strengthening it and running counter to the President’s outcry that he wants a weak currency.

China and Real Estate Are Losing Out

The Chinese consumer is unequivocally losing out. A weaker currency drives up import prices and constrains living standards. Commodity imports in particular will pinch. Since they are priced in dollars, increased commodity prices will pressure input costs, weaken corporate margins and slow government spending.

A weaker yuan also poses a risk to Chinese corporate non-financial debt issued in U.S. dollars, which is close to $850 billion and has tripled since 2014. Meanwhile, banks have also issued $670 billion of dollar debt. Together, this debt load is over 11% of GDP.  Defaults are rising and expected to top the record stress levels set in 2018.

Property developers in particular are vulnerable, as many loaded up on cheap international debt over the last several years. The real estate sector alone accounts for half of Asia’s high yield debt and close to 15% of the entire bond market.

Recent data shows a broad-based slowdown in housing. And with a government that’s unlikely to stimulate the real estate sector, this leaves few supports for property companies struggling with a heavy debt burden. Given a depreciating currency, defaults could quickly accelerate.  

Currency Wars Undermine Growth

Regardless of the immediate winners or losers, in the long run, currency wars are zero sum games. U.S. trade escalation with China is the greatest risk to global growth and continued provocations could prematurely deliver a recession. It’s high stakes for both: China wants continued access to U.S. markets and technology. Trump wants to get reelected next year, and evidence of competent economic stewardship is critical to his appeal.

However, if Trump concedes too easily, he will face harsh criticism that he blew an opportunity to force China to liberalize its economy. Some truce or version of a deal will be accelerated if equity markets revolt or a downturn looks evident. Absent that, a trade cold war could continue, where both sides keep communication open but the status quo prevails. In this scenario, China would hope that a leadership change delivers a more conciliatory U.S. president. Trump meanwhile, would hope that growth deteriorates, forcing China to concede on critical demands.

Any waiting game gets dangerous as economic and market confidence can quickly erode, leaving little room for catch-up political action to shift the momentum. The likely path is that a market scare or a pickup in Chinese defaults forces some agreement that in turn dials back geopolitical risk.  

This material contains opinions of the author, but not necessarily those of Sun Life or its subsidiaries and/or affiliates.

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Trade tensions are entering a new phase. The U.S. has accused China of mobilizing its currency, the yuan, to gain the upper hand in trade. The threat of currency wars isn’t novel. In any trade skirmish, currency adjustments are often a natural consequence of tariffs, blunted growth or central bank action to soften the impact.

So when President Trump threatened to levy tariffs on the remaining $300 billion of Chinese imports, economists expected a weakened yuan and a stronger dollar. But when the yuan moved according to expectations, Trump demanded China be branded a currency manipulator and urged the International Monetary Fund (IMF) to get involved. Despite his protestations, the evidence doesn’t meet the IMF’s checklist to suggest that China has been unscrupulous.   

But regardless of the political posturing, this move will result in winners and losers. Any significant currency escalation could elevate market risk and usher in a significant default cycle in China.

Cheap Yuan Benefits American Consumers

As the Chinese currency depreciated and broke through seven yuan to each U.S. dollar, markets got nervous, fearing a rerun of 2015-16. Back then, as the global economy was in the midst of an energy recession, capital flows out of China spiked as investors turned bearish.

But much has changed since the 2015-16 tantrum. China has tightened its capital controls and limited speculation against the yuan. This gives the central bank greater control over the currency, as it fixes the target for its daily exchange rate.

Ironically, while the U.S. fears that China is undervaluing its currency, the hard data suggests it has been propping it up over the last several years. As China looks to rebalance its economy from manufacturing to services, it has focused on improving consumer buying power through wage increases and a bias towards a strong currency.  

Measures such as the Real Effective Exchange Rate (REER), from the Bank of International Settlements, suggest the yuan is 13.4% above its 15-year average while the dollar is up 10.3%. In other words, the yuan seems to have appreciated more than the dollar over this period.

The big winner from the recent depreciation is the American consumer. Chinese imports are now cheaper, blunting the sting of tariffs. U.S. companies that import from China also benefit.

The other winner is the U.S. dollar. The dollar tends to be a counter-cyclical currency. If growth in the rest of the world is accelerating relative to the U.S., the dollar tends to dip. However, if the U.S. economy leads, then the dollar strengthens - just as we see today.

Therefore, while Trump pushes tariffs, global growth will be under siege and geopolitical risk will be elevated. That excites demand for dollars, strengthening it and running counter to the President’s outcry that he wants a weak currency.

China and Real Estate Are Losing Out

The Chinese consumer is unequivocally losing out. A weaker currency drives up import prices and constrains living standards. Commodity imports in particular will pinch. Since they are priced in dollars, increased commodity prices will pressure input costs, weaken corporate margins and slow government spending.

A weaker yuan also poses a risk to Chinese corporate non-financial debt issued in U.S. dollars, which is close to $850 billion and has tripled since 2014. Meanwhile, banks have also issued $670 billion of dollar debt. Together, this debt load is over 11% of GDP.  Defaults are rising and expected to top the record stress levels set in 2018.

Property developers in particular are vulnerable, as many loaded up on cheap international debt over the last several years. The real estate sector alone accounts for half of Asia’s high yield debt and close to 15% of the entire bond market.

Recent data shows a broad-based slowdown in housing. And with a government that’s unlikely to stimulate the real estate sector, this leaves few supports for property companies struggling with a heavy debt burden. Given a depreciating currency, defaults could quickly accelerate.  

Currency Wars Undermine Growth

Regardless of the immediate winners or losers, in the long run, currency wars are zero sum games. U.S. trade escalation with China is the greatest risk to global growth and continued provocations could prematurely deliver a recession. It’s high stakes for both: China wants continued access to U.S. markets and technology. Trump wants to get reelected next year, and evidence of competent economic stewardship is critical to his appeal.

However, if Trump concedes too easily, he will face harsh criticism that he blew an opportunity to force China to liberalize its economy. Some truce or version of a deal will be accelerated if equity markets revolt or a downturn looks evident. Absent that, a trade cold war could continue, where both sides keep communication open but the status quo prevails. In this scenario, China would hope that a leadership change delivers a more conciliatory U.S. president. Trump meanwhile, would hope that growth deteriorates, forcing China to concede on critical demands.

Any waiting game gets dangerous as economic and market confidence can quickly erode, leaving little room for catch-up political action to shift the momentum. The likely path is that a market scare or a pickup in Chinese defaults forces some agreement that in turn dials back geopolitical risk.  

This material contains opinions of the author, but not necessarily those of Sun Life or its subsidiaries and/or affiliates.

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I am an insurance asset management industry veteran with over 30 years’ experience at global financial firms. As CIO of Sun Life Financial, I lead a 240+ global investme...