International trade has become one of the most prominent topics of the US presidential election. Republican nominee Donald Trump has drummed up a base of populist support by scapegoating China as a currency manipulator that uses world trade deals to directly extract jobs out of the US. A low yuan (NYSEARCA:CYB), in turn, cheapens China's goods, drives demand for its exports, and enhances the country's domestic manufacturing sector.
On Friday, the US Treasury has found that China now fulfills just one of three criteria for inclusion on a currency watch list. The country's current account surplus is now less than 3% of GDP, which serves as one of three benchmark thresholds, in addition to any red flags associated with the country's trade balance and persistent intervention in the markets. The US trade deficit with China stands at $354.6 billion from the year-ended in August 2016, a drop from $367.1 billion for 2015. The trade deficit now represents the only criteria by which China is still placed on the watch list.
However, on the topic of currency manipulation, China's incursions into the currency markets have actually occurred to help prevent the yuan from a large-scale depreciation, to the benefit of other large economies. Year-to-date, China has sold $570 billion of foreign exchange assets to buoy the currency. The currency also received support in November 2015 by the IMF's decision to establish the yuan as a reserve currency, eventually commenced last week.
China is also in the process of attempting to convert the yuan from a largely internally managed float to one that floats conventionally. The IMF's addition placed the yuan as part of the funds basket of world currencies, known as the Special Drawing Rights ("SDR"), and currently consists of the US dollar (NYSEARCA:UUP)(NYSEARCA:UDN) (41.73% of the basket), euro (NYSEARCA:FXE) (30.93%), yen (NYSEARCA:FXY) (8.33%), and British pound (NYSEARCA:FXB) (8.09%). The yuan now makes up the remaining 10.92%. The SDR's creation in 1969 allowed any IMF member country to meet balance of payments needs through the ability to convert the SDR into any currency mentioned. The yuan's placement in the SDR lends credibility to China's ongoing conversion to a market-based economy and encourages migration of foreign reserves to yuan-denominated assets and securities -- to the tune of over $1 trillion.
China's currency has traditionally been managed in close relation to the behavior of the dollar, and expectations of increased tightening in Fed monetary policy from late-2013 onward (e.g., end of QE, eventual rate hikes) has appreciated the dollar to the detriment of the yuan. While the yuan has depreciated against the dollar in recent weeks, it has actually appreciated against most others. But with the IMF's badge of honor, Chinese policymakers will now be more open to letting the yuan run more freely with respect to economic events.
Even though the yuan fell to six-year lows on its first day of trading as a reserve currency, the market's reaction was muted relative to the August 2015 devaluation.
Global macroeconomic events such as Brexit have also toned down the level of scrutiny and criticism that the People's Bank of China may have seen in the past for their management of the currency. With China's drop from the watch list, the US now perceives that none of its trading partners is attempting to gain an unfair trading advantage or manipulate its balance of payments.
While Trump is correct that the yuan has been depreciating versus the US dollar, his notion of how and why the currency is depreciating is not quite the case. China's exports are decreasing as a whole due to the slowdown in the Chinese economy. As of the end of 2015, China's debt at the government, corporate, and household level stood at 234% of annual GDP, much of which was accumulated in a fiscal stimulus to aid its economy in 2008-09 (source: PBoC deputy governor Yi Gung speech 9/2/16). Nonetheless, China's debt capital deployed in the economy will keep increasing in the short-term. Whether China will need to engage in devaluation measures (i.e., money printing) to service this debt in the future is unknown.
Moreover, the slowdown in China's exports comes at a time of a concomitant decline in US inventory turnover. The US inventories-to-sales ratio has been steadily climbing since mid-2014, suggesting that retailers are overestimating business activity, though has regressed somewhat from its 1.41 figure from earlier in the year.
(Source: US Bureau of the Census; modeled by fred.stlouisfed.org)
In a highly intertwined global economy through trade, inventory de-stocking in one major global economy is likely to bring about lower exporting activity in another.
Over the past couple years, the strength of the dollar versus the yuan has been predominantly a function of China's growing economic problems versus the safe haven of the US currency. This outlook seems unlikely to change. The near-term prospects for the dollar are sideways to slightly bullish against practically all major currencies. US rates are likely to rise by 25 bps in December, which will incentivize foreign inflows. The UK's decision to leave the European Union is also causing more capital to abandon the pound in favor of the dollar.
Emerging markets currencies (NYSEARCA:CEW) have largely appreciated this year on the back of commodity price increases led by oil's bounce from its sub-$30 price. However, many emerging markets are currently swamped in debt -- most of it denominated in US dollars -- due to the allure of an extended period of ultra-low rates. As the dollar strengthens against a host of other currencies from safe haven inflows, servicing this debt becomes more difficult. If the US -- still largely the bellwether of the world economy -- weakens, emerging markets are likely to suffer under the burden of that debt load.
It is not just the unsteadiness of the Chinese economy driving funds into the US dollar. Nor is it Trump's assertion that China is engaging in currency manipulation or exploiting lopsided trade deals to pull goods and working-class jobs out of the US. Much of the current depreciation of the yuan versus the dollar has to do with factors surrounding the dollar itself.
With the economic uncertainty surrounding China, the dollar represents more of a safe haven than practically all other major currencies at the moment. Of the other major currencies, it is hard to be bullish on the yen given Japan is facing massive debt levels and has no growth in a deflationary environment; the pound is getting hit severely from its ongoing divorce from the EU; the Euro is likely sideways to down versus the USD going forward due to the EU's own issues regarding weak growth and inflation.
The Canadian economy has many of the same characteristics as the US -- e.g., similar overnight rates, growth and inflation figures, debt-to-GDP ratios, current account-to-GDP. The Canadian dollar (NYSEARCA:FXC) is known as a "commodity currency" and was buoyed by an oil rebound in the first half of 2016 before the USD regained its losses on the back of an expected Fed rate hike later in the year. The Swiss Franc (NYSEARCA:FXF) versus the USD is virtually a neutral relationship. The Swiss National Bank is currently running overnight rates at just -0.75%, which will attract little capital inflow. And even though year-over-year GDP growth stands at 2.00% and a jobless rate of a mere 3.2%, Switzerland is fighting the ogre of deflation. Despite that, other Swiss metrics look good, as its debt-to-GDP ratio is a mere 34% and current account is the third-highest in the world behind Singapore and Taiwan.
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Additional disclosure: I am long USD/JPY.