The Dollar Reigns, China Suffers

| About: iShares China (FXI)

Summary

The bullish dollar trend pushes Chinese foreign exchange policy in a deadlock.

As the USD strengthens against most of its peers, the yuan, which is still pegged to the greenback, loses competitiveness in global trade-weighted terms.

China cannot let the yuan devalue enough, resulting in a underperformance of its exports versus its main Asian competitors.

The Chinese hope for a weaker US dollar! Sounds odd, right? Yet, this statement could not be closer to the truth, especially if one considers the negative side-effects of the strong dollar on China's trade with the non-US world. A generalized surge of the greenback against all major currencies impairs the international competitiveness of the yuan (NYSEARCA:CYB) against its ex-US trading peers. As long as the yuan remains pegged to the dollar, any appreciation of the latter pushes the former's trade weighted value higher as well, weighing on China's total exports. Only an aggressive devaluation of the yuan against the dollar could negate the negative trade effect on China, an unrealistic option for the PBOC, given how vigilant global investors are in regards to yuan jitters. Apart from this negative trade effect, a USD funding shortage in China could multiply the negative side-effects of the almighty greenback, creating a toxic macro mix. In this light, the closer the inauguration day of the new US administration becomes the greater the nervousness of the Chinese. Even in the absence of trade protectionist initiatives, Trump's proposed pro-growth policy mix will reinforce the greenback's rally against its global peers pushing the yuan trade weighted price to higher levels, inflicting pressure on Chinese exporters (NYSEARCA:FXI). Counter to popular wisdom Chinese have many reasons to be wary of the strong dollar; their recent experience has certainly taught them to be so.

A Strong Dollar Ties China's Hands

A year ago, the PBOC introduced its CFETS RMB Index, a trade-weighted basket against 13 important currencies, attempting to signal a shift in its foreign exchange policy from a strict dollar peg towards a more global approach. However, currency developments in 2016 showed that the path to internationalization of the yuan is insurmountable. China's hands are tied against a globally strong USD, since it doesn't want to let the bilateral USDCNY exchange rate to slip too much in order to restore yuan competitiveness in a trade weighted level. In simple terms, when the USD strengthens globally, the yuan has no other choice but to suffer. The only alternative choice is to aggressively devalue the yuan against the greenback prompting a Chinese currency crisis.

Yuan TWI

Source: BIS

How serious is this Chinese FX deadlock? The experience of the last twelve months is revealing. In the first half of 2016 the yuan depreciated steadily against the greenback, weakening against its major trading peers along the way. In the second half of 2016, the yuan remained unchanged against its ex-USD global peers and in some cases appreciated a bit, despite the fact that it kept depreciating steadily against the greenback. The divergent yuan behavior between the first and the second half of 2016 rests exclusively on the behavior of the US dollar.

CFETS RMB Index

Source: CFETS

In particular, from the inception date of the new yuan index, on December 11 2015, until the end of the first half of 2016 the USDCNY climbed by 5%. In the same period, the CFETS RMB Index dropped by 6.5% and the yuan broad trade weighted index, a trade-weighted average against 61 currencies, fell by more than 6%. The generalized devaluation of the yuan against all of its major trading partners, and not only vis a vis the greenback, was allowed to happen because the dollar remained trendless in trade weighted terms. This can be confirmed by looking at the behavior of the US dollar index as well as the dollar broad nominal effective exchange rate. The former slipped by approximately 2% and the latter was virtually unchanged. This shows that the new foreign exchange policy of PBOC was allowed to bear fruits in the first half of 2016 solely due to a globally neutral greenback.

However, in the second half of 2016, a shift in bond market trends and the dollar proved that the Chinese king is naked. The yuan in trade weighted terms, either narrow or broad, stopped depreciating simply because the PBOC didn't have any other choice.

The CFETS RMB Index revalued by 0.1% between the beginning of H2 2016 and 16th of December 2016, the latest date for which there are published data by the CFETS. Similarly, the yuan broad trade weighted index lost about 0.3%, until November 2016, the last month for which there are published data from the Bank of International Settlements. Taking into account the appreciation of the yuan against most of its peers in the last three weeks of December, we could safely assume that the reported drop in its trade weighted index has turned into to a gain. Yet, the yuan lost a further 4% against the dollar in the exact same period.

This shows that a weaker bilateral exchange rate between the yuan and the dollar did not translate into a weaker yuan in global terms, as happened in the first half of 2016. Why? Because the dollar outperformed all its peers globally, leaving no choice to the Chinese but to refrain from a generalized weak yuan policy. The US Dollar index appreciated by almost 8% and the USD broad trade weighted index rose by 3%.

The recent pause in the trade-weighted depreciation trend of the yuan stars to bite, since Chinese exports are trending down in comparison to the improving dynamics of its biggest Asian competitors. In the last 12 months Honk Kong, South Korea, Taiwan, Singapore, Thailand, and Malaysia exhibited strong export growth outperforming China. The ex-USD stabilization of the yuan in the second half of 2016 hit exports, an undesirable outcome for the PBOC. Rather, PBOC was forced to keep the yuan from devaluing against its non-USD peers, in order to distract potential speculators from attacking to the yuan. Such an aggressive devaluation would definitely be needed to put a floor under China's weakening export trends, but policy desires could not meet with harsh reality.

China Exp

Taiwan exp

Source: ieconomics.com

The Chinese are doing whatever it takes to divert investors' attention away from the bilateral rate between the dollar and the yuan. Still, market players perceive the behavior of this exchange rate as the most indicative of the Chinese FX dynamics and for good reason; China is not in a position yet to dictate its own exchange rate policy versus the rest of the ex-dollar world. The dollar reigns? China suffers. It's that simple.

Chinese certainly hope for a weaker dollar further down the line. However, successful exchange rate policies do not rest in wishful thinking but in solid action; and the Chinese have demonstrated wishful thinking so far. Will they attempt to test the markets? Nobody can say for sure. However, they are fully aware that the stronger the dollar becomes, the more they will suffer. Life is not easy even for the super powers.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The views expressed in this article are solely those of the author, provided for informative purposes only and in no case constitute investment advice.

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