Why 7 is the ‘line in the sand’ everyone’s watching when it comes China’s yuan
Date: Wednesday, June 19, 2019
Source: Market Watch
The number 7 is getting a lot of attention as the U.S.-China trade war persists.
It’s all about China’s currency and what many investors and economists have dubbed a “line in the sand” or a “magic number” at seven yuan-per-dollar. A weakening of the renminbi that would see the dollar fetch more than that, some observers fear, would mark another negative turn in the trade fight, sparking U.S. accusations of currency manipulation and potentially sparking a broader, global race to the bottom as other countries move to weaken their currencies in response.
“With trade-talk angst and global growth concerns taking center stage, the question of where the yuan goes from here may be the most important macro issue confronting the global markets today,” wrote analysts at Montreal-based Pavilion, in a May 30 note.
Watching the line
For its part, China’s central bank has appeared intent on keeping the yuan away from that line. On Tuesday, the People’s Bank of China set the midpoint of the yuan’s USDCNY, +0.0072% trading range versus the dollar at CNY6.8942, little changed from CNY6.8940 a day earlier. The PBOC publishes a level for the dollar-yuan exchange rate each day, around which the pair can trade in a set range.
In offshore trade, the dollar on Tuesday fetched 6.9021 USDCNH, +0.0261%down 0.4%. The dollar has rallied nearly 7% versus the yuan in the offshore market over the past 12 months.
China’s slowing economy and fears that trade tensions could bring more headwinds are seen putting downward pressure on the yuan. But the temptation to add to the weakness in an attempt to further offset tariffs and threats of further levies might run strong.
But why is 7 so important? There’s no clear-cut answer. The level seems to have taken on important psychological significance by the fact that the dollar hasn’t traded above 7 yuan since the financial crisis.
As a result, the level “seems to be an inflection point” and a violation of it would be seen running the risk of angering the Trump administration and undercutting China’s longstanding efforts to raise the status of its currency, said Carl Mastroianni, portfolio specialist at Insight Investment, a global asset manager with $840 billion in assets under management, in an interview.
For now, China’s central bank seems intent not to test that hypothesis, maintaining fixings below 6.9 yuan to the dollar.
For most of May and so far this month, those currency fixes at the midpoint have tended to set the yuan at a stronger rate than market participants have anticipated. Analysts have viewed that as a signal that Beijing wants to keep a tight rein on the currency and prevent it from sliding too fast, even if economic fundamentals warrant a decline.
’Just another number’
But there’s no guarantee that the PBOC will prove averse to holding the USD/CNY rate below 7 forever.
Analysts at UBS last week argued that the mark at 7 “should be viewed as just another number.”
Chinese policy makers won’t stand in the way if the market pressures are pushing the rate to the 7.0 level, they said, as such a stance would crimp the PBOC’s wiggle room when it comes to monetary policy.
In particular, a further ramp-up of U.S. tariffs on Chinese goods would make Beijing less reluctant to defend the 7 level, they said, though they don’t see China using the exchange rate as a weapon.
That’s because staking out a deliberate policy to weaken the yuan would run the risk of sparking capital outflows and deepening the trade fight in a way that Beijing would likely want to avoid, they said.
The yuan strengthened Tuesday after President Donald Trump tweeted that he plans to hold an “extended meeting” with China President Xi Jinping at the meeting of Group of 20 leaders in Japan later this month. Indeed, for the near term, analysts have argued that Beijing would be reluctant to let the yuan slide far in the run-up to the G-20 gathering, which could prove pivotal in the long-running trade fight.
The Pavilion analysts, meanwhile, argued that while yuan devaluation is “hardly out of the question” as a policy tool, it isn’t a step Beijing can take lightly due to China’s “voracious demand” for imported oil that is still priced in dollars. There’s also the issue of China’s effort to broaden the international appeal of its currency.
“Not only would depreciation increase the price of importing commodities and dent living standards, but also, it would likely set back Chinese policy makers’ aspirations of internationalizing the renminbi,” they said.
The UBS analysts expect the yuan to breach the 7 mark over the next three months, weakened by slowing growth and rising trade tensions. But they don’t expect the exchange rate to remain above 7 for long.
“We expect USDCNY to stabilize and drift lower toward 6.7 - 6.8 over the next 6 - 12 months for three reasons,” they said. “First, a trade deal — our base case is for an agreement to be reached by the end of the year — would put downward pressure on the exchange rate. Second, improving balance-of-payment flows should support the yuan. And third, we expect the USD to weaken broadly in 2H19.”
Running out of options?
Over the longer run, however, Beijing might find itself with no choice but to lean more heavily on the exchange rate as a policy tool unless it finds a way to boost productivity growth, warned economist Diana Choyleva of Enodo Economics, in a Monday note.
“If Beijing fails to boost productivity growth substantially through structural changes to absorb years of excessive investment and the rapid buildup of debt since the global financial crisis, a weaker exchange rate will eventually become the only pressure release valve,” she said. “But currency depreciation will also be a conduit for cost-push inflation in China.”