what china-us trade tensions mean for chinese economy and ... · the rmb exchange rate and other...
TRANSCRIPT
What China-US trade tensions mean for Chinese economy and business?
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PwC
Contents
Executive Summary 3
What sparked the trade friction between China and the US? 6
How will China-US trade tensions affect the Chinese economy?
7
What is the scope of impact from China-US trade tensions? 9
Bilateral trade 12
Two-way direct investment and M&A 15
Which industries and enterprises are likely to be affected by China-US trade tensions?
17
Machinery 19
Automobiles 20
Electronics 20
Agriculture 21
Aviation 21
Conclusion: How should Chinese enterprises respond? 22
Appendix: The outlook of RMB exchange rate in the second half of 2018
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Executive Summary: The Sino-US trade relations have recently seen signs of escalated tension, as the US moved to impose 25% tariffs on US $34 billion worth of imports from China on 6th of July. China has retaliated by taking measures of similar magnitude on US imports. Shortly after on 11th of July, the US government announced its plan to impose 10% tariffs on an additional US $200 billion of Chinese products, while opening a window of around two months for public consultation. On 20th of July, in an interview with CNBC, US President Trump said he is prepared to further expand the tariff measures to include US $500 billion worth of imports from China.
On 1st of August, President Trump released plans to raise the tariff tax rate on US $200 billion of Chinese products from 10% to 25%, and this measure was later confirmed by US Trade Representative Wright Heze. The Chinese Ministry of Commerce responded swiftly. On 3rd of August, it declared that US $600 billion of goods from 5,207 categories originating from the US will be subject to tariffs ranging from 5% to 25%, with details of implementation and effective date to be announced separately. Nevertheless, the US and China are in hopes of returning to the negotiating table, according to Bloomberg news.1
How the US government will eventually carry out its action plan - and how the Chinese government will manoeuvre in response - still remains largely unclear. In the scenario that billions of dollars worth of Chinese exports to the US market are to absorb impacts from additional tariffs and with China taking a certain degree of retaliatory (monetary and fiscal) measures, the following ramifications may result:
• China’s GDP growth is expected to slow down by at most 0.5% in the next year and a half, although it will not result in a major shock to the economy2, according to the International Monetary Fund (IMF) estimation;
• Apart from putting pressure on the depreciation of the RMB exchange rate, the trade friction has precipitated the fall of domestic stock market in both scope and speed. It has also hurt investor confidence, affected consumer purchasing behaviour, and heightened urge for safeguarding against financial risks;
• The trade friction may greatly affect the business activities of both domestic and foreign enterprises, particularly those involved in Sino-US import and export businesses. These mainly include food and beverage, chemical products, electronic products, textiles, metals, machinery, furniture, automobile and agriculture. In addition, it will also seriously restrict two-way investments and mergers/acquisitions in both economies;
• For Chinese local enterprises, the “ZTE incident” is a wakeup call to re-examine and step up their compliance practices. Enterprises previously relying on the US market need to develop new ones in other regions/countries to diversify market risks. In the medium and long term, companies that heavily rely on US-imported core technologies need to consider alternative solutions while strengthening their own capabilities in research and development.
_________________________________________________________________________________________1 https://www.bloomberg.com/news/articles/2018-07-31/u-s-china-said-to-seek-to-restart-talks-to-defuse-trade-war2 https://www.ft.com/content/02f49c50-94c0-11e8-b747-fb1e803ee64e
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On July 11, the US government announced the plan to impose about 10% tariffs on US $200 billion worth of Chinese imports. Although the US government provided a period of about two months for solicitation of public opinion and the media reported on the possibility of resumed negotiations between China and the US, the probability of the two sides resolving the trade dispute by restarting negotiations is slim, given the less than fruitful outcomes from the previous round of high-level talks. There is reason, however, to believe that the taxable product range and amount of tariffs imposed may be lower than originally planned given the flip-flopping in US government policy, as evidenced by a reduction to 25% tariffs on US $34 billion of Chinese imports from the original US $50 billion. Nevertheless, the influence will still remain huge.
As the two largest economies in the world, China and the US are highly dependent on each other for trade. In 2017, China was the third largest export market of the US, trailing behind only Canada and Mexico, and also the largest source of imports for the US. The impact of the large-scale trade tensions between China and the US might go beyond the two countries to the value chains across numerous industries in other countries.
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The convenient truth is trade friction is a double-edged sword and can harm the economy, enterprises and people on both sides. So why did the US government still insist on initiating a trade tussle against China?
First and foremost, in the view of Professor Chen Zhiwu, who previously taught at Yale University and now serves as Director of the Asia Global Institute at the University of Hong Kong, US president Trump and his cohorts are pursuing trade protectionism and tariff increases similar to the practices the US adopted between the 1920s and 1930s, in an attempt to protect their industries and make the economy stronger, which also helps explain why the US has simultaneously sparked conflicts against various countries, apart from China.
Secondly, from the perspective of competition between great powers, some experts argue that China and the US might be stumbling into a “Thucydides trap”, a term derived from a metaphor put forward by the famous ancient Greek historian Thucydides, that a rising power will definitely challenge the established power, inevitably causing conflict to varying degrees. The current trade tensions might be a prelude to the competition between the world’s two largest economies, and a manifestation of their conflict.
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Thirdly, there are multiple signs indicating that the US might consider China to be its “main strategic competitor”, a policy that is currently adopted by the Trump administration and is likely to be the long-term national policy of the US. For instance, China is seen as a “strategic competitor” of the US in President Trump’s first National Security Strategy issued on December 18, 2017.
In light of the seemingly inevitable uptick in China-US trade tensions, what are the ramifications for the Chinese economy and enterprises at large, and how should Chinese enterprises respond?
What sparked the trade friction between China and the US?
How will China-US trade tensions affect the Chinese economy?
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Generally speaking, once implemented, the US government’s 10% tariffs on US $200 billion worth of Chinese imports will further widen the China-US trade conflict. Despite the possibility of this being a drag on China’s economic growth, the tariffs are not powerful enough to derail the steady growth path of the Chinese economy nor will they lead to an economic downturn in the country. Nevertheless, China should be on high alert to prepare for the impact of growing trade conflict on the domestic economy, including strong depreciation pressure on the Chinese yuan, the falling stock market, faltering investor confidence, a drop in consumer purchases, and a heightened urge to safeguard against financial risks.
A rough calculation pointed to an increase of US $20 billion burden on exporters if the 10% tariffs on US $200 billion worth of Chinese imports take effect. When the previous round of 25% tariffs on US $34 billion of Chinese goods is factored in, the total amount will rise by US $8.5 billion to near 190 billion yuan. In 2017, the Chinese goods trade totaled 27.79 trillion yuan (equivalent to US $4.04 trillion*) , among which Chinese exports reached 15.33 trillion yuan (equivalent to US $2.23 trillion*) . The value of products taxed by the US
accounted for approximately 9.6% of the total Chinese exports. Even taking into account the retaliatory measures from China, the China-US trade conflict is expected to have a limited direct impact on the overall foreign trade of China.
A recent estimation from the IMF showed that growth in the global economy might be down 0.5 percentage points in the next year and a half amid damaged business confidence if the US implements its trade measures targeted at a range of countries, possibly followed by retaliatory moves.
Many institutions have estimated the influence of the China-US trade conflict on China’s GDP, and PwC holds the view that, if the US imposes an additional 10% tariffs on US $200 billion worth of Chinese goods, the China-US trade conflict is likely to lead to a 0.3%-0.5% decline in the growth of China’s GDP in the coming 12 months, a figure consistent with the IMF forecast. That is to say, calculated using the total GDP in 2017, the China-US trade conflict will probably cause an
8
economic loss ranging from 250 billion to 415 billion yuan (equivalent to US $36.3 billion to US $60.24 billion*) to the Chinese economy. This estimation is relatively reasonable, but it fails to take into account the possible depreciation in the RMB exchange rate and other indirect consequences that are likely to occur or have occurred.
In fact, the trade tussle that the US has waged against China has already exerted influence on the exchange rate of RMB against the US dollar, accompanied by a fall in the RMB index, namely, the exchange rate of RMB against a basket of currencies. The Chinese yuan weakened by 4.4% and 6.1%, respectively, against the US dollar in the past one month and three months. The depreciation is very likely to continue as driven by market forces amid escalating China-US trade tensions. A weakened yuan can not only help reduce the adverse impact of the US tariffs on Chinese goods and boost Chinese exports on the whole, more importantly, it might largely offset some of the damage brought to China’s imports and exports by the trade conflict.
* Conversion based on market rates on 17/8/2018
What is the scope of impact from China-US trade tensions?
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Statistics from China‘s General Administration of Customs (GACC) showed that the total trade between China and the US amounted to US $583.7 billion last year, among which China’s exports to the US came in at US $429.8 billion and imports from the US stood at US $153.9 billion, generating a difference of US $275.8 billion. Exports from China to the US made up about 18% of the total Chinese exports, while the total value of products including the already taxed US $34 billion of Chinese goods and to-be-taxed US $200 billion of Chinese goods account for 54% of total Chinese exports to the US.
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The last round of the China-US trade conflict ended with a 25% levy by the US on US $34 billion worth of Chinese goods effective on July 6. The tariffs were mainly targeted at automobiles, computer disk drives, pump parts, valves, printers, among other varieties of industrial parts and components. China then took countermeasures to levy the same percentage of tariffs on 545 categories of US products, including agricultural produce, aquatic products and automobiles. “Some US $20 billion, about 59%, of the US $34 billion worth of Chinese goods in the list of proposed tariffs are products manufactured by
foreign-funded enterprises in China, many of which are American companies. Therefore, the US tariffs are in essence striking a blow to the global industrial chains and value chains,” said Gao Feng, news spokesperson of China’s Ministry of Commerce (MOFCOM).
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Bilateral trade
China ran a record high of US $275.8 billion trade surplus with the US in 2017, data from the China‘s General Administration of Customs (GACC) showed, while the figure released by the US Department of Commerce was up to US $375.9 billion. Such a huge discrepancy can be attributable to factors like statistical methods, transit trade and service trade.
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According to Chinese experts, the existing statistical methods are not applicable in this period of globalisation. Furthermore, the resulting trade balance is also partly explained by restricted US exports of advanced technologies to China.
1,709
1,434
1,8132,023
2,189 2,1592,370
2,6082,507
2,758
0
500
1,000
1,500
2,000
2,500
3,000
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Figure 7: China-US trade surplus
Source: General Administration of Customs, P.R. China
(US $100 million)
As China‘s second largest trade partner, the US mainly exported transportation devices (aerospace vehicles and automobiles), electromechanical products, plant products (soybeans) and chemicals to China.
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Based on ‘An Overview of the 2017 US Trade of Goods and China-US Bilateral Trade’ issued by MOFCOM, the bulk of exports from China to the US were mechanical and electronic products, with total values reaching US $256.6 billion in 2017 and accounting for 50.8% of the total imports of the US from China.
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Specifically, the value of mechanical and electrical products amounted to US $147 billion, with machinery equipment responsible for the remaining US $109.6 billion. Meanwhile US-bound exports of furniture and toys, textiles and raw materials, and base metals (all metals excluding precious metals such as gold, silver and platinum) and relevant products stood at US $60.6 billion, US $39 billion and US $25.4 billion, respectively, in 2017.
Two-way direct investment and M&A
Beyond their direct damage to bilateral trade, the China-US trade tensions are also likely to affect Chinese direct investment in the US. The US has planned to further restrain Chinese enterprises from making direct investment in the US. In the future, the Committee on Foreign Investment in the United States (CFIUS) might take tougher measures on reviews of investments involving Chinese enterprises, which will lead to a higher probability of vetoes over investments and acquisitions relating to key technology transfer.
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Statistical data from US-based economic research firm Rhodium Group showed that two-way direct investments between the US and Chinese enterprises declined by nearly one third in 2017 from the previous year impacted by political factors. Specifically, the Chinese direct investment in the US saw a 37% drop from US $46 billion in 2016 to US $29 billion in 2017.
During the first half of this year, US-bound takeovers and greenfield investments made by Chinese enterprises decreased by 92% annually to US $1.8 billion, the lowest level over the past seven years. From January to May this year, the amount of US assets sold/undersold by Chinese investors was up to US $9.6 billion.
Both the MOFCOM and Rhodium Group recognised the trend of a significant slump in China’s direct investment in the US despite huge differences between their statistical methods. Worsening trade tensions threaten to further exert influence on Chinese direct investments in the US and US investments in China.
According to the China Foreign Investment Development Report issued by MOFCOM, China engaged in US $17 billion direct investment in the US throughout 2016, including outflow of US $20.5 billion non-financial outbound direct investment (ODI) and inflow of US $3.5 billion financial ODI. The figure was 2.1 times larger than that of the previous year and hit a record high, making up 8.7% of China’s total ODI flows during the period. As of the end of 2016, US-bound investment from China reached US $60.6 billion, making up 4.5% of the total. In 2016, CFIUS reviewed 170 foreign investment projects, higher than the historical peak of 155 in 2008. China topped the watch list with the highest number of projects subject to national security review.
Flow of Chinese investment in the US Stock of Chinese investment in the US
Source: MOFCOM
In addition to the direct investment from China in the US, the trade conflict is also likely to impinge on mergers and acquisitions (M&A). For instance, Chinese enterprises spent US $35.4 billion in total on 164 M&A projects targeted at their US counterparts in 2016, which were mainly distributed in fields including manufacturing, transportation and warehousing, software and information technology services, real estate, and culture and entertainment.
In recent years there have been a growing number of M&A deals of US-based technology firms by Chinese enterprises. The chances to obtain approval from CFIUS are usually small when the M&A projects pertain to sensitive industries like national defence, aerospace, communications, semiconductors and finance. The probability of CFIUS objections to technology-related
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In comparison, investments made by Chinese enterprises into industries including consumer goods, manufacturing and services in the US have expanded greatly. Chinese enterprises value the prospect of integrated supply chains and market channels in the US through acquisitions in these fields. The trade tensions, coupled with tariff policies, could lead to a sharp decline in US-bound direct investment aimed at gaining market exposure.
acquisitions, especially those involving state-backed Chinese enterprises, will rise in the future. CFIUS has taken a tougher stance on approval of acquisitions since Trump took office as US president, leading to a rising number of objected cases. The year 2017 posted a significant drop in the scale of M&A of US enterprises by Chinese enterprises, with the announced amount of acquisitions reducing from US $62.7 billion in 2016 to US $13.6 billion in 2017, according to statistics from Dealogic.
Which industries and enterprises are likely to be affected by China-US trade tensions?
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Beyond having an influence on enterprises in foods and beverages, chemicals, electronics, textiles, metals, machinery, furniture and other industries included in the list of proposed tariffs, the trade conflict is likely to have a huge impact on Chinese enterprises in other industries such as automobiles, agriculture and aviation. Some exporters that are highly reliant on the US market may find that their products are less competitive (resulting from rising costs and sales prices) and experience
decreased operating income. Worse still, their operations might face severe challenges in the case of failure to find alternative markets in time due to customer loss caused by additional tariffs. The following analysis is time-limited as the proposed 10% tariffs on US $200 billion worth of Chinese goods announced by the US government have not taken effect and the Chinese government has not published countermeasures as of the time this went to press.
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Machinery
China’s machinery industry saw exports of US $73 billion to the US in 2017, accounting for 19.2% of the total exports in this industry. Exports of machinery such as electromechanical products, boilers and mechanical devices, and automobiles and auto parts, are the main drivers of China’s trade surplus with the US in the traditional sense. How the tariffs will influence Chinese enterprises in the machinery industry will depend on the extent of their reliance on the US market.
The 2018 Special 301 report issued by the US mentioned the “Made in China 2025” strategy. However, industries involved in the strategy are still in research, development and application stages and thus exports of relevant products to the US are on a small scale. Thus, the tariffs, even if implemented, will only have little impact on Chinese enterprises. The downside is that losing the US market bodes ill for the development of such industries.
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Some 59% of products on the US $34 billion list are manufactured by foreign-funded enterprises in China
The influence of the China-US trade tensions are not confined to Chinese enterprises. Statistics from MOFCOM showed that some US $20 billion, about 59%, of the US $34 billion worth of Chinese goods in the list of proposed tariffs involve products manufactured by foreign-funded enterprises in China. The following are examples according to a series of reports by Global Times on July 23. General Electric claimed its costs would jump US $400 million given the tariff increases targeted at parts imported from China. Alcoa announced an additional cost of US $15 million incurred by the tariffs. Since the Trump administration released plans to put tariffs on steel and aluminum imports this March, other US companies like Ford and Boeing recorded a nearly 2% decline in their revenue compared with the same period last year. According to the Financial Times, Chinese clients contributed to about 20% to 25% of the orders Boeing has received, which has supported significant number of US jobs.
Automobiles
Auto trade is the main arena in which China and the US are at odds in the trade conflict. Some driving system parts suppliers mainly targeting the US market might be faced with huge challenges as auto parts worth US $17 billion are currently exported from China to the US. In 2017, China purchased US $15.9 billion auto products from the US, including US $13.1 billion finished cars. A 25% tariff increase as part of China’s countermeasures would inflict heavy losses on the sales of US-sourced automobiles in the Chinese market, which, on the contrary would likely bring more opportunities to home-grown high-end car makers.
Amid the possible escalation of the China-US trade tensions, the US electric vehicle maker Tesla recently got the green light to independently build the Shanghai Gigafactory specialised in the research, development, manufacture and sales of electric vehicles. With an annual planned capacity of 500,000 finished pure EVs, the factory became the biggest-ever foreign-funded manufacturing project in Shanghai. This reflected the principle of “not wanting a trade conflict, not being afraid of one, and having to fight one when necessary” repeatedly stated by the Chinese government in the wake of trade tensions. This also indicates China’s pace to continue to expand the opening-up of sectors like automobiles and finance regardless of the trade conflict.
Electronics
In 2017, exports from China’s electronics industry to the US totaled US $146.3 billion, or 20.4% of the total Chinese exports in this industry. Among the list of the US 301 investigation is China’s electronics industry, with printed circuit boards (PCB), light-emitting diodes (LED), capacitors, resistors, discrete semiconductor devices, piezoelectric crystals and ceramic substrates for color TVs taking the lion’s share. But the tariffs would not influence products in the industrial chain of China‘s mobile phone market, including that of Apple, as they are not in the list of goods subject to tariffs.
The China-US trade conflict will inflict pain on Chinese electronics companies that rely a lot on the US market, but the impact on the whole industry is relatively limited. At present, China is more closely related with countries and regions like South Korea, Japan and Taiwan in the field of electronic manufacturing, and is less dependent on the US. On the upside, the trade tensions might turn out to be a development opportunity for China’s high-end products and give a boost to Chinese enterprises in accelerating their technological development amid huge demand for advanced technologies.
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Agriculture
China hit back with tariffs on soybeans imported from the US after the latter’s 25% levies on US $34 billion of goods imported from China took effect on July 6. In the short run, the tariffs will bring higher costs for Chinese importers of soybeans before having an impact on the downstream prices of soybean meal and oil. How these enterprises will be influenced will depend upon whether the upstream purchase costs can be transferred to the downstream consumers. Although food and farming companies using home-grown soybeans as the main raw materials in processing may rake in profits, the prices of domestic soybeans are likely to further rise due to strong demand.
Aviation
The China-US trade conflict will have little impact on China’s aviation sector. The list of goods for targeted tariffs so far released by MOFCOM covered the US aircraft manufacturers including Boeing. In this case, Chinese airlines may turn to Airbus for the purchase of aircraft. Nevertheless, given the overwhelmingly huge numbers of existing orders for Airbus, China’s aviation industry is likely to undergo a slowdown in aviation capacity in the years to come, thus resulting in a definite trend of tightening supply. This will be beneficial in narrowing the gap between supply and demand in the civil aviation industry and push airfares and airline profits upward. However, China might increase plane imports from Boeing if the negotiations between China and the US are successful in the end - which would make a dent in China’s manufacturing of large aircraft.
Conclusion: How should Chinese enterprises respond?
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In conclusion, the probability is extremely high that the US government will impose a 10% tariff on US $200 billion worth of Chinese goods, and China is expected to take countermeasures to varying degrees. It is currently still hard to judge whether China and the US can make progress in talks or negotiations to the extent that the US government could finally scale back the tariffs in part on goods imported from China, or lower the tariff rates. For this reason, despite their limited impact on the overall Chinese economy, the trade tensions will have a huge impact on the stability of RMB exchange rate, the domestic capital market, investor and business confidence, as well as the psychological expectations of consumers. Particularly, the trade tensions will take a heavy toll on enterprises with trade relations with the US and those whose products appear on the tariff list, both psychologically and operationally.
So, how should Chinese enterprises cope with the China-US trade tensions? PwC offers the following suggestions:
1) Chinese enterprises, especially those highly reliant on the US market and technologies, should revisit and reassess their own market expansion, technological strategy and operational procedures. Chinese enterprises should proactively move to tap into the needs of markets in China, Asia and Europe, and diversify their clients in different countries and regions as much as possible. At the technology level, they should prepare for other potential measures the US could take by enhancing independent research and development or turning to alternative sources of technology.
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2) Chinese enterprises should have a clear view of their place and positioning in the global value chain, carry out independent research and development targeted at core technologies, and take advantage of global resources of other supporting technologies, in a move to reduce costs and increase competitiveness. They should proactively integrate themselves into China’s “Belt and Road” initiative, expand their international footprint, and build win-win business relations with global partners through various forms, rather than shrink their overseas businesses due to fears over consequences brought by the trade dispute.
The very crux of the China-US trade tensions this time lies in curbing the rapid development in China’s high-end manufacturing and new economy sectors. As the US now demands strengthened protection over intellectual property rights and Chinese enterprises may run into increasing resistance in their future takeovers of US-based tech firms. Therefore, accelerating their efforts in independent research and development will be one key lesson that Chinese enterprises should learn from the trade dispute.
3) The “ZTE sanctions” should serve as a wake up call to Chinese enterprises, especially those relying on exports and a global presence. They should strengthen compliance education, make further efforts in self-inspection, self-discipline and self-correction targeted at their irregularities, and establish a compliance management system as soon as possible, in a bid to guard against possible major malpractices in the future. An increasing capability in compliance will bode well for Chinese enterprises to gain core competitiveness in the global market and raise their ability to achieve sustainable development in the wake of a changing global trade landscape.
PwC China SOEs leader Jim Chen, Assurance Partner Jean Sun, Strategy Consulting Partner Jun Jin, Senior Manager ZhoudongShangguan with research team and Senior Legal Adviser Jing Wang with Rui Bai Law Firm have contributed to the report.
PwC Mainland China & Hong Kong Markets Leader Frank Lyn, China Central Markets Leader & Shanghai Office Lead Partner Elton Huang, China North Markets Leader & Beijing Office Lead Partner Xing Zhou, Deals Strategy Leader and Assurance Partner Chong Heng Hon have all provided guidance to the report.
PwC senior economist G. Bin Zhao is the author of the report. PwC research team as well as members from Thought Leadership team have also provided data and information to this report. Sincere gratitude to all the leaders and colleagues.
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Acknowledgements
PwC Contacts
Frank Lyn
Mainland China & Hong Kong Markets Leader
+86 (10) 6533 2388
Elton Huang
China Central Markets Leader
Shanghai Office Lead Partner
+86 (21) 2323 3029
Thomas Leung
Mainland China & Hong Kong Deputy Markets Leader
+86 (10) 6533 2838
Xing Zhou
China North Markets Leader
Beijing Office Lead Partner
+86 (10) 6533 7986
G. Bin Zhao
Senior Economist
+86 (21) 2323 3681
Appendix:The outlook of RMB exchange rate in the second half of 2018
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6.0
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6.9
Figure 1: Central Parity Rate : USD to RMB (July 6, 2017 to July 6 2018) (Daily)
The RMB exchange rate against the USD has declined sharply since mid-June due to factors such as the interest rate hike by the US Federal Reserve (FED), the strong USD Index, China-US trade friction and the volatility on the Chinese stock market. Although the RMB exchange rate against the USD rebounded over several business days at the beginning of July, the RMB has become a market focus again. So what is the outlook of RMB exchange rate in the second half of 2018?
Source: Wind
To begin with, despite the recent drop in the RMB exchange rate against the USD, the RMB depreciated against USD by as much as 3.95% for a dozen days between June 15 and July 4. Over a longer timeframe of one month to three months, as of July 9, the depreciation of the RMB exchange rate against USD remained at a high point at 3.2% and 4.7% respectively. But if we judge from a six to 12-month timeframe, the RMB exchange rate against the USD only devalued mildly by 1.28% and appreciated by 2.79% respectively. Over even longer time periods of three years, five years and 10 years, the RMB exchange rate against USD devalued by about 8%, about 5% and appreciated by about 4% respectively.
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Therefore, if we consider the recent fluctuation of the RMB exchange rate against the USD in the context of a longer time frame, the current central parity rate of about 6.6:1 is not surprising, and many analysts even believe the overall RMB exchange rate is still on the high side. For instance, although the RMB devalued by 3.46% against the USD over a 2-year period, it appreciated by 10.80% against the Euro over the same time. The exchange rate dropped slightly against the JPY, GBP, CAD, and the currencies of other key developed economies, but the overall exchange rate remained basically stable.
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Figure 2: Central Parity Rate: USD to RMB (July 6, 2006 to July 6 2018) (Daily)
Source: Wind
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Despite the decline in mid and late-June, the CFETS RMB Exchange Rate Index, officially released by the China Foreign Exchange Trade System (CFETS) on December 11 2015, showed that the exchange rate of the RMB to a basket of currencies was on a general rise in the past year. The small-scale depreciation of the RMB against USD in the past year and the recent larger devaluation has notaltered the upward trend of the RMB Exchange Rate Index .
Firstly, it is important to correctly understand that the reform in the market-based RMB exchange rate formation mechanism is still at its initial stage, which means that the previous market expectation on the unilateral appreciation or unilateral depreciation of the RMB exchange rate over a certain period of time will become a thing of the past, and that the RMB exchange rate against the currencies of major developed economies will demonstrate two-way fluctuations on a regular basis. In the meantime, the initial stage of the reform has defined that it needs to take a longer time to improve the market-based RMB exchange rate formation mechanism,and policy intervention remains rather necessary at a time when speculators try to manipulate the market to profit. Furthermore,when market events significantly shock the exchange rate and the market mechanism is insufficient or not responsive, stabilising and cultivating the market-based formation mechanism appears more important than the reform process. What has happened in the 40 years of reform and opening-up tells us that the great achievements of China’s economic development can be attributed to key progressive measures rather than measures undertaken overnight. This is also true for the exchange rate reform.
Figure 3: Central Parity Rate: Major Currencies to RMB (July 6, 2006 to July 6, 2018) (Daily)
Source: Wind
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Central Parity Rate: EUR to RMB Central Parity Rate: JPY100 to RMB Central Parity Rate: GBP to RMB
Central Parity Rate: AUD to RMB Central Parity Rate: CAD to RMB
90
91
92
93
94
95
96
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99
Figure 4: CFETS RMB Exchange Rate Index (Weekly)
Source: Wind
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Figure 6: US Federal Funds Rate and the USD Index in the same period (Daily) (July 6, 2014 to July 6, 2018)
Secondly, the higher-than-expected economic growth of the US and the increase in the USD Index once again driven by the FED interest rate hike are some of the key factors behind the depreciation of RMB against the USD. As the USD Index has been at its historical high, the likelihood of a further rise in the second half of the year is rather limited. In addition, US President Donald Trump has previously emphasised that an ultra-high USD exchange rate does not help the continuous recovery of the US economy. Moreover, against the backdrop where the US government is paying more attention to trade deficit and even initiating protectionist measures against several countries simultaneously. The stronger USD exchange rate not only goes against the effort to reduce their trade deficit, but also undermines the price competitiveness of US exports. In other words, it is unlikely for the Trump administration to support the further appreciation of USD; rather, it is more likely to expect the depreciation of the currency. However, the market-based pricing power of the USD is still very strong (it is often more powerful than US government policy) and should not be underestimated.
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US Federal Funds Rate (Daily) USD Index
The market predicts that the FED may increase the interest rate two times in the second half of the year, which may drive up the USD exchange rate against the RMB, thus leading to the larger fluctuation of the RMB exchange rate against USD. That said, the basis of mid-to-long-term exchange rate volatility still lies in economic growth. In fact, the recent interest rate hikes of the FED have not pushed up the USD Index.
Thirdly, when the US government announced to impose additional tariffs on Chinese goods, it has triggered the depreciation of the RMB exchange rate against USD, exacerbated the slump in the Chinese stock market, and in turn stimulated the RMB exchange rate. If the Trump administration insists on imposing additional tariffs on US $200 billion worth of Chinese goods in the near future, the continuous downtrend of the RMB exchange rate against the USD will be expected. If the Chinese government steps up efforts toretaliate, the RMB exchange rate against the USD may be subject to larger volatility in the second half of the year as the China-US trade friction intensifies.
Of course, driven by market forces and the RMB exchange rate formation mechanism, the large-scale depreciation of RMB to USD will relieve the additional burden of the tariffs imposed by the US on Chinese products. If the RMB Index demonstrates a large decline on the whole, i.e., the depreciation of RMB to a basket of currencies, this may alleviate the shock of the US imposition of tariffs on the Chinese products.
Source: Wind
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Figure 5: Actual Monthly USD Index: Major Currencies (March 1973 = 100) (June 2006 to June 2018)
Source: Wind
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In summary, in addition to the performance of the USD Index, the degree and scale of the China-US trade conflict represents an important factor that affects the RMB exchange rate against the USD. If the US government collects additional tariffs on US $200 billion worth of Chinese products and if China retaliates to a greater degree the exchange rate may fluctuate on a larger scale. Furthermore, the strong performance of the US economy and the continuous interest rate hikes from the FED will attract more capital to flow to the US and may stimulate the outflow of the Chinese capital, which may also lead to the depreciation of RMB. In this case, the RMB exchange rate against the USD still has room to decline in the second half of the year due to the said factors; if the depreciation case intensifies, it is likely to see a sharp decline, thus causing the scenario that the CFETS RMB Exchange Rate Index may shift from an upward trend in the past year to a downward one.
On the other hand, the China-US trade friction may drag down China’s economic growth rate, but this is not enough to affect the general growing trend of the overall economy and is unlikely to lead to a recession in the Chinese economy. Meanwhile, besides the RMB exchange rates, the effect of the China-US trade friction on the Chinese economy calls for greater vigilance as it
has accelerated the level and speed of the stock market decline, shaken the confidence of investors, affected the purchasing behavior of consumers, and added to the pressure of guarding against financial risks.
Beyond that, consumption is, after all, a key driving force that boosts economic growth. For example, consumption expenditure contributed to 77.8% economic growth in the first quarter of this year. And as China deepens reform and opening up and further opens financial services and other sectors to foreign capital, the current lower valuation of the Chinese stock market will attract international capital to enter into China on a large scale. Together, these factors will underpin the relative stability of RMB exchange rate. Therefore, we believe that the frequent two-way fluctuation of the RMB exchange rates against the currencies of key developed economies including the USD will become more regular, and the China-US trade conflict will also evolve into an important point that tests the market-based RMB exchange rate formation mechanism in the medium and long run. For example, the People’s Bank of China did not intervene when the RMB depreciated against USD for more than 10 days, pointing to the bigger step taken towards the market-based process of the RMB exchange rate.
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Shanghai Composite Index Central Parity Rate: USD to RMB
Figure 7: Central Parity Rate of USD to RMB and the trend of the Shanghai Composite Index in the same period (Daily) (July 1, 1996 to July 1, 2018)
Source: Wind
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This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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