FX: Effective link between tariffs and CNY
- How will effective tariff rates hit the CNY?
- If trade talks fail, USD/CNY will cross 7
- USDCNY will cross 8 on a full-blown trade war
- USDCNY will fall to 6.50 on successful trade talks
Chinese President Xi Jinping and US President Donald Trump agreed, at the G20 Summit on December 1, to a 90-day ceasefire on their tit-for-tat trade tariff war. To facilitate trade negotiations, both countries will refrain from increasing tariffs on each other’s goods until March 1, 2019. The US has effectively suspended its original plan to lift the US tariff rate on USD200bn of Chinese goods to 25% from 10% from 1 January 2019. Trump has also toned down his threat to impose tariffs on the remainder USD267bn worth of China’s goods.
In the spirit of stress testing the impact of tariffs, already implemented or in the realms of possibility, we have devised a simple model.
Back-of-the-envelope calculation on the impact of US import tariffs on the CNY
Let’s start with the three tranches of Chinese goods (USD50bn, USD200bn and USD267bn) that Trump has allocated for his import tariffs. The weighted tariff of each tranche is the product of its share of all goods and its respective tariff rate, which together, produce an effective tariff rate for all tranches. The base rate used to calculate the exchange rate needed to offset the impact from the effective tariff rate is 6.51, the end-2017 level for USD/CNY.
During Phase 1, Trump hit USD50bn of Chinese goods with a 25% tariff rate. According to the above table, this would translate into an effective tariff rate 2.4%. To hypothetically offset the impact of the tariff, USD/CNY would need to rise to 6.66. Coincidentally, USD/CNY was around 6.64 on 6 July, the day the tariff took effect on the first USD34bn of goods.
USD/CNY averaged 6.92 after Trump hit an additional USD200bn worth of Chinese goods with a 10% tariff rate from 25 September. Uncannily, the implied USD/CNY rate was also 6.92 from the effective tariff rate of 6.3% for cumulative USD250bn of goods.
USD/CNY to surpass 7 when trade talks fail
If the China-US trade talks fail to produce a deal after 90 days of negotiations, US President Trump will make good his pledge to become “Tariff Man” again.
The first step would be to reinstate the original decision to lift the tariff rate on USD200bn of Chinese goods to 25% from 10% from 1 March 2019. This would double the effective tariff rate to 12% for the cumulative USD250bn of goods and imply a USD/CNY rate near 7.30.
Hence, we have maintained our forecast for USD/CNY to hit 7.20 in mid-2019. At this juncture, it is prudent to be more cautious than optimistic about the trade talks between the world’s two largest economies. Our forecast is also based on our expectation for three cuts in the reserve requirement ratio totaling 150-300 bps.
Worst-case scenario sees USD/CNY above 8
Trump has not rescinded his threat to impose tariffs on the remainder USD265bn of Chinese goods. Assuming no desire for future trade talks with China, the risk for Trump to the final tranche with a 25% tariff cannot be discounted.
To offset the 25% tariff on all USD517bn headed to America, USD/CNY would hypothetically need to rise to 8.13. If this worst-case scenario materializes, the outlook for the yuan and other Asian currencies would need to be downgraded. Imposing tariffs on all of China’s goods is expected to accelerate the slowdown in its economy.
The above simulations do not imply that China is a currency manipulator. The yuan’s one-off devaluation in August 2015 helped to realign it to the USD’s resurgence.
Since then, USD/CNY has been tightening its relationship with the major USD indices in DM and Emerging Asia (EA), both in direction and magnitude. The yuan’s correlation with the EA currencies has been particularly high at 94% in 2017 and 99% this year. That said, the correlation with DM currencies has also been meaningful at 87% in the past two years. This was easily explained by China’s position as the top trading partner in most Asian countries and many DM countries.
Hence, the weaker yuan from failed trade talks would spill-over negatively into EA/DM currencies. Conversely, if the trade talks surprise on the upside (and remove tariffs), USD/CNY could find its way back to the 6.50 base level and bring the USD lower against EA/DM currencies.
To read the full report, click here to Download the PDF.
The information herein is published by DBS Bank Ltd and PT Bank DBS Indonesia (collectively, the “DBS Group”). It is based on information obtained from sources believed to be reliable, but the Group does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation & the particular needs of any specific addressee. The information herein is published for the information of addressees only & is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Group, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Group or any other person has been advised of the possibility thereof. The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Group & its associates, their directors, officers and/or employees may have positions or other interests in, & may effect transactions in securities mentioned herein & may also perform or seek to perform broking, investment banking & other banking or financial services for these companies. The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Sources for all charts & tables are CEIC & Bloomberg unless otherwise specified.
DBS Bank Ltd., 12 Marina Blvd, Marina Bay Financial Center Tower 3, Singapore 018982. Tel: 65-6878-8888. Company Registration No. 196800306E.
PT Bank DBS Indonesia, DBS Bank Tower, 33rd floor, Ciputra World 1, Jalan Prof. Dr. Satrio Kav 3-5, Jakarta, 12940, Indonesia. Tel: 62-21-2988-4000. Company Registration No. 09.03.1.64.96422.