FX: Effective link between tariffs and CNY

If trade talks fail, CNY could depreciate to 7-8.
Philip Wee13 Dec 2018
  • 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
Photo credit: AFP Photo

China-US trade talks resume

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.

Currency manipulation?

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.

Philip Wee

FX Strategist - G3 & Asia

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