IS THE YUAN IN CHINA´S TRADE-WAR ARSENAL? / THE WALL STREET JOURNAL

Is the Yuan in China’s Trade-War Arsenal?

The new central banker says Beijing won’t use depreciation as a weapon—but that doesn’t mean the yuan won’t depreciate

By Nathaniel Taplin



STILL LEAKY
Quarterly net capital flows in and out of China

Source: CEIC

China’s new top central banker says Beijing won’t use yuan depreciation as a weapon in a trade fight. Should investors believe him?

A sharp, deliberate devaluation—as in 2015—would be risky, given the country’s rickety financial system. But there is reason to think the currency might come under pressure later in 2018 anyway, and that could be misinterpreted as provocation by a hostile Trump administration.

The yuan’s current stability against the dollar is more fragile than it appears. Markets read its rebound in 2017 as a testament to China’s new capital controls, with an assist from the weaker dollar. But two other factors were critical: First, China’s net exports rebounded sharply, providing a shot in the arm as exporters sold dollar earnings for yuan. And second, foreign investment capital moved back into the country as the economy improved and a crackdown on leverage pushed up interest rates.

Unfortunately, there’s not much evidence any of this has curbed Chinese hunger for foreign assets. Logan Wright, China markets research director at the Rhodium Group, notes that the “errors and omissions” term in China’s balance of payments—one good indicator for capital flight, as it partly reflects money moving in or out of the country through unrecognized channels—is still negative. It has moderated only slightly since 2016. In other words, a lot of Chinese capital is still eyeing the exits: If global trade falters and U.S. rates rise, China’s currency could be in for another test sooner than many expect.

And that’s worrying given how much money is sloshing around in China. China’s foreign-exchange reserves sound large—$3.1 trillion—but they are dwarfed by domestic money supply, at nearly $30 trillion. If even a small portion of that capital finds its way out through the cracks, and the central bank steps in to prop up the yuan, those reserves could run down in a hurry.

With the yuan, and China’s financial system, still vulnerable to renewed outflows, a sharp, deliberate depreciation to bloody the U.S.’s nose would be risky—particularly with U.S. inflation and rates now steadily rising.

Yet a gradual depreciation might be in the cards this year if global trade momentum slows, as many expect, and China loosens monetary policy to goose the economy.