China, the USA and the “Potemkin Villages” of FX stability

The USA and China are on the verge of making a breakthrough to a new trade treaty. The subject of “foreign exchange” is said to play a key role and there are apparently “exactly defined structural agreements” in place – we wait with bated breath to see what they look like. The speculation to date is that China has promised to take the lid off its interventions in the foreign exchange market. Meaning the emphasis is not on forgoing interventions and also not on ex-ante information or even US permission, but simply on making the interventions more transparent after the event.

That said, we should not forget that China has long since ceased to keep the Yuan on the desired track only by resorting to the entrance-level model of forex-policy, namely simply cash market interventions. The structure today is far more complex and includes a mixture of outright, forward and swap transactions, liquidity management in the interbank market and a plethora of other refined moves (e.g., requirements as regards the collateral to be put up for foreign-exchange deals by commercial banks). Has China really stated its willingness to reveal the entire gamut of transactions to the USA? And to do so at such short notice that the information is not already completely out of date and thus meaningless? We have our doubts.

What would be highly promising in the sense of a win-win situation for both sides at the negotiating table would be for Beijing to come out officially in favour of exchange-rate stability. Trump could then hold this up to his voting base as a “great victory” – and it would cost China nothing more than verbal agreement. In the current market situation it is no big challenge to prevent a Yuan devaluation. Thanks to the Fed having renounced further interest-rate hikes, the seedbed for the supra-ordinated strength of the US Dollar has disappeared, with the result that the obverse of it, namely a Yuan devaluation, is no longer an issue. So what would happen to the deal when the Dollar next takes off? We do not think it would be an objectionable, competitive matter for the Yuan to yield to a fundamentally justified, global upwards trend for the US Dollar. It would also not involve Beijing providing support for the Chinese export sector. Rather, it would be the logical application of the concept of free market forces that has for years now repeatedly been called for precisely with a view to China. To this extent, any thoughtless promise of FX stability without considering actual conditions on the ground would be a step backwards rather than forwards.

Does the promised stability apply in both directions? The USA does not want a Yuan devaluation. And what about a revaluation? Must or may China also prevent such in order to keep the exchange rate stable? Stability is after all not a one-way street, or is it one after all if it transpires that China intervenes in a way with which the US representatives are not comfortable?

As long as this semblance of transparency as regards interventions and exchange-rate stability is successfully maintained, China’s ostensible concessions may be a smart move to render the trade treaty currently under discussion viable for both sides. The actual test as to whether the agreement is worth more than the paper it is written on will only take place once the next supra-ordinate Dollar trend emerges.

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