The RMB Dilemma and Why I think a new trade deal will be signed by end 2021

Written: 03 Jan 21

Driven by the search for yield, investors have poured billions into the Chinese bond and stock market in 2020. With the Fed maintaining zero rates for the forseeable future, and with a strong chinese economic recovery, the demand for RMB assets has never been larger. Whilst the Chinese government welcomes such strong interest in its capital markets, the sudden surge of demand has caused the yuan to appreciate xxx in 2020.

While imports will become cheaper, and outward investments by chinese investors (especially in property in other countries) pick up pace, the appreciation of the yuan has hit the profits of many export companies who settle in USD. Even though since 2008, China has been shifting its economic structure from an export driven economy, to one driven by domestic consumption, exports still make up X% of the chinese economy and employs millions of workers. SMEs are the hardest hit by the appreciation in yuan. Even though the double circulation strategy is sure to increase domestic consumption in the future, this demand will not manifest immediately in 2021. How to prevent the RMB from appreciating, or even better yet how to devalue the RMB, and maintain profitability and employment for the export sector is a huge challenge the chinese government will face in 2021. So what are some measures the chinese government can take to depreciate the RMB in 2021? Let’s look at some options:

1. Lower interest rates. This will decrease the demand for rmb – denominated bonds, but at the same time increase demand for rmb – denominated equity, but hopefully the net effect will reduce demand for RMB, and increase RMB supply enough for yuan depreciation. The risk to lowering interest rates however is that the domestic economy might ‘overheat’ again, like what we saw in 2008-2010. This is not what the central government wants.
2. Make it easier for capital to flow out of China. QFII and RQFII limits have been removed, which has allowed for large capital inflows into China. But capital outflows are still somewhat restricted. By decreasing barriers to capital outflows, this will increase RMB liquidity in the FX market, increasing RMB supply which will depreciate the yuan to a certain extent. The risk however is that by allowing capital to flow freely, it might cause an asset bubble similar to what we saw in Japan in the 1990s. We all know how that one turned out.
3. Issue RMB denominated debt to countries who badly need capital during this crisis. This is a huge challenge since USD rates are so much lower. This is a strategy that can be taken, but the result on FX markets will be minimal.
4. Buy USD Debt in large amounts, similar to 2008, increase return on USD bonds which will cause capital outflows from China, devaluing the Yuan. With heightened tensions and the trade war still ongoing, it is unlikely the chinese government will be buying USD debt anytime soon. Even if they do, the amounts will unlikely be enough to make a big impact on capital markets.
5. Re-negotiate trade war with US. I think this is the most likely outcome that we will see in 2021. Biden will re-negotiate a new deal with China, remove trade restrictions and tariffs. This will allow the US economy to recover quickly, decrease RMB demand, and depreciate the Yuan as capital flows back to the US. In addition, with the Chinese economy expected to grow at ~10%, this will increase Yuan M2, increase Yuan supply, which will also depreciate the RMB. I think this is the option with the least amount of risk, and with the largest amount of short-term returns, and is favourable for both countries. The issue now is what the terms of the new deal deal will look like, and whether it can be signed quickly.

In sum, the coronavirus rapidly changed the dynamics of international capital markets and accelerated the appreciation of the Yuan. There is no ‘easy way out’ for the chinese government to quickly depreciate the yuan in order to support its export industry. The most likely outcome would be a re-negotation and a new deal with the Biden administration in order to end the trade war.

Note: The US needs a new deal more badly than the Chinese, the economic figures tell the whole story.

Update: 09 Jan 21

On 7 Jan, PBOC “中国人民银行、国家外汇管理局决定将企业的跨境融资宏观审慎调节参数由1.25下调至1。” In sum: Restricting Capital inflows by limiting cross-border financing.

8 Jan PBOC ” 中国人民银行与泰国银行（中央银行）续签了双边本币互换协议，互换规模为700亿元人民币/3700亿泰铢，协议有效期五年，经双方同意可以展期。”

Currency swap agreement with Thailand to increase RMB liquidity for thailand, and also increase offshore RMB supply. The key phrase in this sentence is ‘经双方同意可以展期’, which translates as: the 5 year agreement can be extended as long as both parties are willing to. This is a long term agreement, and not short term (like Fed liquidity swaps).

US perspective:

The US will still be very hawkish on China this will not change. But the approach will be different. With the democrats in control of congress, Biden has to make the most of the next 2 years. I think Biden will renegotiate a trade deal for sure because the US economy needs an extra kick for recovery as well. And as US recovers, capital will flow back to support a falling dollar. This will help the US to continue running budget deficits. However, Biden will pressure China on other areas.

1. Technology. This is the core of the US-China rivalry. Whether chip makers can sell the newest 5nm chips to China remains to be seen. Some propose to continue supplying the chinese so that chinese companies will spend less money to develop their own IP and knowledge in semiconductors. If this happens, then chip maker stocks will rise dramatically. Others propose to continue the ban on semiconductor exports. Another area of contention is in Intellectual Property enforcement. Talks of chinese companies stealing secrets will probably return to mainstream media.

2. Climate change. The paris agreement will be back and this time Biden intends to lead it. We will probably see the beginnings of a global carbon emissions trading market and the ‘race’ to go ‘green’. That is why solar and wind company stocks have been on such a bull run in 2020.

3. Financial Markets. I think Biden will pressure China to open up its capital markets even more. In the Euro-China BIT, China opened up certain financial services for European companies. Wall street definitely does not want to miss out on this. I think it is unlikely the Chinese will cave in to pressure in this area and China will open up at its own pace. But what this means is that hong kong will be even more important in the next few years, so keep your eyes on HKEX. With the US being so hostile to chinese companies, chances are that many will follow Alibaba and return to HK. Since HKD is on a tight peg to the USD, both currencies offer pretty much the same pool of capital.

In sum: The US will re-negotiate a trade deal with China because their economy needs it. But on key areas such as technology, climate change, financial markets, Biden is going to put alot of pressure on the Chinese which will have ripple effects for the rest of the world as well.