Stable Yuan Policy - Part of Trade Deal?

While the discussions on trade war is nearing towards a resolution, talks about an exchange rate pact as a part of trade negotiation between the US and China has been gaining attention. According to select reports, the US is seeking a pledge from China to keep the value of the yuan stable as a condition of ending the trade war. By doing this, the US administration is aiming to defuse any effort by China to devalue its currency to offset US tariffs or even boost exports. On numerous occasions, the US administration has raised concerns about the depreciation of Chinese Yuan against the US dollar as unfair and has accused China of currency manipulation.

However, in late 2018, the US Treasury released its Foreign Exchange Report, without labeling China or any other country a currency manipulator. Although US Treasury Secretary indicated his openness towards modifying the criteria which the treasury uses to identify currency manipulation, but no practical modification would lead to the conclusion that China has manipulated its currency last year. The concept of currency manipulation originates in the Articles of Agreement of the International Monetary Fund (IMF). The key components of currency manipulation are that a country has a significant current account (trade) surplus and that it has supported this surplus by excessive official purchases of foreign currency assets, which keep its currency and its export prices undervalued. US Treasury’s criteria for these components are reasonable, and China does not come close to meeting either of them. In the first half of 2018, China’s current account balance and official foreign currency purchases were close to zero.

In the wake of tariffs, Yuan depreciated over 9% during the period of tariff action and counter-action by both sides. It is also true that China heavily manages its exchange rate, and it could have prevented any depreciation had it wished, by using its foreign exchange reserves to buy back its own currency. Although depreciated, China did not took any active steps to push its currency down further. Contrary to the popular belief, PBOC’s action suggested that the Chinese administration were aspiring for stable Yuan, despite tariff action and volatility. Hence, if the US administration emphasize on stable yuan (currency policy) to be a basis of a trade deal, this mandate may be easily incorporated in order to have a trade resolve, as China has been working towards achieving similar goal since mid-2015. 

Impact on exchange rate

In case if the currency policy pact materializes between China and the U.S., it could introduce an appreciating bias in the yuan, in following two ways –

• Yuan may experience augmented gains when the U.S. dollar weakens.
• When the dollar strengthens, then the magnitude of yuan’s depreciation would be constrained, even when greater depreciation might be justified by economic and financial fundamentals.