The trade war between the U.S. and China reached a new phase after the U.S. announced to impose a new 10% tariff on USD 300 billion worth of imports from China. China’s currency, the renminbi (also referred to as yuan), subsequently weakened to just above 7 to the dollar, which led the U.S. Treasury to designate China a currency manipulator. This, of course, is true as the PBoC repeatedly intervened in the currency markets but mostly to prevent weakening of the renminbi, whereby the rate of 7 to the dollar was deemed a magical level that should not be crossed.

Although China does have a large trade surplus with the U.S. (USD 420 billion in 2018 and USD 167 billion in 1H19), its current account is barely positive (forecasted at 0.5% in 2019) due to an increase in domestic consumption (think of tourism, for example). Looking at real effective exchange rates, as calculated by the BIS, it doesn’t seem that China’s competitiveness increased over the last 10 years by means of currency manipulation or monetary easing (unlike the EU or Japan). China booked a cumulative real appreciation of 20% over the last 10 years. The graph below shows normalized REERs for the 4 economic blocks. Mr. Trump seems to bark at the wrong tree…

Indeed, according to the U.S. Treasury’s own framework, China does not qualify as a currency manipulator. China does have a large trade surplus with the U.S. but a declining and, by now, negligible current account surplus and, at least over the last couple of years, it has not intervened in currency markets to weaken its currency. The U.S. Treasury said that its boss Steven Mnuchin will now engage with the IMF “to eliminate the unfair competitive advantage created by China’s latest actions”. However, the IMF recently already concluded that China’s external position was in line with fundamentals.

In any case, China only has limited room to devalue its currency because a significant weakening of the renminbi could result in capital flight despite strong capital controls (the Chinese are very ingenious when it comes to protect their wealth). A deliberate policy of intervening in currency markets to weaken the renminbi would also be at odds with the government’s desire to open up its capital markets to foreigners in order to attract funding to finance the current account. Who wants to invest in bonds whose values in dollars are consistently eroded by depreciation? Those investors would demand a (currency) risk premium for sure.

The impact of the trade dispute on Emerging Markets (EM) is not easy to predict. Certain countries, like South Korea and Taiwan, are large exporters of components to China and would therefore be negatively impacted as production in China is adversely affected by lower exports to the U.S. Other countries, like Mexico and Vietnam, could actually benefit as in the longer term manufacturing capacity shifts from China to those places. Obviously, as global trade in general will decline, the overall impact on EM will be negative. The IMF believes that the trade war could shave 0.5% of global growth in 2020 and this is before taking into account the latest tariff tweets from the U.S. president.

Trump’s 20 20 vision…

In addition to the trade war, we now also may have a currency war at our hands. This could be even more detrimental to EM. A weaker renminbi will mean that exporters to China, especially those in Asia (but also LatAm), will (need to) weaken in tandem whilst growth slows down. This could expose the financial vulnerabilities, in terms of increased public and private debt and reliance on foreign capital, that some of these countries (including China) built up over the last couple of years as in dollar terms these debt piles will become higher. Although yields on EM local currency bonds (5.5% on average compared to 1.5% for the U.S. and -0.8% for the EU) offer a buffer against some currency weakness, we would expect returns (7.4% YTD but already down 2.1% this month) to suffer if the renminbi weakens further. For the higher-risk countries, like Argentina, Brazil, India, South Africa and Turkey, this eventually could lead to distress if investors reprice risk. Therefore, it may be advisable to overweight EM “safe havens” like Indonesia, Peru, Philippines and Russia and underweight the higher-risk countries. It all depends on how strong Mr. Trump will lean on Federal Reserve chief Jerome Powell to cut dollar interest rates whether we will see a bigger sell-off. Ultimately, the buck stops with the Donald…