G20 Reassurances Not Enough To Stop A Currency War

PTA

By John Richardson

PRESIDENTS XI Jinping and Barack Obama have made a commitment to avoid competitive currency devaluations at the G20 summit in Hangzhou.

The fact sheet released by the two presidents also contained this statement: [China will] “continue an orderly transition to a market-determined exchange rate, enhancing two-way flexibility.

“China stresses that there is no basis for a sustained depreciation of the RMB (Yuan). Both sides recognise the importance of clear policy communication.”

Does this mean we can rest easy over the risk of a further weakening of the Yuan versus the US dollar?

I am afraid not. If market forces are allowed to have a greater influence in the way that the Yuan trades against the greenback, you can make a strong case for a considerably weaker Yuan over the next 12 months. Here is why:

  • During the big devaluation panic last summer, the Chinese government rightly pointed out that the fall in the Yuan was not a competitive devaluation. It was instead the result of the adoption of a more flexible, market-based exchange rate mechanism.
  • The weaker Yuan was thus down to currency-market investors being able to more easily vote with their feet – and some of them chose to short the yuan because of concerns over the impact on growth of economic reforms.
  • Devaluation pressure has again increased over the last few months as Xi moves into the next phase of economic reforms. This has led to a weakening of the Yuan from 6.47 to the dollar in April to 6.63 against the dollar in August.
  • In July, a net $55bn flowed out of China compared with $49bn in June, reports the Wall Street Journal. Some exporters were said to be hoarding dollars and keeping earnings overseas, whilst investors were reportedly showing some hesitation towards sinking money into Chinese government bonds and other yuan-denominated assets, the newspaper added.
  • If Xi and other pro-reformers continue down their current path – and I can see no reason why this will not be the case – devaluation pressure will build. In other words, the worst China’s economic data becomes, the more that currency markets will want to get out of the Yuan.

How might the West respond? This will hinge both on the extent of the devaluation and the political climate in the US and Europe. European Commission President Jean-Claude Juncker gave an indication of the current climate when said - again at the G20 - that the problem steel overcapacity was “unacceptable” to the European industry.

Calling for a global mechanism to deal with the problem, he added: “Overcapacity is a global problem but there is a particular Chinese element”.

Regardless of the result of the US presidential election, the popular mood has swung decidedly against global free, with the Brexit vote for now the biggest concrete example of this alarming change in mood.

Here is a scenario that you must, as a result, take into account:

  • Currency markets send the Yuan a lot lower as millions of jobs are lost in China through rationalisation of overcapacity in heavily oversupplied industrial sectors such as iron and steel, aluminium, cement and coal.
  • This is misread by the West - and by the other Asian export-based economies – as a competitive devaluation by China.
  • Round after round of deliberately engineered currency evaluations then follow, with China involved as it seeks to protect its export trade.
  • And/or we could descend into a global trade war as global free trade agreements fragment.

Overly pessimistic? No. Xi highlighted exactly why this could happen in comments that he again made at the G20. In his opening address he talked about the risks from rising protectionism and highly leveraged financial markets.

“Growth drivers from the previous round of technological progress are gradually fading, while a new round of technological and industrial revolution has yet to gain momentum,” he added.

If the Yuan does fall in value over the next 12 months, what will this mean for chemicals markets? Imports will become more expensive for China and exports more competitive. This will encourage higher local production. Most affected will be the value chains where China has either reached is moving closer to self-sufficiency.

Think of purified terephthalic acid as one of the most worrying examples. Vast capacity additions have already led to a net export position compared with as recently as January-July 2009, when net imports stood at 3.6m tonnes (see the above chart)

But even in polypropylene which still remains  in big deficit, net imports have steadily declined on new local capacities (again see the above chart). Here, too, there is the potential for lower imports and more exports.

The implications of currency wars and a breakdown in free trade would obviously be far more severe for the global chemicals business.  If this worst-cause outcome takes place, historians will conclude, “at least China had the vision and courage to address its economic policy shortfalls, whereas central bankers and politicians in the West entirely missed the No1 challenge: Demographics”.

,