(27AUGUST 2019) DAILY MARKET BRIEF 2：China unlikely to weaponize the yuan

The yuan hit a new 11-and-a-half year low on Tuesday, testing 7.16 against the US dollar amid a worsening US-China trade backdrop. The depreciative pressure follows the US announcement it would increase existing tariffs on USD 250bn of Chinese exports to 30% (from 25%) on 1 October, and would ratchet up planned tariffs on USD 300bn of Chinese exports to 15% (from 10%) in two steps over September and December.

But while further yuan weakness is likely in the face of domestic and external pressures, we expect the currency's fall to be both controlled and limited:

• Rapid yuan depreciation would likely further provoke the White House, like when USDCNY climbed past the 7.0 mark in early August and the US Treasury in turn labeled China a “currency manipulator.” China this week called for "calm negotiations" in the wake of the latest trade escalation, and is unlikely to pursue a yuan policy that would fuel US claims of yuan weaponization.

• Beijing is well aware of the potential negative consequences of currency depreciation. The balancing act will be to quietly weaken the currency without unhinging CNY depreciation expectations in a way that spurs a repeat of the capital outflows of 2015 and 2016. Tuesday's PBoC yuan fix, which came in less weak than market expectations, looks like an attempt to slow the pace of appreciation.

• USDCNY trade has two sides, and a stronger easing bias from the Federal Reserve amid heightened trade tensions could potentially limit the currency pair's upside. At the same time, if the US continues to raise tariffs, we think China might find holding a specific line on the yuan against depreciative pressure to be counterproductive and unfeasible.

  
  

So barring a significant improvement in US-China trade relations, on balance we believe further depreciation could be ahead for the yuan. We have shifted our USDCNY forecasts higher to 7.4 over the next three and six months, and 7.3 over the next 12 months. With heightened trade tensions and a slowing Chinese economy, we continue to advise investors to hedge CNY long exposure versus the greenback.