Tuesday, May 14, 2019

The trade talks between China and the United States have recently undergone a sudden change. Based on the tracking of information related to the trade talks conducted by the Anbound research team, the talks between the two countries, while not yet crippled, are stuck in a dilemma that is difficult to resolve. It is said that the U.S. has asked China to include some institutional and legal changes in the trade agreement, but China believed that this affects the bottom line and would damage China's "equality" and "dignity", so it could not agree with the new requirements from the U.S. As commentators of the People's Daily stated, "At no time will China forfeit the country's dignity, and no one should expect China to swallow bitter fruit that harms its core interests."

Vice Premier Liu He has once said it is highly irresponsible to accuse the talks of "backsliding." At present, China and the United States have reached important consensus on many aspects, but China's three core concerns must be addressed: First, if an agreement is to be reached, all the additional tariffs must be eliminated. Second, trade procurement figures should be realistic. The two sides have reached a consensus on the trade procurement figures in Argentina, and it should not be changed at will. Third, the text must be balanced and expressed in terms that are acceptable to both and does not undermine the sovereignty and dignity of any country.

The disagreements over the bottom line of the agreement have sent the negotiations between China and the United States into great uncertainty. Trump said that the threat of tariffs on US$ 325 billion Chinese goods is not an empty promise but is rather a very real sword hanging over China. Considering the huge economic size of China and the U.S., the risk of a breakdown in the talks has shaken up global capital markets, especially the Chinese stock market. Since Trump threatened to hike tariffs on May 5, China's stock market has been hit hard, with A shares plunging more than 5% on May 6.

Of course, such a sharp drop in the stock market easily draws global attention, but it is important to point out that this is by no means the biggest threat to China. It is also not the biggest risk that the market should be on guard against. In Anbound's internal discussions, Chief Researcher Chen Gong made it clear that the biggest challenge China would face in the future would be the exchange rate issue, and it is necessary to be prepared for an upcoming fluctuation in the RMB exchange rate. Arguably, nothing else matters as much as the RMB exchange rate.

In fact, during the China-U.S. trade conflict in the past year, Anbound's macro team suggested that the Chinese financial markets are more vulnerable to the impact of the United States than those in the trade sector. The United States could easily destabilize China's financial markets by showing a threatening attitude, and this is without even having to come up with a real policy. The most worrying issue is that of RMBs' exchange rate. Once the RMB continues to depreciate, it will trigger a series of chain reactions: exchange rate depreciation, asset price decline, intensification of capital flight is intensified, the continuous weakening of RMB, which would eventually lead to the weakening foreign exchange reserves. If this vicious cycle occurs, it will undoubtedly have a broad impact on China's financial market, asset market and real industry market.

The recent trend shown by the RMB exchange rate has confirmed our aforementioned concerns. According to data from the China Foreign Exchange Trading Center, the central parity of the RMB against the U.S. dollar on May 13 was reported at 6.7954, down 42 basis points from the previous trading day. This reflects a new low since January 24, 2019. The exchange rate fluctuations in the foreign exchange market are more suited and able to reflect the depreciation pressure of the RMB. On May 13, the offshore RMB fell below the 6.90 mark against the U.S. dollar, hitting a new low since the end of December last year, falling more than 600 basis points during the day. Meanwhile, onshore RMB fell below the 6.86 mark against the U.S. dollar, and fell more than 420 points in the day. This effectively means that the RMB has lost almost all its gains for the year in just six trading days.

What we wish to emphasize is that even if China-U.S. trade negotiations are able to reach an agreement in the follow-up negotiations, the pressure on the Chinese market caused by the tension between China and the U.S. will still exist. China-U.S. trade conflict is just a small part of the extensive strategic competition between China and the United States. In addition to Trump's tariff threats, the United States has formed a "strategic suppression" against China, which ranges from technology to investment, from the real economy to financials, from the geo-economics to geopolitics and from personnel exchanges to wide fields such as education. The formation of this pattern, as we pointed out a year ago, is due to the U.S. undertaking a strategic adjustment to China. China is deemed to be the "long-term strategic competitor" to the U.S. Given this, a long-term competition between China and the United States will be inevitable.

In the short term however, the depreciation of the RMB exchange rate is not without its pros and cons. On one hand, it can be seen as China's counterattack to the trade problems. The depreciation of the RMB will be conducive to China's exports, which will "hedge" the effect of the U.S.' tariff hikes on Chinese goods. This is something that Trump does not want to happen. On the other hand, the loss caused by the devaluation of the RMB exchange rate is also relatively large. In addition to the devaluation of RMB assets and the aggravation of capital flight, the devaluation is particularly unfavorable to the Belt and Road Initiative (BRI) investments. In general, a moderate devaluation is a suitable approach for now, with the pros slightly outweighing the cons. However, in the medium and long term, we should be alert to the continuous depreciation of the RMB exchange rate as well as the knock-on effect caused by the sharp depreciation of the exchange rate.

Final Analysis Conclusion:
The biggest challenge China would face under the external pressure from the United States is the issue of the RMB exchange rate. As such, it is necessary to be prepared in keeping the RMB exchange rate stable in the future.

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