As the “Trump trade” returns – again – fueling concerns of new geopolitical turmoil, hedge funds worldwide are scrambling to short the Chinese yuan. They are betting that Trump’s tax and trade policies, if elected, will strengthen the dollar, with China seeking a more competitive exchange rate as domestic growth slows.
But if the last few years of the Xi Jinping era are any guide, betting on a weaker yuan could turn out to be a big blunder. Clearly, the US election is full of surprises. One day the polls show that Kamala Harris’s Democrats will prevail and the next day Intel emerges telegraphing that Trump is coming to the White House again.
This week, the Republican wave appears stronger, prompting many hedge funds to bet on a weaker yuan in the $300 billion foreign exchange market. And the truth is that yuan volatility is now at its highest level since late 2022.
However, expectations that Trump could favor a stronger dollar appear to ignore his 2017-2021 term. Trump was – and probably still is – adamantly in favor of a weaker US exchange rate to benefit American manufacturers and to…punish China.
It is also worth remembering Trump’s attack on the US Federal Reserve for the cycle of monetary tightening it opened, strengthening the dollar. The American candidate almost had a stroke when the Fed chairman, Jerome Powell, continued the policy of rate hikes of his predecessor Janet Yellen. In this context it is worth saying that, in addition to the degraded credibility of the Fed, the American national debt has skyrocketed under Trump and the current President Joe Biden, so that it now exceeds 35 trillion dollars.
Add to the above the risk of political polarization between now and January 20, 2025, when the next government officially takes office.
Also, even if Trump loses, no one believes he will lay down his arms quietly.
After all, the aftermath of January 6, 2021, when thousands of Trump supporters stormed the Capitol, was one of the reasons why Fitch Ratings stripped the US of its AAA rating… Standand & Poor’s followed suit. The question now is what Moody’s Investors Service, which is the last of the “big three sisters” to rate America AAA, will do.
China
There are at least four reasons why Beijing is unlikely to allow the yuan to sink:
1. A fall in the yuan could make it harder for heavily indebted companies such as property developers to make payments on offshore debt. That would raise default risks in Asia’s biggest economy. Seeing #ChinaEvergrande rise again in cyberspace is the last thing Xi wants.
2. The monetary easing needed to sustain the yuan’s decline—especially with the Fed cutting interest rates as well—could hurt Xi’s deleveraging efforts. In recent years, his inner circle has made great strides in eliminating financial excesses. That explains why Xi and Premier Li Qiang have been reluctant to allow the People’s Bank of China (PBOC) to cut interest rates more strongly even as deflationary pressures dog China Inc.
3. Increasing the use of the yuan globally is arguably Xi’s biggest achievement since 2012. In 2016, China won a place for the yuan in the International Monetary Fund’s “special drawing rights” basket, joining the dollar, the yen , the euro and the pound. Since then, the currency’s use in commerce and finance has soared. Now, too much easing may erode confidence in the yuan, slowing its progress toward becoming a reserve currency.
4. It could make China a bigger and more contentious issue during a uniquely bitter US election. The only thing Republicans and Democrats agree on is that they need to get tough on Beijing.
“Currency Manipulation”
Tariffs aside, “currency manipulation” may be the first red flag for the Asian economy. Notably, a weaker yuan would send a signal of panic and desperation. And that’s not the kind of headlines Xi wants global investors thinking about as 2025 approaches.
Instead, Xi and Li have boosted the economy by injecting liquidity into the market without triggering episodes like the ones we had in 2015 or 2008. Earlier this month, Beijing cut borrowing costs, bank reserve requirements and interest rates of mortgages, and introduced market support tools to floor stock prices.
Bolder fiscal stimulus steps are also being considered. On Thursday (Oct 17), Xi’s team raised the loan quota for unfinished housing projects to 4 trillion yuan ($562 billion). The blow was less than what markets wanted, as evidenced by Chinese stocks falling into “correction” territory this week.
The CSI 300 ended Tuesday down 1.1%, down 11% from its October 8 high. The biggest issue, of course, is the restoration of the developers’ balance sheets.
In recent years, the Xi team has pledged to devise a mechanism to remove toxic assets from developers’ balance sheets. Beijing has indeed proven that it knows what it takes to turn things around:
- a bold strategy to strengthen developers’ finances,
- providing incentives for mergers and acquisitions;
- improving capital markets so that consumers stop seeing real estate as their only investment option
- creating social safety nets so that households spend more and save less.
The hedge funds
Indeed, in recent decades there have been many crises from which we can draw lessons. These include:
- Japan’s efforts in the early 2000s to take toxic loans off banks’ balance sheets and
- the Troubled Asset Relief Program, or TARP, used by the US to deal with troubled assets after 2008.
More fundamentally, Xi’s reform team must
- intensify efforts to recalibrate the drivers of growth away from exports towards innovation and highly specialized industries.
- It needs to reassure investors that the draconian crackdown on tech companies from 2020 is over.
- China must also abandon its aversion to the basic financial transparency demanded by global capital.
But as Xi and Li understand, a weaker yuan won’t bring about any of these major reforms. They may buy some time to meet this year’s growth target of 5%, but at a higher cost than China’s top leaders seem willing to accept.
Back in the US, there are myriad other reasons to believe the dollar’s outlook will contain more red ink than black.
- The US national debt is now twice the annual gross domestic product of China.
- So are the chances that Trump, in the event of a second term, dusts off some of the economic tricks he came up with during his first – only to be stopped by financial advisers.
- One of them was the cancellation of parts of debt to Beijing, in retaliation for China’s trade policy.
- At the time, Moody’s Analytics economist Mark Zandi spoke of “complete madness” that “could unleash a financial Armageddon.”
- In his first term, Trump considered a devaluation of the dollar against the yuan.
- However, rather than America first, such a decision could benefit China more in the long run.
- If devaluation were a strategy for prosperity, Turkey and Zimbabwe would be global superpowers.
In any case, if the US attempts this game, it will exacerbate inflationary pressures by jeopardizing the dollar’s status as a reserve currency – to China’s advantage.
The chances of Xi doing so are very low. Beyond the Communist Party’s aversion to being pressured, China remembers how when Japan accepted a stronger yen it crippled its economy for a few decades. Even so, hedge funds betting on a weaker yuan in the coming months may be missing the big picture of the Xi era.
