Now is not the time to shorten the yuan

As the “Trump trade” returns and fears of geopolitical unrest rise again, global hedge funds are looking to short the Chinese yuan currency.

They are betting that Trump’s planned mix of tax and trade policies will push the dollar higher if elected and that China could seek a more competitive exchange rate as domestic growth slows.

But if the final years of the Xi Jinping era are anything to go by, betting on a weaker yuan could be quite a mistake.

Let’s start with the Trump calculation. Obviously, the US election on November 5th was a real bad decision. Polls suggest Kamala Harris’s Democrats will one day prevail. Next, information emerges that Trump 2.0 is coming to the White House.

This week the momentum seems to be on Trump’s side. That’s prompting hedge funds to increase their bets on a weaker yuan in the $300 billion currency options market. Yuan volatility is now at its highest level since late 2022.

But expectations that Trump might embrace a stronger dollar appear to be forgetting his 2017-2021 term. Trump strongly advocated a weaker U.S. exchange rate to benefit American manufacturers and punish China.

It is also worth remembering Trump’s attack on the Federal Reserve. Trump was appalled that his elected Fed Chair, Jerome Powell, continued his predecessor Janet Yellen’s rate hikes. He then pushed Powell to cut interest rates and added stimulus in 2019 that the economy didn’t need.

In addition to the Fed’s weakened credibility, U.S. national debt has skyrocketed under Trump and current President Joe Biden and now exceeds $35 trillion.

There is also the risk of political polarization between now and January 20, 2025, when the next government officially takes office. Even if Trump loses, no serious expert believes he will quietly disappear.

The fallout from the Trump-incited insurrection on January 6, 2021 was one of the reasons Fitch Ratings revoked its AAA rating on U.S. debt and joined Standard & Poor’s. The question now lies with Moody’s Investors Service, the last rating company to give America a AAA rating.

But the Beijing part of this puzzle is more important. There are at least four reasons why Beijing probably wouldn’t allow the yuan to fall too much.

First, a falling yuan could make it harder for heavily indebted companies like real estate developers to make payments on offshore debt. That would increase the risk of default in Asia’s largest economy. Seeing #ChinaEvergrande trending again in cyberspace is the last thing Xi wants.

Second, the easing of monetary policy needed to sustain the yuan’s decline – especially given the Fed’s interest rate cuts – could harm Xi’s deleveraging efforts. In recent years, Xi’s inner circle has made great strides in eliminating financial excesses.

This explains why Xi and Premier Li Qiang were hesitant to allow the People’s Bank of China (PBOC) to cut interest rates more decisively, even as China Inc. was hit by deflationary pressures.

Third, expanding the yuan’s global use is arguably Xi’s biggest economic reform achievement since 2012. In 2016, China gained a spot for the yuan in the International Monetary Fund’s basket of “special drawing rights” alongside the dollar, yen, euro and pound.

Since then, the use of the currency in commerce and finance has increased significantly. Excessive easing now could weaken confidence in the yuan and slow its progress toward reserve currency status.

Fourth, it could make China a larger and more contentious issue during a particularly bitter U.S. election. Trump’s Republicans and Harris-loyal Democrats agree on one thing: They must take tough action against Beijing.

Evidence that China is manipulating the yuan downward could spark bipartisan scorn in Washington. Especially in the Trump camp, which is already announcing 60% tariffs on all goods made in China.

“Along with tariffs, the label ‘currency manipulator’ could be an early warning sign for an Asian economy,” said Robert Carnell, head of Asia research at ING Bank.

If Xi gave the green light to a weaker yuan, it would be a sign of panic and desperation. Not the kind of headlines Xi wants global investors to ponder as 2025 approaches.

Instead, Xi and Li have tightened stimulus without triggering echoes of 2015, 2008 and other previous episodes of massive growth-boosting “bazooka” attacks.

Earlier this month, Beijing cut borrowing costs, lowered banks’ reserve requirements, lowered mortgage rates and unveiled market support tools to cap stock prices. Bolder economic stimulus measures are also being considered.

On Thursday (October 17), Team Xi increased the loan quota for unfinished housing projects to 4 trillion yuan ($562 billion), almost double the previous amount.

The rise was less than markets wanted, as evidenced by Chinese stocks falling into “correctional territory” this week. The CSI 300 index ended Tuesday down 1.1%, bringing its decline from an Oct. 8 high to about 11%.

The bigger problem, of course, is cleaning up the balance sheets of giant real estate developers.

“They’re still trying to talk the talk, with more noise about stabilizing the property market,” said Stephen Innes, an economist at SPI Asset Management.

As housing construction progressed on Thursday, “it was clear: the dealers were not enthusiastic,” said Innes. “But let’s be honest: China’s real estate chaos cannot be solved with a few speeches and half-baked measures.”

The economist Robin

In recent years, Team Xi has repeatedly promised to develop a mechanism to remove toxic assets from real estate developers’ balance sheets.

Beijing has indeed shown what is needed to change things: a bold strategy to bolster the finances of high-quality developers; incentivize mergers and acquisitions; Improving capital markets so consumers no longer view real estate as their only investment opportunity; and creating social safety nets so households spend more and save less.

In fact, there have been numerous crises in recent decades from which we can learn. These include Japan’s efforts in the early 2000s to remove toxic loans from banks’ balance sheets and the Troubled Asset Relief Program (TARP), which helped the United States struggle with troubled assets after 2008.

More fundamentally, Xi’s reform team needs to step up efforts to reorient the engines of growth away from exports and toward innovation and highly niche industries.

It needs to reassure investors that the draconian crackdown on tech companies since 2020 is over. China must also abandon its aversion to the basic economic transparency that global funds demand.

But as Xi and Li know, a weaker Yuan will not bring about any of these major reforms. It could buy China some time to reach this year’s 5% growth target, but at a higher cost than Chinese leaders appear willing to accept.

Back in the US, there are countless other reasons to believe that the dollar’s outlook will contain more red ink than black.

The fact that US national debt is now twice as high as China’s annual gross domestic product is a cause for concern. But there’s also a reasonable chance that in a second term, Trump could pull off some of the financial stunts he considered in the first – only to be stopped by economic advisers.

One was that Trump was considering canceling some of the debt the U.S. owed Beijing to punish Xi’s economy in the wake of trade negotiations. Such considerations did not come out of the blue.

In May 2016, six months before his first election, Trump, a frequent bankruptcy offender as a businessman, expressed his abandonment of US debt in a CNBC interview.

“I would borrow because I knew you could make a deal if the economy collapsed,” Trump said. “And when the economy was good, it was good. That’s why you can’t lose.”

Mark Zandi, an economist at Moody’s Analytics, spoke for many when he called the idea of ​​a U.S. debt waiver “utter madness” that would be “financial Armageddon.”

Trump 1.0 considered a dollar-to-yuan devaluation like Argentina or Vietnam might use. In April, for example, Politico reported that Trump 2.0’s inner circle was “actively debating an Argentina-like turnaround” at the behest of advisers like Robert Lighthizer, Trump’s former international trade representative.

But instead of “America first,” such a detour could be more to China’s advantage in the longer term. If devaluation were a strategy for prosperity, Buenos Aires would operate a Group of Seven economy. Turkey and Zimbabwe would boom. Indonesia would compete with China as Asia’s largest economy.

If the US were to attempt this move, it would increase inflationary pressures and jeopardize the dollar’s status as a reserve currency – to China’s advantage.

“While Trump and his team have loudly called for a weaker U.S. dollar to boost the competitiveness of U.S. manufacturing, investors generally believe that the measures they advocated to promote U.S. reindustrialization—high tariffs on goods imports— Other currencies will tend to lead to US dollar strength,” Gavekal analysts wrote in a note.

However, they added that “the likely consequences of this discrepancy include a potential conflict between the White House and the Fed and a diplomatic push to weaken the US dollar, possibly involving a new version of the 1985 Plaza Accord.”

Attempting such a move in 2024 would be extraordinarily destabilizing. The chances that Xi would choose to do so are very slim. Aside from the Communist Party’s reluctance to be pushed around, China remembers how Japan’s acceptance of a stronger yen devastated its economy for decades.

Still, hedge funds betting on a weaker yuan in the coming months may be missing the bigger picture of the Xi era.

Follow William Pesek on X at @WilliamPesek