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Beijing May Question Yuan Peg As Fed Prepares For Liftoff

By Sober LookMarket OverviewAug 06, 2015 05:00AM ET
www.investing.com/analysis/beijing-may-question-the-yuan-peg-as-the-fed-prepares-for-liftoff-260721
Beijing May Question Yuan Peg As Fed Prepares For Liftoff
By Sober Look   |  Aug 06, 2015 05:00AM ET
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Yesterday's ISM non-manufacturing report showed US services sector expansion considerably stronger than economists had anticipated. The strength of the services sector expansion however has diverged materially from what we see in US manufacturing.

ISM PMI MFG. vs Non-MFG 2008-2015
ISM PMI MFG. vs Non-MFG 2008-2015
Source: St. Louis Fed, ISM

The reason for the divergence is the strength of the US dollar, which on a trade-weighted basis is at the highest level in over a decade.

Trade Weighted USD 2003-2015
Trade Weighted USD 2003-2015
Source: St. Louis Fed

The strengthening US currency has generated a significant drag on growth in the manufacturing sector. We've all read the headlines:

USD Headline/CNBC
USD Headline/CNBC

But haven't we seen this divergence between the services and the manufacturing sectors elsewhere? Indeed, on Tuesday Markit published a similar chart for China.

Caixin China PMI Output Services vs MFG vs Composite: 2006-2015
Caixin China PMI Output Services vs MFG vs Composite: 2006-2015
Source: Markit

This of course is more than a coincidence. China's currency tie to the US dollar resulted in a similar dynamic of manufacturing sector significantly underperforming. Unlike the US however, China's manufacturing is more sensitive to exports, making the slowdown far more pronounced and resulting in an outright contraction (PMI below 50 in the chart above).

In recent months the yuan has been firmly pegged to the dollar. There are a number of reasons for this linkage, including China's wish to make the yuan part of the so-called Special Drawing Rights (SDRs), a basket of currencies constructed by the IMF and held by various central banks. Beijing reasoned that the yuan's stability would help them with that cause.

USD/CNY 2014-2015
USD/CNY 2014-2015
Source: barchart

However, on Tuesday we got this headline:

IMF SDR Headline
IMF SDR Headline
Source: Reuters

Time to give up the peg? There are of course other reasons China may want to maintain the link to the dollar - one of them is to continue "rebalancing" the economy.

China: MFG/Construction vs Services as % of GDP 2000-2015
China: MFG/Construction vs Services as % of GDP 2000-2015
Source: MRB

This policy however could prove to be too costly, as competitors whose currencies have been devalued may take market share from China. Here is how the yuan has appreciated against the Mexican peso for example (chart below). With margins tightening in a number of industries, when a manufacturer decides where to build a factory, Mexico (and a number of other countries) may now be a cheaper solution.

CNY/MXN 2010-2015
CNY/MXN 2010-2015

It's unclear if China will ultimately let the peg go or if the yuan will continue tagging along with the US dollar. Will China want to wait until the 2016 IMF decision on the SDR inclusion? With the Fed getting ready for "liftoff" in September, while most central banks are easing the dollar could continue marching higher.

This could slow China's economic growth materially below the current ("reported") 7% per year. In effect the tightening of monetary conditions in the US will be transmitted to China via the peg. If the dollar indeed moves higher as US rates rise, will Beijing finally run out of patience?

Beijing May Question Yuan Peg As Fed Prepares For Liftoff
 

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Beijing May Question Yuan Peg As Fed Prepares For Liftoff

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Comments (1)
Brad Smith
Brad Smith Aug 07, 2015 12:17PM ET
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"This could slow China's economic growth materially below the current ("reported") 7% per year.". . If only we could even get remotely close to growth levels of that nature. I have a feeling Beijing will be patient for a while longer regardless if the dollar moves up. They can afford to wait.
 
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