FxWirePro: Petro-Yuan – A perspective from trade clash to FX clash

The launch of the petro-yuan in last week has been the talk of the FX streets now as it has the potential to boost CNY over the medium term: as it will add to the currency’s credentials as a viable reserve currency and comes at a time when the USD is facing considerable headwinds from widening twin deficits.

CNY internationalization is clearly under renewed focus, as the launch of the petro-yuan comes after it was announced that China bonds’ are scheduled to be included in a major IG crossover index. CNY’s share of global transactions and allocated FX reserves has ample room to grow from a low current base.

In this write-up, at first glance, the idea probably seems logical to many people. The news that China was looking into using a devaluation of the renminbi as a tool in case the trade conflict with the US was going to escalate, caused some movement on the markets for a brief moment yesterday.

As the import tariffs harm the Chinese export sector, CNY depreciation against USD to the same scope as the tariffs could make Chinese products competitive on the US market again. But things are not as simple as that. In fact, long-term China would suffer an even bigger welfare loss than would be the case as a result of the tariffs anyway. The import tariffs lead to a deterioration of China’s terms of trade.

China can buy fewer imports in return for its exports and thus suffers a welfare loss. Renminbi depreciation would cause China’s terms of trade to deteriorate even further as the weaker currency would make imports even more expensive. So as to reverse the terms of trade effect of the US tariffs currency appreciation against the USD would make more sense. Does that mean it is unlikely that China will use CNY depreciation? Not necessarily. The US tariffs have another disadvantage: they hurt the export sector and thus the Chinese economy. The Chinese leadership has to decide: to either counteract the short-term economic effect or the long-term welfare loss. It is probably fair to assume that growth stabilization might seem more important to it than the long-term welfare loss for the population.

The reasonable option premium can be collected from shorting EUR calls/CNH puts due to negative points carry on both the EUR-and CNH-legs, which offsets some of the disadvantages of depressed EURCNH vols relative to USDCNH vols in an elevated USD-correlation environment.

A potential pushback against shorting EURCNH calls is that a Euro surge of the kind seen in 3Q’17 could drag EURCNH higher even absent a USD revival; it is a fair critique, but one we judge is low probability at the moment since the unique initial conditions associated with that Euro move.

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