How the euro could become collateral damage in the US-China trade war as the yuan comes into focus

Neal Kimberley says if China accedes to US pressure to strengthen the yuan against the dollar, it would also result in a rise in the yuan’s value vis-à-vis the euro. This would be unpalatable to Chinese exporters and a blow for the euro zone

PUBLISHED : Tuesday, 29 January, 2019, 4:00pm
UPDATED : Tuesday, 29 January, 2019, 10:20pm

A slower pace of economic expansion in China is one of the drivers of dimmer prospects for the euro-zone economy. Not China’s problem? Maybe not, but if the euro comes under sustained pressure in the currency markets, it will complicate Beijing’s efforts to keep the yuan stable. 

With China already embroiled in trade negotiations with the United States that include discussions about the value of the yuan, Beijing might rationally conclude some degree of yuan strength will be needed to assuage US concerns. If so, an accompanying appreciation of the yuan versus the euro would be unhelpful, leaving China’s exporters with a loss of competitive advantage on two major fronts at the same time.

“The risks surrounding the euro area growth outlook have moved to the downside on account of the persistence of uncertainties,” European Central Bank President Mario Draghi said on Thursday. That day, the currency market pushed the euro down to its lowest level versus the US dollar since December 14.

It remains to be seen whether euro weakness will re-emerge as a dominant currency market theme or whether the post-ECB price action was just a fleeting market reaction.

But no one should be in any doubt that the outlook for the euro-zone economy has dimmed and that part of the problem lies in the fact that a slowing China may have less appetite than before for euro-zone goods – and most notably German ones.

Although the euro zone is comprised of many nations, its economic powerhouse is Germany and a material part of Germany’s success emanates from the country’s ability to sell its goods abroad.

Germany’s DIHK Chambers of Industry and Commerce, has estimated that some 900,000 jobs in the country depend on exports to China.

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So it matters when data from China’s General Administration of Customs, as reported by Bloomberg, indicates that December saw imports from Germany fall 15.6 per cent on an annual basis.

Indeed, slower Chinese demand for German goods last year goes some way towards explaining why the German economy only expanded by 1.5 per cent in 2018, its lowest pace of growth for five years, with consequent implications for the euro zone which the German economy dominates.

As for the European Union itself, Stephen Li Jen and Joana Freire of London-based Eurizon SLJ Capital argued on January 21 that, over the past decade, China has come to exert much more of an economic influence on the EU than China has on the United States or the rest of the world.

“The sharp slowdown in European Purchasing Managers’ Indices starting early-2018, and the relative resilience of US data throughout much of the year, are in line with this thesis,” Jen and Freire argue, concluding that “the idea that Europe is much more exposed to China than the [United States] is one of the factors that we think could weigh on the [euro-zone] economy and on the euro in the near term.”

If the currency market embraces that logic, then the euro would come under pressure and, because the driver would be specific euro weakness rather than other currency strength, it would probably result in a more general euro depreciation, including versus the yuan.

As the daily mechanism for setting a value for the yuan aims to maintain its stability against a basket of 24 other currencies, ensuring stability in the face of euro weakness versus the yuan would necessitate some degree of compensatory yuan depreciation against other basket constituents, even if China tried to avoid euro depreciation.

While there might be 24 currencies in the yuan basket, the constituent weightings lean towards the US dollar and the euro. The greenback constitutes 22.4 per cent and the euro 16.34 per cent.

So if the euro was to come under sustained pressure in the currency markets resulting in a lower euro-yuan exchange rate, keeping the basket stable might well require some degree of accompanying yuan weakness against the US dollar.

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That wouldn’t play well with the Trump administration which still has issues around the yuan’s value. Indeed, last week, US Treasury Secretary Steven Mnuchin said that currency will come up when China’s Vice-Premier Liu He visits Washington this week.

A degree of yuan strength versus the greenback might be a price Beijing deems worth paying to help resolve the China-US trade war. But China might also find it becomes saddled with a lower euro-yuan exchange rate.

Faltering euro-zone economic prospects could well complicate Beijing’s efforts to maintain yuan stability.

Neal Kimberley is a commentator on macroeconomics and financial markets