Don't rule out a yuan devaluation despite Xi's overtures

DON'T relax yet: A potential yuan devaluation is still very much on the table. Currency traders sighed with relief on Tuesday after Chinese President Xi Jinping moved to ease trade tensions with the US, reiterating pledges to open the country's economy further and cautioning against a cold-war mentality and zero-sum thinking. The yuan had weakened for the four previous days, with jitters exacerbated by a Bloomberg News report on Monday afternoon that China is studying the potential impact of a gradual depreciation. It climbed 0.3 per cent as at mid-afternoon Tuesday.

Look carefully at Mr Xi's speech, though: He didn't weigh in on currency policy at all. That indicates that the yuan remains a powerful tool for China to deter unwanted actions by not only US President Donald Trump but also, perhaps, his Federal Reserve chairman Jerome Powell.

While Mr Xi took the moral high ground in his keynote address to the Boao Forum in Hainan, China needs to retain ammunition to match any escalation in the trade war. Beijing has already retaliated with higher tariffs on goods from soybeans to aircraft, meaning it's running out of US goods imports to target.

In addition, those punitive measures come at a cost to China's own economy. For instance, the soybean tariff could raise the local inflation rate by as much as 0.5 per cent, estimates HSBC Holdings Plc. That potentially could force the People's Bank of China to raise interest rates earlier than planned.

Hence, Beijing may have put the yuan into play as another deterrent.

One can't blame China for feeling defensive. The yuan has appreciated more than other major currencies on a real effective exchange rate basis since 2010, according to data from the Bank for International Settlements. Beijing could easily point a finger at Japan, charging that the value of the yen is artificially suppressed. The yen and euro, which has also depreciated, account for about 30 per cent of the basket that China uses as its reference in managing the currency, so authorities may have some reason to regard the yuan as overvalued.

In this light, would a cheaper Chinese currency really be such a bad idea? The 2015 devaluation may have triggered capital outflows and a stock-market tumble, but it also slowed the pace of the Fed's rate increases.

Recall the Fed's September 2015 meeting, where it was considering its first hike in almost a decade. In the event, former chairwoman Janet Yellen left rates unchanged, citing "recent global economic and financial developments". Market turmoil could put further downward pressure on inflation, making a rates move less urgent, Ms Yellen had said. The S&P 500 Index has rallied 38 per cent since.

Fast-forward to 2018. So far, Mr Powell hasn't offered stock investors much protection, sticking to his view that the Fed should continue gradually raising rates as long as the economy continues on its path towards 2 per cent inflation, even as the US Treasury yield curve threatens to invert.

Inflation is likely to keep ticking higher if Mr Trump does indeed slap tariffs on imports from China - unless its trading partner responds with a cheaper currency.

This could be the PBOC's signal to the Fed to slow down. BLOOMBERG GADFLY