China: Mapping potential tariff adjustments into RMB movements

■     With inflation running high in the US, rolling back some of the tariffs imposed by former President Trump on Chinese imports has been suggested as a way to cool inflation on the margin. Recent comments from senior US officials had suggested that some further reductions were under consideration, though a remark overnight by the US Trade Representative suggested this was unlikely in the very near term. Our baseline is no major tariff reductions, but we examine the potential implications for the renminbi in a scenario analysis in this note.

■     Our previous research finds that CNY is sensitive to tariff-related news but does not seem to respond consistently to other types of geopolitical headlines. Intraday price movements on May 23 showed a similar pattern: President Biden’s comment on tariff reduction moved CNY notably while his comment regarding Taiwan did not.

■     Applying our sensitivity estimates based on prior trade war experience, we calculate that if the US were to remove tariffs on all consumer goods (which face lower tariff rates), but not intermediate and capital goods (which face higher tariff rates), CNY would appreciate 1.2% against USD. If all the Trump administration’s tariffs were to be lifted, an unlikely event in our view, CNY could appreciate 4.9%.

■     Overall, announcements of tariff relief, if any, are likely to lead to a stronger renminbi, with the precise magnitude depending on the scope of the tariff reduction. However, looking beyond the day of announcement, other drivers such as the direction of the broader USD and China’s growth outlook may be more important to the movements in CNY than tariffs. Additionally, the impact of partial tariff reductions on China’s real GDP growth is likely modest.

US inflation has been running at multi-decade highs, forcing the Federal Reserve to hike interest rates at a faster pace than previous cycles to slow demand and control inflation. In this context, partially removing or granting more exclusions for some of the tariffs imposed by former President Trump on Chinese imports during the 2018-19 trade war has been suggested as an additional policy tool to cool inflation (Exhibit 1). Most recently on June 5, US Commerce Secretary Gina Raimondo made a comment that the Biden administration is considering lifting some of the Trump administration’s tariffs on China to ease inflation. However, on June 7, the US Trade Representative Katherine Tai said tariffs cuts were taken off the table for the moment. Our baseline is no major tariff reductions, but we examine the potential implications for the renminbi in a scenario analysis in this note.

Rolling back tariffs on Chinese goods may reduce US inflation on the margin. Our US Economics team estimate that the Trump administration’s tariffs increased the core price level by 0.25% cumulatively (Exhibit 2). The actual impact on prices would be even smaller when considering partial tariff reductions. On the other hand, cutting tariffs may risk appearing “soft” on China ahead of the mid-term election. Therefore, we do not think major tariff reductions are likely, though some exclusions for consumer products is possible

We previously looked at how CNY reacted to various tariff news during the 2018-19 US-China trade war as well as other types of geopolitical headlines. Exhibit 3 shows that CNY consistently weakened against the USD in days after announcements of new tariffs on Chinese goods. In contrast, CNY did not seem to move in a systematic manner in response to other types of geopolitical news in recent years (Exhibit 4).

We observe a similar pattern more recently. On May 23 at a news conference in Japan, President Biden said that he was considering cutting tariffs on Chinese goods that were imposed by former President Trump. Exhibit 5 shows the minute-by-minute price movements of CNY during the news conference. CNY strengthened notably immediately after the tariff comment. In contrast, his remarks related to Taiwan at the same news conference, which got wide press coverage, did not seem to move CNY much. This implies that, even if the Biden administration launches additional trade investigations or tightens exports controls at the same time when it lifts some of the tariffs to keep a tough stance on China while incrementally alleviating domestic inflation, the CNY may still appreciate on net because of its asymmetric reactions to tariff vs. non-tariff news.

To quantify the extent of CNY strengthening, we leverage our Global Markets team’s previous research and conduct a scenario analysis. Analyzing the US-China trade war events in 2019, the study finds that CNY appreciates 0.7% for tariff increases that are equivalent to raising $10bn revenue (e.g., a 10% tariff on $100bn of imports). In Exhibit  6, we apply such estimates to different scenarios of tariff reductions. For example, if the consumer goods in List 3 and List 4A tranches were to be exempt from Trump administration’s tariffs, it would translate into $18bn less tariff revenue and lead to a 1.2% appreciation of CNY against the USD. This scenario is similar to the tariff  exclusions announced on March 23 which affected around 20% of US imports from China under US tariffs. Relative to our 3-month target of 6.75 under the baseline expectation of no major tariff reductions, USDCNY would be 6.67 in this scenario. In an extreme scenario where all tariffs imposed during the 2018-19 trade war were to be removed, USDCNY would decline 4.9% by our estimates. This is unlikely as Secretary Raimondo said to keep tariffs on steel and aluminum to protect US workers, but provides an upper bound to various scenarios.

Although our calculation suggests that CNY may strengthen noticeably on the day of a tariff relief announcement, we believe other drivers of CNY, including the direction of the broader USD and China’s growth outlook, outweigh tariffs if we look beyond the day of announcement. The economic implications of partial tariff reductions are also likely to be modest. In our previous research, we estimated that the total drag from the US-China trade war on China’s real GDP growth peaked at around 0.5pp in late 2019 through net trade, FCI, real income and trade policy uncertainty channels. Even if all of the Trump administration’s tariffs are lifted, the boost to China’s real GDP growth may be smaller than 0.5pp since some of the FCI and trade policy uncertainty impact may not fully reverse given continued US-China tensions on other fronts. Therefore, in the scenario US tariffs on another 20% or so of Chinese goods are lifted, the positive impulse to China’s real GDP growth could be less than 0.1pp. That said, short-term dynamics could be bigger. For example, exporters may delay shipments until tariffs reductions take effect, just like they frontloaded exports before tariff increases during the 2018-19 trade war.