The trade war's getting bloody... and the key battle could be on foreign exchanges

ref: - " Xi lays the groundwork for all-out trade conflict with the US" Tom Mitchell in the Financial Times, Global Insight

" Renminbi volumes surge as investors square off with China's central bank", The Financial Times, Markets and Investing

So where are we with all this? The US' assault on Huawei, with all its enormous ramifications, would seem to put the mockers on the idea that the recent upsurge in tension between Washington and Beijing is likely to be just a short-term thing, just part of the belligerent "negotiating process” long favoured by President Trump. If such tactics were likely to see immediate results, we probably wouldn't have China's ambassador to the EU calling US actions "bullying and blackmail". Neither would we be likely to see the Chinese authorities rolling out vintage footage of the Korean War (1950 -53) when China's vastly superior numbers and willingness to sustain losses fought a score-draw against (mostly) US forces that were technologically far better equipped but less accepting of long casualty lists.

Thankfully, this time around we are only talking about a trade war rather than the real thing. The costs will be measured in economic terms rather than in lives, but at one level the comparison is worth noting. Forget for a moment whether or not you believe that President Trump has valid reasons to take the current course of action or that President XI Jinping has reneged on undertakings that he has given in the past. The fact is that by drawing on a huge residual well of resentment against foreign powers perceived to have abused China over centuries, XI has the support of the Chinese people if things get nasty. China may be more pragmatic than was once the case, but she doesn't like being dictated to and many Chinese would subscribe to the view that "the Chinese people can endure more pain than the spoiled and hubristic Americans". Sound familiar?

Which all means that although many observers might feel that China, with its massive trade surplus with the US, has the more to lose, it doesn't necessarily follow that Beijing will accede to the US demands. The prospect of a quick end to a spat between trading partners, always over-optimistic, is now looking ever more remote.

In these circumstances it's no surprise to read that trading volumes in the Chinese currency -- the Yuan, or the Renminbi, or even the Yuan Renminbi -- have more than doubled their recent average in the first part of May. We've talked many times about how the level of the Yuan is both a source of Pres. Trump's anger (he thinks Beijing is still deliberately fostering weakness in the Yuan to gain an unfair advantage for their exports), and how it could again become a weapon in the future for the Chinese if we get to a "no-holds-barred" conflict between the two superpowers.

CNY 7.00 versus the US Dollar is a key level that hasn't been breached for over 10 years, and with the Yuan having weakened from USD/CNY 6.70 to above 6.90 in little over a month we are fast approaching what some see as the make-or-break point. Some say that a slowing Chinese economy merits an upward breakthrough USD/CNY 7.00, but on balance it seems that a small majority reckon that Beijing will act in foreign exchange markets to defend that level. The fact the Beijing has been choosing the daily USD/CNY fix at a lower (i.e. stronger) rate to that of the offshore Yuan where it has less direct control suggests that they have not been keen to encourage a weaker currency.

We've often pointed out that to let the Yuan weaken may theoretically aid the competitiveness of Chinese exports but has more disadvantages than benefits. It would of course anger Mr Trump and make successful negotiations less likely, but more to the point it would most likely provoke huge capital outflows from China and a loss of confidence as a result. That's something China doesn't want or need... not one bit.

And if they are going defend the Yuan, they have enormous resources in terms of reserves with which to do it... this is not poor old Argentina scratching around trying to borrow the money to defend the Peso. So, we're approaching crunch-time, and it's not surprising that trading volumes reflect that. Is a break of the psychologically and technically crucial USD/CNY 7.00 on the cards, signalling sharp moves higher, or will the Bank of China wade in with the big stick? The FT quotes Gregory Perdon of Arbuthnot Latham:

"Speculators have been trying to fight the Chinese government for decades, but we'd rather be on the side of the 800lb gorilla than against it."

On this occasion, we assume that being likened to a big gorilla is a compliment...