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Not Just Trade : Interest Rates Are Also Dragging China's Yuan Down

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08/08/2018 | 03:03am EDT

By Saumya Vaishampayan

Asian stocks mostly rose Wednesday, with the 0.9% gain in Taiwan's Taiex standing out as one of the region's biggest advances. Major indexes in mainland China, however, pulled back after a big rally. The Shanghai Composite fell 0.3% following its largest one-day percentage gain in more than two years Tuesday.

Wednesday's Big Theme

It's hard to separate the yuan's swoon from the trade tiff between the U.S. and China. But a narrowing interest-rate gap between the two is also crucial.

What's Happening

Beijing is eager to cushion its slowing economy from any pain caused by U.S. tariffs. Trade data released Wednesday showed China's trade surplus narrowed in July, as exports grew more slowly than imports, an early warning of potential trouble ahead.

As part of the official response, the People's Bank of China has ensured lenders are flush with funds. The cost for Chinese banks to borrow from each other in the short-term money markets has dropped as a result. The three-month Shanghai interbank offered rate, which helps determine interest rates on everything from corporate loans to mortgages, hit 2.84% Wednesday, its lowest since late 2016. That rate was 4.91% at the end of December.

The opposite is happening in the U.S. There, interbank borrowing costs have risen this year as the Federal Reserve continues to lift official interest rates. The three-month London interbank offered rate for borrowing in dollars stood at 2.34% Monday, up from 1.69% at the end of last year.

Analysts say the rapidly narrowing gap between Chinese and U.S. rates is pressuring the yuan. The Chinese currency fetched 6.8229 per dollar Wednesday, having fallen 6.8% in three months. That decline could have been even worse if the central bank hadn't used foreign-exchange swaps to manage expectations about where the currency was headed.

Market Reaction

Finding a culprit for the yuan's decline matters: if the blame lies mainly with converging interest rates, then China and other developing countries might be less at risk of destabilizing capital flight driven by fear of a hard landing.

"If trade tensions are merely exacerbating currency weakness caused by narrowing rate differentials, and there is no sign of panic, then we can potentially avoid a significant spillover to broader [emerging markets], " analysts at Standard Chartered led by Eric Robertsen wrote recently, adding that they see evidence to suggest that's the case.

However, in this case even if the U.S. and China eventually play nice on trade, pressure on the yuan could persist, unless tighter policy brings borrowing costs back up. If there's no interest-rate advantage to be gained by holding the yuan, investors may dump it.

Elsewhere

The world's largest initial public offering in two years had a lackluster debut. Shares in China Tower, which owns almost all of the country's cellphone masts, rose just 1.6% from their IPO price of 1.26 Hong Kong dollars per a share. The company had raised $6.9 billion in the deal, which was priced at the low end of the range, indicating tepid investor interest.

Write to Saumya Vaishampayan at saumya.vaishampayan@wsj.com

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