Chinas New Currency Regime
The base unit for the renminbi is the yuan, which is how the
Chinese currency is most commonly referred to. The official ISO
abbreviation for the yuan is CNY, but it is also commonly
abbreviated in the forex industry as RMB.
The yuan had been pegged at 8.28 to the dollar since 1994.
While China has been openly discussing scrapping the dollar peg
for several years, many traders weren't expecting a move until
later in the year.
The PBC declared that the new regime would be a managed
floating exchange rate based on supply and demand in relation to
a basket of currencies comprised of the U.S. dollar, euro, yen
and the Korean won. The yuan s central rate against the dollar
was then adjusted by just over 2% to 8.11. Keep in mind that the
RMB exchange rate is quoted in dollar terms, in other words, the
dollar is the base rate of this currency pair. A 2% positive
revaluing of the RMB results in a 2% decline in the dollar rate
versus the Chinese currency.
According to the PBC, the RMB will now be allowed to fluctuate
up to 0.3% on any given trading day with the daily closing price
then serving as the midpoint of the next day's trading range.
That could mean as much as a 6% move in either direction in a
month. However, the PBC is very unlikely to allow for that kind
of movement and has in fact already intervened in the forex
market to prevent the yuan from straying too far from 8.11. With
over US$700 billion in currency reserves they certainly have the
power to enforce their wishes and it's doubtful that forex
speculators will be willing to test the resolve of the PBC in any
meaningful way any time soon.
While the floating of the yuan, albeit tightly controlled, is
a significant policy shift, the initial revaluing of the RMB is
seen as largely symbolic. Chinese president Hu Jintao visits
Washington in September and the modest revaluation may have
succeeded in heading off a face to face showdown on China's
exchange rate policy. Critics contend that the yuan is
undervalued by more than 20%, affording China an unfair trade
advantage. U.S. manufacturers have demanded as much as a 40%
revaluation. A more significant move than 2% is needed to truly
affect the massive trade imbalance between China and the U.S., so
there will undoubtedly be calls for further RMB appreciation.
So where might the renminbi be headed longer term? One year
non-deliverable forward contracts in Singapore rose to RMB 7.64
before edging higher again, suggesting scope for an additional 6%
of RMB gains over the next twelve months. More aggressive
projections suggest potential for 7% appreciation by year end and
up to 15% gains by the end of 2006. However, traders can be
assured that any such projections will only be achieved if the
PBC will allow it.
Given the tight constraints of the new renminbi regime it is
unlikely that CFS clients will see any RMB trades in their
accounts any time soon. First of all it will take several months
of operation to allow traders to get a handle on how the new
managed float will operate. There's just very little transparency
at this point.
While there may not be any trading opportunities in the RMB
any time soon, China's move has created opportunities elsewhere.
Other Asian currencies such as the Japanese yen rebounded on the
news, but quickly retraced when it became apparent that the RMB
wasn't really going anywhere. The yen is likely to remain under
pressure as the dust settles, although near term losses may be a
little more tentative while focus remains on China.
The biggest reaction to the policy shift by China, and likely
the most sustainable, was seen in the U.S. treasury market where
yields shot higher. The new exchange regime suggests that China
is likely to be a less reliable buyer of U.S. treasuries as well
as the dollar. Higher treasury yields will net higher mortgage
rates which may prick the U.S. housing bubble, dampening home
sales and the consumer spending commonly associated with the
purchase of a home.
Higher corporate lending rates are likely to negatively impact
stock prices and the broader U.S. economy. Ultimately we could
see a resumption of the long term downtrend in the dollar. While
this assessment may seem bleak in a broad sense, this is exactly
why alternative investments, such as the Managed FX products of
CFS, are an integral part of a diversified portfolio.
The burning question now becomes: are we better off having
forced China's hand on their currency policy? I don't think
there's any question that the ideal is a free floating and open
exchange rate, where market forces set the price and government
intervention is limited. However, the pains associated with the
aforementioned scenarios may be greater in the near term than any
competitive advantage the U.S. might gain as a result of higher
Peter Grant has spent the majority of his career involved in
the global foreign exchange (FX) market. He is the Vice President
of Operations for CFS Capital Management http://www.cfscap.com and may be
reached at email@example.com or by calling
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