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 yuan.

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 pgrant@cfscap.com or by calling 303-940-7777.

Read the entire CFS Capital Newsletter 'The Alternative', at: http://www.cfscap.com/news.htm

Latest News

Currency Trading Market Conditions Remain Challenging: Breakout ... Daily FX, NY - 16 hours ago Sharp US Dollar gains have produced profits in several of our currency trading strategies on the week, and a continuation of US Dollar strength would make ... US Dollar Forecast to Rally Against Euro, British Pound, Fall ... Daily FX all 4 news articles

China Daily

Stocks drubbed at open CNNMoney.com - 16 hours ago US crude for January delivery tumbled $3.46 to $50.99 a barrel on the New York Mercantile Exchange. In currency trading, the dollar fell against the yen and ... Video: Stocks Drop Nearly 700 on Recession Confirmation AssociatedPress Stocks Look Ripe for Profit Taking; Manufacturing Survey Results ... Trading Markets (press release) all 1,154 news articles

Voice of America

Treasury’s Lead Role in China in Flux New York Times, United States - 3 hours ago Besides, some noted, China’s currency, by maintaining its peg to the dollar, has risen in relation to the currencies of other trading partners because the ... Yuan's Fall Watched Ahead of US-China Summit Wall Street Journal China hopes talks with US boost coordination The Associated Press Paulson Seeks to Broaden Access to China Wall Street Journal all 239 news articles

Maktoob

Yen Strengthens as Manufacturing Slump Weakens Yuan, Ruble Bloomberg - 17 hours ago Bank Rossii, which manages the currency against a basket of dollars and euros to mitigate the effect of currency swings, widened the ruble’s trading band to ... Dollar Rises as Global Manufacturing and Stock Markets Plunge International Business Times Down Is Dollar's December Direction Wall Street Journal Yen Extends Gains as Signs of Global Recession Sap Carry Trade Bloomberg Bloomberg - Bloomberg all 261 news articles

UK Pound Plunges, Gilts Rise as Data Add to Signs of Slump Bloomberg - 14 hours ago The British currency declined against all of its 16 major counterparts tracked by Bloomberg after property Web site Hometrack Ltd. said house values in ...

New York Times

Some Nations That Spurned the Euro Reconsider New York Times, United States - 2 hours ago After turmoil in the currency markets nearly destroyed the currencies of Iceland and Poland, the two countries are rethinking their opposition to the euro. ...

GLOBAL MARKETS-Grim economic outlook pummels stocks, oil slides guardian.co.uk, UK - 9 hours ago ... also lifting the dollar, so it's possible the dollar will get a bit of a bid out of this, but currency trading is going to be choppy," Reid added. ...

AU Preview: Q3 GDP Should be Bo... ForexTV.com, NY - 1 hour ago Forex (or FX or off-exchange foreign currency futures and options) trading involves substantial risk of loss and is not suitable for every investor. ...

Ruble Plunge Prompts Doubling of Reserve Spending, Survey Shows Bloomberg - 7 hours ago Bank Rossii buys and sells foreign currency to keep the ruble within a trading band against a basket comprised 55 percent of dollars and rest in euros. ... Russian Stocks, Ruble Drop as Production Falls More Than in ’98 Bloomberg all 9 news articles

Currency Trading Market Conditions Difficult to Forecast: Look for ... Daily FX, NY - Nov 24, 2008 Currency trading market conditions have been especially difficult to predict as of late, and strategy preferences for our forex trading signals are far from ...