China changes the ball game

“The journey of a thousand miles starts with a single step” – Mao Zedong

With a single stroke China has dealt with the short term political pressure from the US and at the same time set up a currency structure that will serve it well in the medium term. Furthermore, market disturbance is likely to be minimal as the long term consequences of this major change are opposed to current cyclical market forces. The short term market implications are not that great, but the longer term repercussions are highly significant.

First let’s start with the full text of the statement from the central bank of China:

          “With a view to establish and improve the socialist market economic system in China, enable the market to fully play its role in resource allocation as well as to put in place and further strengthen the managed floating exchange rate regime based on market supply and demand, the People's Bank of China, with authorization of the State Council, is hereby making the following announcements regarding reforming the RMB exchange rate regime:

          1. Starting from July 21, 2005, China will reform the exchange rate regime by moving into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. RMB will no longer be pegged to the US dollar and the RMB exchange rate regime will be improved with greater flexibility.

2. The People's Bank of China will announce the closing price of a foreign currency such as the US dollar traded against the RMB in the inter-bank foreign exchange market after the closing of the market on each working day, and will make it the central parity for the trading against the RMB on the following working day.

3. The exchange rate of the US dollar against the RMB will be adjusted to 8.11 Yuan per US dollar at the time of 19:00 hours of July 21, 2005. The foreign exchange designated banks may since adjust quotations of foreign currencies to their customers.

4. The daily trading price of the US dollar against the RMB in the inter-bank foreign exchange market will continue to be allowed to float within a band of 0.3 percent either side of the central parity published by the People's Bank of China, while the trading prices of the non-US dollar currencies against the RMB will be allowed to move within a certain band announced by the People's Bank of China.

The People's Bank of China will make adjustment of the RMB exchange rate band when necessary according to market development as well as the economic and financial situation. The RMB exchange rate will be more flexible based on market condition with reference to a basket of currencies. The People's Bank of China is responsible for maintaining the RMB exchange rate basically stable at an adaptive and equilibrium level, so as to promote the basic equilibrium of the balance of payments and safeguard macroeconomic and financial stability.”

 

 

The short term political solution

Not only was there a minor revalution of the RMB, but the structure is now a managed floating exchange rate. Even with such a small adjustment, which was merely in line with forward foreign exchange rates, it is now very hard to challenge the notion that the RMB is now a more flexible currency. The managed float is in line with both Singapore and Malaysia, and currency intervention is widespread throughout Asia. This move therefore takes the political sting out of US objections concerning China’s foreign exchange policy.

At the same time China still has very considerable control over the RMB exchange rate, which is still not fully convertible, and so can easily limit the currency strength. Despite continued strong economic growth China still regards itself as having an unemployment problem and so will resist a major revaluation at this time. In the short term therefore this is only a minor policy change, with minor effects.

New Ball game longer term

In the longer term, though, this change is far more significant. Although we are not sure what the basket of currencies against which the RMB is now referenced, the key element is that it is now no longer measured uniquely against the US dollar. This must have been the objective of US policy makers. The US link with the RMB limited the extent to which the dollar could be devalued. While the link was in force a lower US dollar simply made China too competitive against the rest of the world. The next time the dollar becomes a weak currency this constraint will have been removed. US dollar investors take note!

Furthermore, the new currency regime means that over time Asians central banks have less need for US dollars, and greater need for other major currencies. Current foreign exchange reserves are overly concentrated in US dollars.

There can be little doubt that in the longer term the new ball game is a negative for  the US dollar in particular and but also Treasuries.

Cyclical forces oppose long term implications

We may, however, see very little short term market impact because cyclical forces are currently positive for both the US dollar and Treasuries. In January this year we explained why the dollar the likely to recover at least on a cyclical basis, as it was supported by rising interest rates, both in absolute terms and relative to other currencies, the relative strength of the economy, and overwhelmingly bearish sentiment on the US dollar. To a great extent these factors remain supportive of the dollar, at least for now.

Similarly, we have been relatively optimistic on Treasuries, given a stronger dollar, a falling fiscal deficit, a weaker economy than in 2004 and higher short term interest rates. Here too these positive forces are still in play, and indeed the time to buy Treasuries is usually around the time when short term interest rates are close to peaking. We cannot be precise about the timing, but it remains our view that interest rates are not far away from peak levels for the current cycle. Furthermore, global bond markets are still signalling major deflation risks.

With cyclical forces remaining positive the markets reaction to the longer term negatives to the US dollar and Treasuries of the Chinese initiative are likely to be very muted.

Summary

China may have been forced by US demands to revalue sooner than it wished, but the revaluation so far is insignificant and was largely already discounted. In the short term there is very little market impact and China has headed off the political pressure from the US. China is clearly not in any great hurry for a major revaluation and with sizeable reserves has a great deal of control over the exchange rate, which is still not fully convertible.

Longer term, however, the move weakens support for the dollar and the dollar standard. In the new regime foreign central banks are overly invested in US dollars, and will need to diversify over time. Also the benefit to US policy makers is that they now have much further scope to devalue the dollar than before. These factors should also be negative for Treasuries. Long term Treasuries have become much less attractive relative to foreign bonds, particularly in Asia, and TIPS (Treasury Inflation Protected Securities).

However, in the short term, as discussed above, cyclical forces remain positive for both the US dollar and Treasuries, so there is unlikely to be much market disturbance, given the gradual introduction of the new currency regime. Cyclical forces will likely continue to dominate market developments, but investors should still take note that a new ball game has just begun.

 

 

 

Notice

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Opinions expressed in these reports may change without prior notice. Chris Belchamber (the author) may or may not have investments or positions in any assets or derivatives cited above.

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