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

---

Discovering Turnaround Candidates

There are many types of investment methodology out there. All... Read More

The Major Players in the Foreign Currency Exchange Market - FOREX

Since the US dollar is the centerpiece of the market,... Read More

Trade Entry Techniques

Most traders tend to concentrate on pinpointing the perfect entry... Read More

The Yin and the Yang of Markets

I am reading a fantastic book on trading, first published... Read More

Types of Foreign Currency Hedging Vehicles

The following are some of the most common types of... Read More

Forex Options Market Overview

The forex options market started as an over-the-counter (OTC) financial... Read More

How to Trade Currency

We all know when you go on a trip to... Read More

Where to Get Forex Training

For those of you who are interested in forex trading,... Read More

Commodity Trading - Advantages and Disadvantages

What Is Commodity Trading?Commodity futures markets allow commercial producers and... Read More

Stopping Yourself

I read on a bulletin board a traders comment that... Read More

Forex Broker

A broker is any person or firm that charges a... Read More

The Basics of Forex

Foreign exchange market is also known as Forex or FX... Read More

Options Trading - Advantages and Disadvantages

What is Options Trading?An option is simply granting someone the... Read More

Trading Tips No 1: Learn How to Trade The Moment of Truth

So you have learned how to trade the markets by... Read More

Forex Profits

The Forex Market-What, When and Why?Forex, FX and the Forex... Read More

Day Trading Training ... You need more than just going to a free stock market workshop to learn

Day trading is all about making buy and sell decisions.... Read More

Your Mother Could Make Money In Forex Trading

The question would be not whether she could but rather... Read More

Creativity in Trading

"Is it important to be creative in your trading?"I'm not... Read More

The Margin Advantages of Trading FOREX.

There is one aspect that is considered as one of... Read More

Crisis of Confidence in the EU

The European Union (EU) constitution was dealt a double blow,... Read More

An Evaluation of the Devaluation

A Minister of Finance is morally right to lie about... Read More

A Look at Forex Market Makers

The investor in the currency market takes for granted that... Read More

Forex Made Easy for Everyone

Forex made easy is as simple as you would want... Read More

Adaptation to the Realities of the Market

Do you think adaptation to the realities of the market... Read More

What is Forex Trading?

Forex, or Foreign Exchange, is the simultaneous exchange of one... Read More