Fisher Investments Editorial Staff
Others

Yuan for You, Yuan for Me

By, 06/22/2010

Story Highlights:

  • China announced over the weekend it will "enhance" the flexibility of its currency—in other words, they'll loosen the US dollar-yuan currency peg.
  • Some worry the yuan revaluation will negatively impact US Treasury holdings, but worries are likely overwrought.
  • China's US Treasury purchases may slow, but only gradually, if at all.
  • The controversy surrounding the Chinese currency peg has mostly been political saber-rattling—and here, China's allowed a revaluation on their terms, while giving US politicians ground to stand on. 

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In a surprise move over the weekend, China announced it will "enhance" the flexibility of its currency. Don't speak bureaucrat? That means they'll loosen the yuan peg to US dollars—in place since mid-2008. The yuan subsequently clocked its biggest one-day move since 2005 on Monday, the last time China "enhanced" currency flexibility. Back then, yuan appreciation proceeded gradually and little affected Chinese stocks. Though the Chinese government isn't (and never has been) forthcoming with their exact plans, we expect similar results this time around. They also confirmed the 0.5% daily trading band will remain unaltered.

Some worry a revaluation could negatively impact China's US Treasury holdings, but such worries are probably overwrought. China's Treasury purchases in the last few years have likely been driven in part by the yuan peg to the dollar. The government has to keep excess dollar reserves to satisfy all currency demands at the official rate. And, of course, they don't want those reserves to depreciate, so they invest them in the safest dollar-denominated assets they can find—US Treasuries. If the Chinese fully did away with the peg, they wouldn't need the same level of reserves as before, and, theoretically, Treasury purchases would fall over time.

But what happened over the weekend is somewhere in between the two scenarios—the yuan is neither free-floating nor so rigidly pegged. Chinese US Treasury purchases may slow if Chinese dollar reserves fall, but the pace (in line with the revaluation) would be gradual. And we doubt they'd ever completely lay off Treasuries—at least for the foreseeable future (and likely well beyond). The Chinese have other reasons to maintain huge dollar reserves—the massive amount of mutually beneficial trade they conduct with the US, for example. And as long as the peg survives, even if only partially, they may elect to maintain excess reserves to defend against the threat of a currency run (a legacy from the Asian Financial Crisis, when investors forced a number of Asian countries to float their currencies).

If the yuan appreciates, Chinese exports (a massive driver of its GDP) may fall off a bit, but the risk of inflation would decline some too, as businesses and consumers tap cheaper imports. (The benefit of free trade is nations can specialize in whatever they do best—and import the rest at lower prices than could be achieved domestically.) Further, at bottom, the controversy surrounding the Chinese currency peg has mostly been political saber-rattling. US politicians railed against China's "unfair" trade advantage—and the Chinese government wasn't about to give in to Washington's demands and risk its reputation of "rising power." By loosening the peg, but not abandoning it, China's allowing a revaluation on their terms, while simultaneously sating US politicians' appetite for action—lessening the likelihood the recent US/China trade spat worsens. Yuan for you, yuan for me—not a bad trade.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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