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Yuan Small Step

Heading into the weekend the big news  on trading desks was a blown call in Friday’s US soccer match against Slovenia.  Friday’s “Quadruple Witching” was about as uneventful as possible.  Over the weekend China decided to stir up the pot by announcing that it “has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.  To do so, China will place continued emphasis…[on] reflecting market supply and demand with reference to a basket of currencies.”  As is evident by the reaction of index futures over the weekend, this news was somewhat unexpected and a largely positive development.  In anticipation of the G-20 summit set to kick off in Toronto next week, China and US Treasury Secretary, Tim Geithner alike were both facing mounting pressure with regard to China’s exchange rate policy.  Both should now be breathing a sigh of relief.  The question begs whether the news is as significant as the market reaction to it.

It remains unclear as to how exactly China will pursue a more market-based exchange rate.  The statement itself is particularly vague as to this point and leaves a lot of room for speculation.  I agree with Barry Ritholtz’ statement that “the Chinese announcement is only that — an announcement which may or may not be followed through. As such, we should treat it as a precursor, and not the significant shift the market seems to be making of the announcement.”  Until there is clarity of action and an actual plan, these words are merely conjecture.  That being said, these words are significant conjecture and reflect a change in policy and posture from China on a significant issue of international significance.

In order to discuss the impact, we first have to understand the policy as to why China pegs the yuan to the dollar.  As a result of the Asian crisis in the late 1990s, countries learned that in order to whether an economic storm in which a currency crisis is but one component, countries need to stash a reserve of the dominant global currency (the dollar) in order to intervene and maintain an equilibrium for export prices.  These countries were very reliant on the international export market for domestic demand, and as such, exchange rate volatility led to export volatility.  Additionally, the IMF’s response to the crisis called for currency protection (i.e. the raising of interest rates) in a time when monetary policy should have been deployed to stimulate the domestic economy (i.e. the cutting of interest rates).  With a stash of US dollar reserves, countries learned that they could increase their level of control over their domestic economies, without having to rely on international decision-makers whose preference was to protect international players.

The stashing of reserve dollars overall results in the suppression of a large chunk of global aggregate demand and ultimately leads to large, pervasive imbalances in trade between nations.  This heightens global economic volatility (in a sense, these countries w/ dollar reserves gain stability by exporting volatility to the global market at large).  The impact of the change in policy from China (should it truly materialize) will be reflected in three key areas: 1) the price of exports from China to the US will increase; 2) the pricing of other countries’ exports to the US will be increasingly more competitive in international trade markets; and 3) China’s purchasing power on a global level will increase.  Each of these are significant in their own right.

In pegging the Yuan to the dollar, China has placed a significant burden on other global exporters and resource rich countries in order to compete internationally.  China’s policy directly led to Brazil placing capital controls on foreign purchases of assets and to New Zealand’s direct intervention in currency markets in order to make their dollar more competitive internationally.  Furthermore, the pegged Yuan has been one factor in the US undertaking an unprecedented trade deficit.  To many, this is the most significant component to watch as this news lays out.  While a freer floating yuan should have some impact, it remains to be seen whether this alone is enough of a step in order to really change the situation.  As Joseph Stiglitz said in March of this year, the rebalancing of the Yuan  “won’t do very much for the U.S. trade imbalances….the adjustment to the exchange rate will not be the full answer for global imbalances.”  We run a significant trade imbalance with the oil producing nations of the world, and until we figure out another way to harness energy, the bigger imbalance problem will persist.  All in all, I see this as one small step that deserves an optimistic, but tempered response.

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