Forex Trading Strategies Blog

China’s central bank has stated that it will not reduce its dollar holdings for the present levels when it revamps its currency mix for its forex holdings. China’s forex reserves have now crossed $819 billion and it is widely believed that around 70% of these holdings are in US dollars. This high level of exposure to the US dollar can spell doom for China if the US dollar were to depreciate. On the other hand, if China were to reduce its dollar holdings it will have to sell that currency. This will lead to a drastic jump in the availability of the dollar in forex market and cause the currency to depreciate.

At the same time we are aware of the fact that China uses its massive dollar reserves to prop the US dollar by investing in US federal securities. China is also facing intense pressure from the G8 to allow its currency to float and appreciate to its true value. If China were to move to full convertibility in a jiffy, its need to hold dollar reserves will decline, which will have a major impact on the dollars value.

An appreciation in the Chinese Yuan combined with deprecation in the US Dollar, will reduce China’s export competitiveness to the US substantially and slow down its economy. We all know that China’s spectacular growth is key to global economic stability at this point of time and disturbing this will bode unfavourably for the global economy.

Thus, it is a catch 22 situation for China and it will have to be very careful in its forex management and take a very gradual approach towards full convertibility.

Click here to read more about China’s forex strategy.

While China had been facing tremendous pressure form G7 to revalue its currency and put it on a float, their stance softened after  China undertook token adjustments and introduced a narrow trading band.

The French issued a new statement that the Yuan’s value is the sovereignty of China and it may be better to approach the subject in an informal way rather than exert formal pressure.

While, certain lawmakers in the US have threatened to introduce legislation that will erect trade barriers against China, the Bush administration is completely against the idea.

It’s the complex nature of the global economy that is making nations shy of taking a firm stance on the issue. Disturbing the equation by revaluing the Yuan could slow down the Chinese economic rate of growth as its exports would become dearer. That could prove to be disastrous for global economic growth, so why take chances.

China holds one of the largest forex reserves in the world. China has managed to accumulate such huge reserves from a record growth in their exports. Till recently, the Chinese currency was pegged at a fixed value to the USD. On July 21 last year China, ended this decade old peg and allowed the Yuan to float in a highly-guarded narrow trading band, while allowing it to appreciate marginally. The Yuan’s current value is 20% to 40% below its true market value.

Its undervalued currency gives China a huge trade advantage vis a vis other countries and is one of the key reasons for its high GDP growth. China has been facing multilateral pressure to allow its currency to float. China’s Central Bank Governor commented in Davos on the side lines of the World Economic Summit that China will follow a prudent economic policy and introduce gradual decontrol of the Yuan.

That China’s currency is highly overvalued is a commonly known fact. What is unknown is when China is likely to correct this aberration. Until July last year the Yuan’s value was pegged to the dollar and determined by the government. As a first step towards liberalizing the currency, the government allowed the currency to float in a narrow band and revaluated it by a paltry 2.1%

The expectation that China would either revalue its currency in the near future or allow it to float, led to a large amount of hot money pouring in to make a killing from this appreciation. However, Bank of China’s Governor issued a very clear statement that the country is not considering a revaluation anytime in the near future. This has cooled of the inflow of hot money for now.

One will have to wait and watch whether the Governor made this statement to curb hot money flows or if this is the direction that China wants to take.

China is the largest exporter in the world. US is the largest importer in the world. US has the biggest current account deficit. China has a huge stockpile of forex reserves. Its almost like putting a jigsaw puzzle together to see how both the nations are maintaining their unsustainable currency values.

China uses these huge forex reserves to buy US government securities. This helps keep the Yuan undervalued and at the same time keeps the interest rate in the US low. Low interest rates in the US fuel consumption growth, which China fulfils through exports kept artificially cheap through an undervalued Yuan. Truly, a strange relationship!

While, there is a plethora of factors that govern the value of a currency, the overall economic health of a nation sets the long term perspective for the currency. However, other factors like government control may block the free movement of the currency and its trading value may not reflect its true value.

Let’s take the example of India and China. India’s currency is not fully convertible and its value is determined by a managed float. Under a managed float, the central bank of a country intervenes in the Forex markets by buying and selling foreign exchange so as to avoid sharp fluctuations in the domestic currency’s value. However, a managed float usually reflects the true value of the currency sans sharp fluctuations. In effect, the central bank soft lands the domestic currency. The strong growth that India has experienced in the last decade is well reflected in the value of its currency, which has gone up from INR 49 to the US dollar to INR 43 to the US dollar over the same period.

China on the other hand has not allowed its currency to appreciate even though their economy has posted exuberant growth. This is well reflected in the huge foreign currency reserves that the country has accumulated. The chief reason for this is that if they allow their currency to appreciate, their export produce will become more expensive for their trade partners and China will lose out substantially on their export income. Exports as of now are China’s main GDP growth driver and China is extremely averse to allow its currency to appreciate.

Viewing this in another way, China’s undervalued currency gives it an unfair trade advantage over other nations that compete for the same export market. Hence, China is facing pressure from several countries to allow its currency to appreciate and align to its market value. Of late, China has succumbed to the pressure and allowed a minor appreciation in its currency, but a huge correction is overdue.

After revaluation of the Chinese Yuan, the currency closed at 8.0675, as opposed to the 8.0702 it was previously trading at. The new value for the Yuan was determined after reviewing quotes from the commercial banking sector.

The Yuan has been known to fluctuate over a 0.3 percent range, and has grown 0.52 percent since the middle of summer. During this time the Chinese government appreciated the Yuan to 8.11, which was a 2.1 percent gain.

HSBC was one of the few banks chosen to submit quotes on the price of the Yuan. Its CEO Richard Yorke is quite pleased with the new value of Yuan, as he feels the new system being implemented by China is “highly efficient and smooth”. Against the Euro, the Yuan is fixed at 9.7091.

For 11 years the Yuan was pegged to the dollar at an exchange rate of 8.28 Yuan to the dollar. The Chinese economy has perhaps been the fastest growing economy over the last decade, which has caused their currency to be significantly undervalued.

Some US based businesses have complained about unfair trade practices associated with the cheap Yuan, stating that it hurts US domestic sales and exports by keeping Chinese products artifically cheap. In July, due largely to US presure, China floated the Yuan to allow for revaluation.

Floating the Yuan has caused the US treasury department to not label China as a currency manipulator, although the US expects further revaluation of the Yuan. Marketwatch reports:

China was able to avoid being labeled a manipulator because of its "initial step" towards a floating currency, said Treasury Secretary John Snow in a statement released alongside the latest report to Congress on global exchange rate practices.

But Snow warned China that the U.S. expects further reform of its foreign exchange regime "as quickly as possible."

Snow said the reluctance of Treasury to name China a currency manipulator is "contingent on further progress to incorporate flexibility reflecting underlying market forces in China's exchange rate by the time of the next foreign exchange report" due in the spring.

Read more: China is not a currency manipulator, U.S. says