Chinese Yuan Band Widens - How Close Are We to A Free Float?

Once again, as we have been forecasting for some time now, the People?s Bank of China made a move and widened the Yuan?s trading band. Planned perfectly to coincide with the weekend?s G8 finance minister?s summit and the Strategic Economic Dialogue with US Treasury Secretary Paulson next week, the highly anticipated decision continues to have broad implications beyond currency markets. Foreign exchange effects were immediate as the Japanese yen gained rapidly against the dollar shortly after the release.

[B]So what didChina do?[/B]
[B][/B]
[B]- [/B][B]China[/B][B] widened the daily trading band against the dollar to 0.5%[/B]
[B][/B]
The daily trading band, which represents a daily limit for appreciation or deprecation of the Chinese yuan against the US dollar, was widened to 0.5 percent from 0.3 percent effective May 21, 2007. The People?s Bank of China has enacted this measure amidst major pressure from its international trade partners of which US was the most aggressive voice. The main purpose of this change is to allow the yuan to rise against the US dollar faster, but given the small value of the actual band widening, markets should not expect wild fluctuations or rapid appreciation of the Chinese currency. The yuan has never moved the maximum range under the previous daily limit of 0.3 percent, as the biggest move this year against the dollar was a 0.22 percent gain on May 11. Furthermore, the 0.3 percent trading band has been a long standing one, as it was initially enacted in 1994. The People?s Bank of China and the Chinese government have stated previously that they would allow appreciation of the currency, but that it would be a slow process. Thus, we may expect continued widening of the trading band at a later date - compared to an outright revaluation of the yuan - leaving the issue is unlikely to fade from the limelight.
[B][/B]

[B]- [/B][B]China[/B][B] will maintain a managed float against a basket of currencies [/B]
[B][/B]
The People?s Bank of China has said that their exchange management methods will not change, and a basket of currencies will still be used as a reference for the yuan exchange rate so as to avoid sharp fluctuations. Since the US, Euro-zone, Japan and South Korea are China’s biggest trading partners, their currencies were naturally established as the main ones in the basket when the composition was initially revealed in August 2005. Also included in the calculation were: the Singapore dollar, the British pound, the Malaysian ringgit, the Russian rouble, the Australian dollar, the Thai baht and the Canadian dollar. [B][/B]
[B][/B]
[B]What motivates China to do this?[/B]
[B][/B]
China has many reasons to want to revalue their currency. First and foremost the country wants to preempt any protectionist measures imposed against it by the US Congress. US legislators have been in a uproar, saying that an artificially weak currency has given China an unfair trading advantage against American competitors. The Congress recently showed its discontent with China?s $177.5 billion trade surplus by levying taxes on imports of coated paper. Although the move was largely symbolic as it comprised a tiny fraction of Sino-US trade, it was nevertheless a warning shot aimed at Chinese policymakers. Therefore, today?s announcement by the Chinese was partly diplomatic, intended to soothe tensions ahead a key meeting between Chinese Vice Premier Wu Yi and US Treasury Secretary Henry Paulson May 22-24 in Washington to discuss economic and financial issues, of which the value of the yuan will surely be a primary topic…

However, the Chinese decision may be driven as much by economic necessity as by political consideration. The move while not dramatic is a clear a gesture by the Chinese authorities signaling their willingness to move the yuan exchange rates closer to a free-floating model. The Chinese authorities now find themselves combating the growing asset bubbles in the Shanghai equity market and have become quite concerned about the possible fallout should it collapse. This policy change is just the latest attempt by the Chinese government to reign in speculative sentiment in the country by slowing inflationary pressures. Instead of simply viewing this policy change as a one off diplomatic event traders should consider the possibility that this may be a precursor to a more free-floating model of foreign exchange in China. Until recently most analysts believed that China would never consider a free -float solution given the enormous problems with non-performing loans in its banking sector. However, several years of double digit GDP growth, along with major recapitalization of its four primary banks through recent IPOs in Hong Kong, have radically changed the financial stability of this sector over the past year. With more than 1 Trillion dollars in foreign exchange reserves which most market observers believe will increase to 2 Trillion by end of 2008, China?s balance sheet appears rock solid, allowing monetary policymakers far greater freedom to entertain the idea of a more free-floating foreign exchange regime.

[B]What does it mean for the markets?[/B]
[B][/B]
[B]Treasuries [/B]- China?s decision has ramifications for all of the financial markets. Notably, effects will be felt in the US treasury market as Chinese officials will likely continue their investment in US dollar based assets. Although their currency is widely managed by a basket of currencies, reducing the exposure to US treasuries, demand for US bonds will remain for the time being in controlling the band that still remains over the currency. The notion will help to suppress long term yields in the long bond market, exacerbating the already rising sentiment that Federal Reserve officials may be cutting rates at the end of the year.

[B]Currencies - [/B]The increased demand for US treasuries and investments will be more than beneficial for the dollar, no question. However, the focus will be placed on the Japanese yen as pressure will likely come on the heels of the People?s Bank of China decision. For some time now, the global market place has demanded for further flexibility in the Chinese currency regime. Now that the trade band has been widened, economic leaders will want to see some tangible results from Japanese officials. Although central bankers have not intentionally suppressed the value of the yen, world leaders will want some answers for an undervalued currency and an increasing competitive advantage.

[B]Stocks - [/B]The stock market should have a mixed reaction. Shares of companies such as Wal-Mart and Target have and will probably continue to be under pressure because the widening of the trading band means that their cost of imports will increase. So Wal-Mart and Target will either have to increase prices or take a cut out of profits. Comparatively shares of manufacturing companies that compete against China should rise along with shares of companies that are targets for Chinese acquisition. On one hand, the decision to widen the band would help boost the competitiveness of the American made goods on the open market as the price of Chinese exports would rise. On the other, an the same appreciated yuan makes its cheaper for Chinese companies to snap up US companies while at the same time giving them more political sway to a demanding US Congress. Both scenarios will ultimately help US companies attract investment interest as it benefits the bottom line.

[B]Commodities[/B] - Commodity markets are set for a boost in demand for the short term as raw materials will now become cheaper for China based manufacturers. With a higher valued currency, producers and manufacturers will be able to not only afford more of the materials they need, but may increase their desire for raw materials in order to increase capacity and meet rising demand. The resultant effect will be higher prices in the commodity markets, with significant focus on base metals, especially copper and gold, and crude oil.
[B][/B]
[B]Is there more to come?[/B]
[B][/B]
It was said before, and will be said again. More flexibility is on its way. Although the recent decision to widen the trading band was not as market moving as the July 21st revaluation, it shows that Chinese officials have a longer term plan to finally move the currency to a free floating status. The notion couldn?t come at a better time with global funds continuing to pile into any Chinese asset. The increase in foreign investment, a widening trade surplus and an overheated economy still leave the necessity for further adjustments in the short term, leaving the yuan to even greater appreciation.