Long-term perspective on currencies and central bank policies

I was doing some house cleaning, tagging old entries and came across something I wrote in 2005 on central bank policies:

On a related note, foreign CBs will not turn net sellers of dollar assets. They will stop adding to USD reserves which still creates a substantial problem for U.S. interest rates. The markets will continue testing the CBs' appetite for dollars until we see real policy changes and a market determined equilibrium.

This referred to the US dollar but the underlying logic still applies to this week's scare regarding China turning seller of Euro assets.  China has deep pockets and very little interest in adding to currency instability.  The status quo (Yuan pegged at sub-market rates to stimulate Chinese exports) has done well by them and while it can't go on forever now would be a shockingly poor time for a drastic change.  Why would they do this in the midst of speculative fervor to short the Euro and a general panic regarding European assets?

My 2005 self went on to make the following predictions:

There will be some sort of market event with the most likely candidates being housing and interest rates.

This market event will ultimately require international cooperation (G7, G10). It may take a series of trials (maybe a series of crises) by various CBs and governments but eventually they will need to coordinate policy. The world will need to decide how to handle the issue of the weakening dollar as its main reserve currency.

On a related note, foreign CBs will not turn net sellers of dollar assets. They will stop adding to USD reserves which still creates a substantial problem for U.S. interest rates. The markets will continue testing the CBs' appetite for dollars until we see real policy changes and a market determined equilibrium.

Unemployment seems like the best indicator of how hard or soft the landing is in the real economy. Below the June '03 high of 6.3% seems like a good definition of a soft landing for the U.S.[The main question being discussed was whether the US was whether the Fed hiking cycle was leading up to a soft landing.]

The U.S. current account deficit will get worked off through the growth of emerging market consumption rather than U.S. economic contraction. These emerging economies are the logical target for the world's investment dollars so once the market regains control of capital distribution they should see some benefits.

While this was a useful high level map, in the end it mostly helped me to avoid risks.  The policy coordination I expected has yet to materialise and instead it is a dog eat dog world of competitive currency devaluations.  This makes a fertile (read volatility swings) ground for trading, especially in currencies.  I expect this will continue until central bank coordination occurs enabling debt-heavy importing countries to start paying off their creditors.

Renminbi: Less Currency Basket More Dollar Peg

From Bloomberg:

China's central bank said today it will allow the yuan to strengthen by as much as 3 percent from a daily fixed rate against the euro, from 1.5 percent previously. It kept the range against the dollar unchanged. The 12-nation currency is also being hurt by expectations the interest-rate advantage of U.S. government debt over European bonds will widen.

Macroblog has more on the news but Brad Setser had something a few weeks back that telegraphed this pretty well. To me this news means China is not giving up on the dollar peg anytime soon. More important than my interpretation is what the U.S. congress makes of it. A lot on their plates now but protectionism was certainly more popular before China announced its currency basket. Probably bad for stocks if that sentiment returns.

Currency Story Continued

From Reuters:

MORE TO COME?
The Singapore dollar, widely used with the yen to bet on a yuan move, shot higher to a two-month high of 1.6503 per U.S. dollar, up 2 percent on the day compared with 1.6843 on Wednesday, before dealers reported the intervention.
Singapore said it will maintain its policy of gradual and modest strengthening of the Singapre dollar and said fundamentals of the city-state's economy had not changed.
Hong Kong said it would not consider changing its currency peg to the dollar even if the yuan keep appreciating and said the Hong Kong dollar will remain very stable.
The Indian rupee rose to a six-year peak against the dollar around 43.20, up more than half a percent.
"The move is clearly positive for Asian currencies first, and to some extent the euro. It is pretty clear that the basket will involve a reasonable chunk of Asian currencies," said Emanuele Ravano, European strategist at PIMCO in London.
The Korean won's non-deliverable forward prices, used by offshore investors to trade the won, showed investors are factoring in a 2.2 percent rise in the won/dollar rate in one-month's time.
...

Following the yen's rise of more than two percent, Japan's top financial diplomat Hiroshi Watanabe said he is watching the market carefully and would take action if needed.
Japan has been urging China to reform the rigid FX regime but it had repeatedly said the yuan revaluation doesn't mean a higher yen and it has hinted it would intervene if necessar

Update 2:51 PM: This quote from Nouriel Roubini sums up what I am watching for:

And this could really be the beginning of the end of the Bretton Woods 2 regime of fixed pegs to the U.S. dollar in Asia. Malaysia already decided today to drop its peg relative to the U.S. dollar. This China move may also force Hong Kong to phase out its long term currency board and U.S. dollar peg. And other Asian currencies will soon sharply appreciate, following the yen's lead today. Even currencies at the periphery of this Bretton Woods regime (such as those in Latin America) may sharply appreciate. The systemic consequences of this currency realignment throughout Asia and the world could be radical and have significant impacts on U.S. long-term interest rates, on U.S. financial markets and on the U.S housing bubble.

Asian Currency Revaluations

China and Malaysia both moved their currency pegs last night. The move in the Renminbi was 2% which is smaller than the 5-10% most analysts had been mentioning but the impact could be quite large if other countries follow suit.

From the FT:

The effect of China’s move was expected to spread to other Asian currencies as other countries in the region were set to decouple their currencies from similar pegs to the dollar to make them more competitive.
Shortly after China’s announcement, Malaysia said it would alter its peg and allow the ringgit to fluctuate freely and Singapore, whose currency is tied to a trade-weighted basket of currencies, was also due to make an announcement.

Makes me wonder if the story won't continue to unravel for the next couple of weeks as other government reaffirm or change policy. That is a different story than the smaller than expected Chinese move in the headlines and it is what I will be watching for.

Snow Knows when China will Revalue

From the FT:

The Bush administration has told key senators that it expects China to revalue its currency in August ahead of a planned visit to Washington by President Hu Jintao in September, according to people familiar with the matter.
Senators Charles Schumer and Lindsey Graham, co-sponsors of a bill that would impose a 27.5 per cent tariff on Chinese imports, agreed to delay a vote on their bill after receiving what they regarded as an assurance that China will move on its currency next month.
In a June meeting attended by Alan Greenspan, Federal Reserve chairman, John Snow, Treasury secretary, told the senators that he believed China would allow the value of the renminbi to increase against the dollar in August, the people familiar with the discussion said.

Though I agree with the timing I am surprised they would tell Snow and surprised it would leak. The yen is trading 112.15 so I guess the market is yawning it off. Not sure that will continue.

The dollar seems like it is in a prime spot for a reversal (DXY is sitting below some long-term resistance in the 90-92 range). Also this fits with the current interest rate environment as the Fed has primed traders for more rate hikes while the yield curve threatens to invert. Seems like a bit of a disconnect between the carry traders in currencies and the "conundrumless" bond market.

China's Peg Planning

From the NYT:

China's political leadership is actively considering breaking the 11-year link between the dollar and China's currency, the yuan, and tying its value instead to a group of currencies, current and former senior Chinese officials said in interviews. The proposal being weighed at almost daily meetings of the Standing Committee of the Chinese Communist Party's Politburo would use a so-called basket of currencies to set the yuan's value. The yuan would move up and down in currency markets in relation to the average values of the dollar, yen, euro and possibly other currencies like the British pound.

But the initial value of the yuan under the new system could, in dollar terms, be very close to its current value of 8.277 to the dollar.
...
The Politburo's Standing Committee - which includes President Hu Jintao, Prime Minister Wen Jiabao and seven other top officials - has made no decision yet on when or whether to act, and may decide soon or wait as long as next year, the officials said. But the deliberations have taken on a pressing quality, with the Standing Committee meeting almost every day last week to review currency policy. Senior economic officials have been told to be on hand for consultations at any moment.
In a telling instance, Yang Weizhe, the mother of Zhou Xiaochuan, the governor of the Chinese central bank, died at 6:30 a.m. on May 31, but Mr. Zhou was still required to attend a Standing Committee meeting on the currency an hour and a half later.

...

Victor Fung, a Hong Kong tycoon who is chairman of one of the world's largest garment companies and heads the territory's airport authority, said, "They recognize the need to go away from a peg and move toward a basket."
Mr. Fung said each currency's percentage in the basket should match the percentage of China's trade conducted in that currency, an approach favored by many economists. He also said that China should reveal the relative weightings of the currencies in the basket.
But other advisers said Chinese officials were leaning strongly toward switching to a basket without disclosing the currency weightings. Singapore has long done this with its dollar.

A few weeks ago speculative pressures were the reason for not moving. The current sentiment (knowing it is coming but it will be small and hard to time) is probably the best Chinese politicians can hope for.

They sure seem to be focusing on the finer details right now. In currencies I have quite a few yen longs on and most recently shorted AUD/JPY near here (stop at 83.5). That chart is bouncing along just on top of a long uptrend and looks set to have a big reaction to any yen strength. Other than oil, the commodity stocks have not put in much of a recovery so I am also watching the AUD to see if it is pointing out continued weakness there.

Renminbi NDF Growth

From Cynic's Delight:

Second, there is a growing market for non-deliverable forward contracts for Chinese renminbi. NDF contracts are traded offshore and are used to hedge against exchange rate movements in non-convertible currencies. In this case they are agreements to buy or sell renminbi at a specific future date at a specific exchange rate. At maturity, the contracts are settled using only the hard currency, usually dollars, and no renminbi are deliverable. Dollar payments are made or due based on the difference between the prevailing spot rate and the NDF rate. If, at maturity, the renminbi has appreciated against the dollar, the holder of the NDF will be paid a certain dollar amount. If the renminbi has depreciated, the holder will owe a certain dollar amount.

The BIS report suggests that the growth of these renminbi NDF markets presents one of the few real price signals from the markets as to future expectations of the renminbi exchange rate. Billion dollar daily turnovers are now common, and most of the activity seems to be hedging against a renminbi revaluation. Moreover, the report has uncovered evidence of a movement away from strictly dollar oriented exchange rates among Asian currencies towards an "effective exchange rate orientation." In other words, Asian exchange rates are seeing higher volatility against the dollar as compared to between Asian currencies.

This is important, as it is evidence of market signals that the renminbi will play an increasingly important role in determining exchange rates across East Asia. Considering the rising trade flows between China and the other Asian economies, this only makes sense. It is becoming increasingly likely that a renminbi revaluation could allow other Asian currencies to rise against the dollar while maintaining (or at least limiting the rise in) their renminbi exchange rates.

Still, so long as the Chinese prevent current account convertibility, they will be free to determine exchange rate and monetary policy as they see fit, without bowing to pressure from the financial markets or foreign governments. But as China's share of international trade grows, renminbi turnover will inexorably rise along with it. Importers and exporters will find increasingly sophisticated ways to manage their foreign exchange needs, and capital flows should prove harder and harder to manage. In the long run, international financial markets will provide the real challenge to Chinese efforts to maintain control over their exchange rate and monetary policies, and not foreign governments.

Yuan Revaluation Effects

Ezra Marbach summarizes a NYT article that lays out some possible effects of a renminbi revaluation.

China's dilemma

This article provides some good food for thought about the timing of a yuan revaluation and the state of the Chinese economy. Some of the highlights.

Walker sees China hitting a wall, chiefly in the form of a labour shortage; not the much-publicised reluctance of inland Chinese recently to serve as factory fodder in the sweatshops of Guangdong, the industrial province bordering Hong Kong, but supply gaps in skilled workers and managers.
With about 1 million Taiwanese already employed on the mainland - about 10 per cent of the island's workforce and therefore probably close to the limit - newspapers in Hong Kong and South-East Asia are packed with ads for supervisory or technical jobs in China.

...

Nor was the diet of low-yield government paper doing much for profitability in the scandal-prone Chinese banks, whose non-performing loans Roubini and Setser put at somewhere between 46 and 56 per cent of China's GDP.
Also last week, the ratings agency Standard & Poor's said recapitalisation of two of the big four state banks - the Industrial and Commercial Bank of China, and the Agricultural Bank of China - would require injections of between $US110 billion and $US190 billion.

Indeed, the weak position of the Chinese banks and their huge requirements for capital are cited by Xie as one more reason against early revaluation. As well as adding to bad debts by raising domestic real estate and other prices in relative terms, a higher yuan would require more US dollar investment to achieve sound capital adequacy.
Although disposal of bad debts via asset management corporations is lagging badly, Chinese financial authorities are still hoping to bring two large banks - the China Construction Bank, whose assets are mainly infrastructure loans to governments, and the Bank of Communications, which already has a 19.9 per cent "strategic" holding by HSBC - to international share offerings in coming months.

A good general rule in economics is that flexibility and transparency lead to stability. Along those line I guess I can see why China's policies have left it with few good options.

Stephen Jen's Opinion on the Yuan

From Bloomberg:

``People should take advantage of these levels'' and sell the won and Taiwan dollar, said Jen, head of global currency research in London at Morgan Stanley. ``This is not the time to put on the China revaluation trade. China is not ready'' and probably won't revalue the yuan before the end of June, he said.
Investors should sell the Korean won until it weakens to about 1,015 per dollar from 999.80 at 3 p.m. in Seoul, said Jen. The Taiwan dollar could drop to NT$32 versus the U.S. currency, from NT$31.19 at 4 p.m. in Taipei, he said.

Renminbi Tests the Air Outside the Band

From the FT:

China's renminbi currency traded briefly outside its tightly controlled band on Friday, triggering a renewed wave of speculation that the government was set to allow a long-expected revaluation.
The People's Bank of China, the central bank, late on Friday blamed the change on "technical problems", with officials speculating a dealer may have keyed in the wrong rate.
In spite of mounting international pressure for China to allow its currency to appreciate, a spokesman for the PBoC said no announcement of a change in policy was planned.
Traders said the renminbi, which has been pegged to the US dollar for a decade, was briefly in the market at a rate of Rmb8.2700 to the dollar, outside of the usual band of 8.2760 to 8.2800.
Traders could not say whether the State Administration for Foreign Exchange, the Chinese government agency which handles currency trades, conducted any business at the higher rate.
Frank Gong, a strategist with JP Morgan in Hong Kong, said he would not be surprised to see some kind of announcement from the PBoC on currency over China's week-long May holidays, which start on Sunday.
"But the point is that they are ready to do it and could move at any time," he said. He said the higher rate remained on trading screens for up to 20 minutes, a sign that the authorities may have been testing the market "to see how much ammunition they may need to keep everything under control".

Hard for me to imagine someone not noticing the price trading outside a band thats been in place for 10 years.

* Update 11:20 AM - The FT has a second story that is more heavily weighted towards the trades being a technical glitch. It also mentions some statements in an official newspaper that "conditions for a renminbi revaluation were "ripe" thanks to reforms of the commercial banking sector and the forex market, although any widening of the existing band could be small."

FYI, Friday after the close is primetime for announcing currency band moves. The idea is that it gives the markets the weekend to figure out how to react.

* Update 1:45 PM - This story sums up a couple of banks' opinions about how and when the Chinese gov't will move the peg. I am surprised that a few are still not expecting a revaluation this year. Another story discusses this week's action in the won.

I am assuming that China will be successful in limiting any move to a small one (< 10%) but think that could still cause some pretty big trade adjustments around Asia. I expect the yen and won appreciation vs. Europe's currencies will continue.