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FX Briefing July 22, 2005FX Briefing July 22, 2005
- China gives up dollar peg, renminbi to be tied to currency basket
- Greenspan once again confirms interest rate hike policy
Renminbi appreciation: Cracks in the Chinese Wall
This week was characterized by two big economic policy events: Alan Greenspan’s report on monetary policy and the change in the Chinese currency regime. Mr Greenspan’s testimony to Congress was more or less as expected. The Fed mChairman confirmed that the central bank intends to raise interest rates further. His relatively outspoken critique of speculative housing market trends indicates that the Fed would like to see interest rates rise at the long end of the curve too. Moreover, Mr Greenspan sees a trend towards higher long-term capital market rates against the background of a rise in countries’ investment propensities.
In view of the strong US economic data and previous hints from Fed representatives, the markets had expected Greenspan to be hawkish. Accordingly, the dollar was firm overall in the run-up: USD-JPY rose to JPY113; EUR-USD was somewhat more volatile, but dropped below USD1.20 at least for a while. After the report, the yen and the euro initially lost ground, but the trend turned quickly, especially for EUR-USD. The European currency gained about 150 points to around USD1.2150. Quotations for USD-JPY only moved from 113.50 to below JPY113. The second major event of the week was China’s announcement to replace the renminbi’s rigid dollar peg with a system of managed floating. The markets had speculated about such a step for a long time but in the end the move came as a surprise to most participants.
As of now, China has given up its dollar peg where the renminbi was fixed at CNY8.28 per USD. In a first step, the renminbi was revalued by 2.1% to CNY8.11. In future, the exchange rate will be tied to an as yet unspecified basket of foreign currencies, which means that more or less significant exchange rate adjustments against individual currencies are possible. The closing price of the renminbi against the dollar would become the opening price the next day, with daily fluctuations around this central rate limited to ±0.3%. Thus the exchange rate against the dollar could move by a maximum of 3% over 10 trading days.
This system leaves the People’s Bank of China a lot of leeway. We do not yet know what the currency basket will look like and how tight the regulations for stabilizing the renminbi against this currency basket will be. It is unlikely that the Chinese authorities will want to subjugate themselves to a strict set of rules. It thus remains to be seen how China will handle this system in practice. Under the new regime the central bank still controls the exchange rate, especially since the capital controls remain in place. It can yield to market pressure in one or the other direction but it does not have to. Currently the renminbi forward contract has priced in a further appreciation to CNY7.73 in 12 months’ time, which would be a good 7%.
This step was not only taken to placate the industrialized countries which have been urging China to adjust its exchange rate, but it is also a step towards the development of modern financial markets which China is aiming for – although this is still in the very early stages. At the same time China is adding to its economic policy tool box. Although the current appreciation is probably too insignificant to have a macroeconomic effect, the exchange rate is generally a useful instrument. Moreover, a more flexible exchange rate widens the scope of interest rate policy.
A renminbi appreciation has been played through so many times by the markets that the reaction was a textbook case. The Asian currencies appreciated in step with the renminbi, headed by the yen which firmed by 2.5% to JPY110 per dollar, but then fell back slightly to around 111. The other Asian currencies like the Korean won, the Taiwan dollar and the Thai baht appreciated between 1 and 1.5%, with Japan and Korea warning against possible upward speculation.
EUR-USD first appreciated in a reflex reaction, but then quickly corrected and is now back where it was before the renminbi was “cut loose” – just below USD1.22. So was this a non-event for EUR-USD? Not quite, but it is in fact unclear what this all means for the relationship between the dollar and the euro. Some observers have interpreted the appreciation of the euro as a substitute for an appreciation of the Asian currencies to bring about the necessary correction of the US current account. This impulse in favour of the euro would disappear.
Sometimes it is argued that the central banks which peg their currency to a basket would have to hold respective reserves for interventions. But this is not convincing in this particular case. The Asian countries have a structural excess supply of foreign currencies and therefore do not need any additional reserves for interventions. So the introduction of a currency basket does not lead to any further demand for euro from China or other Asian countries.
Other observers assume that the planned or expected appreciation of the renminbi against the dollar has led to shifts in currency reserves (and in private assets) from dollar into the euro. This impulse would remain, at least to some extent, if China is planning a further appreciation. However, investing in the euro is no longer necessarily more attractive than investing in the dollar. But ultimately, every market participant has to make up his own mind about this.
Stephan Rieke +49 69 718-4114
+49 69 718-3642
Foreign Exchange Trading
+49 69 718-2695
Matthias Grabbe / Klaus Näfken
+49 69 718-2688
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