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Thursday July 28, 2005 - 22:52:37 GMT
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Forex: China's Reserve Management More Impressive Than China's Trade Relations Management

There has been some very compelling reasons to sell euro/dollar this week...namely strong data out of the US and still mixed data from the Euro Zone...and yet the dollar is set to end the week lower once again barring decent gains Friday following the release of US 2Q GDP. And no one buying euros and selling dollars is talking about my favorite beef with the buck...twin deficits. This time it is all about reserve management...codefor central bank euro/dollar buying for much of the last two years. Based on the names bank traders are seeing in the market in size on the bid it would appear to be the work of Chinese monetary authorities. As we have suggested in recent FXA Alerts and on FXA On-line, China may have a new mandate in its new currency regime to oppose volatility in euro/dlr and dlr/yen as big swings here will impact the new basket (finally we have been told it is a reference basket, not a distinct target). Still a large rise in the dlr will in theory make it difficult to walk the yuan higher versus the dollar. I have little doubt that if the market could really set dlr/yuan in a normal market (the one that trades in Beijing is not a market) it would have been lower versus the dlr on the whole dlr retracement that followed the big move down for the buck on the reval news last Thursday. But not if China is all over the bid taking offers at 1.20 and lower. No one wants to challenge activist central banks (I will venture into why at some later date if I remember to).

So rather than seeing euro/dlr at a new 14-month low, it is unable to break 1.2000 for more than a few minutes at a time (surely until calls go out to officials in China for fresh buy instructions). So far it is working. The market senses the invisible but visible hand of government agents and heads for the hills ignoring every reason for doing just the opposite...adding to dlr longs.

Meanwhile in Washington legislators are growing restless...two in particular, Senator Schumer (Dem-NY) and Senator Graham (Rep-SC). These two are the leading trade protectionists in the Senate who think the dlr/yuan is so undervalued that it alone is causing an erosion of the US manufacturing base and loss of jobs abroad. If only the yuan were freed up for the market to set the level, this outflow of labor would cease. Surely the two Senators have not looked at wage and income differentials because if they did they would move to far more effective measures addressing intellectual property rights (lack thereof) rather than the yuan. That said they are not and will not as polls show US voters think the yuan is at the heart of the loss of jobs and trade imbalance. So today Schumer and Graham said what China did a week ago was a good first "baby" step, but more needs to be done or the severe Schumer-Graham bill will go to a floor vote in the Senate in October and very likely win the backing of a majority in not just the Senate but the House forcing a Bush veto and possibly an override. This bill has trade war all over it and few reasonable minds think this will do any good for world growth, financial market stability and inflation.

Moreover it is a bit ironic to see Schumer and Graham whine about the yuan being grossly undervalued while Chinese authorities are preventing the dollar from appreciating versus the euro, a currency pair that is far more meaningful for US workers and firms. Still China is not helping its case by having senior officials state that currency adjustment is over for the foreseeable future, or by concocting a sponge parable that is lost in translation. China needs some help from a US political/financial market consultant to learn how to talk to Washington and to financial markets. So
ar efforts here are unimpressive.

Surely China sees where US Congress is headed on trade sanctions and will acquiesce with more yuan appreciation, even if it has to finesse the yuan higher against the will of a market eager to take the US dollar higher against most currencies. For China allowing the yuan to rise another 2% by the fall is a small price to pay for avoiding a costly round of trade sanctions. Furthermore, China is still on a shopping spree for resource-based firms like Unocal and the last thing it needs is an isolationist drift in the US. President Hu Jintao will be in the US next month speaking to the UN and visiting President Bush. One should expect a still higher yuan before the visit in an effort to check the likes of Schumer and Graham from usurping control over trade policy from the more free-trade oriented Bush administration.

Between more currency management by China (checking broad dlr volatility and in current environment dlr upside) and incremental rises in the yuan, I think people should rethink getting long Asian currencies, the yen included.

David Gilmore


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