FOREX TRADING

• People’s Bank of China (PBoC) this weekend announced that it will abandon the defacto USD peg that has been in place since mid 2008 when the global financial crisis accelerated. Instead China will return to a managed float targeting a basket of currencies. This will largely be a return to the exchange rate system from before the financial crisis.
• PBoC has tried to tone down expectations of a major appreciation. It ruled out a major one-off revaluation and left the daily trading band against USD unchanged at 0.5%. In addition, PBoC this morning left its reference rate against the USD unchanged, but has allowed CNY to appreciate in the spot market and on balance it now appears PBoC is allowing CNY to appreciate.
• There are two reasons for China’s move this weekend. First, with signs of a solid recovery PBoC is increasingly turning its focus from supporting growth to containing inflation and preventing asset bubbles. Second, there will probably be a significant political payoff from just a minor appreciation. The announcement just ahead of the G20 summit next week is no coincidence.
• We have left our CNY forecast unchanged. We only expect a modest 4% appreciation against USD over the next year. Although this is now only slightly more than the market expects, we maintain our recommendation to hedge longer-term CNY expenditures because we expect USD/CNY volatility to increase.
• The market reaction this morning has been positive with a marked improvement in risk sentiment as markets focus on a possible positive impact on global growth

China returns to managed float targeting a basket of currencies

People’s Bank of China (PBoC) Saturday announced that it will abandon the de-facto peg of the renminbi (RMB) that has been in place since mid 2008, when the global financial crisis started to escalate, see Statement on RMB exchange rate policy. On Sunday PBoC clarified its position further in a Q&A statement. So far it appears that China will basically return to a managed float with a reference to a basket of currencies started in July 2005 and prevailing until the global financial crisis accelerated in mid 2008. However, the statements from PBoC leave two important questions unanswered. First, will China allow RMB to appreciate and if so by how much and second to what degree will it allow more flexibility and volatility in the RMB exchange rate.

In our view we are unlikely to see major changes in the short run. China will allow RMB to appreciate slightly against USD and volatility in USD/RMB exchange rate will increase substantially compared to the past two years. It is important to note what China did not do this weekend. First, it did not announce a minor one-off revaluation of RMB as it did in 2005 when it kicked off the managed float exchange rate regime. Second, China did not widen the current 0.5% daily trading band against USD. There has been some speculation in the market that both a minor one-off revaluation and a widening of the daily trading band would be part of China’s initial move away from the USD peg. Hence, what China did this weekend was the minimum that could be expected. That said, the announcement was a surprise, as the consensus view was that the European debt crisis had postponed a RMB appreciation against USD well into Q3.

Why does China move on the exchange rate now?

The first reason is that the Chinese government’s concern about Chinese and global growth is receding. Instead the government is increasingly focusing on containing inflation and preventing asset bubbles. The return to a de-facto USD peg has always been regarded as a temporary response to the global financial crisis and not a permanent state for China’s exchange rate policy. In its policy statement PBoC says that it has now become desirable to move ahead with reform of the RMB exchange rate regime, because of the solid upturn in the Chinese economy and a gradual recovery in the global economy. Not least has it been important for the Chinese government that the latest Chinese data for May showed very strong exports and an increase in the surplus on the trade balance.

The Chinese government is increasingly focusing on preventing the economy from overheating. In May inflation exceeded the government’s 3% target for 2010 as a whole and in our view it could be close to 4% by year-end. In its Q&A statement PBoC says that RMB reform will benefit China, because it will help curb inflation and asset bubbles and strengthen effectiveness of macroeconomic tools. In other words, a return to the “old” exchange rate policy will give China greater flexibility to use its exchange rate policy actively to cool down the economy if needed and greater autonomy in its monetary policy.

The second argument is political and is particularly important for the timing of the announcement. As we have argued earlier there will probably be a substantial political and economic payoff for China from just a minor appreciation of its currency. This explains why China chose to announce the end of the USD peg just ahead of the G20 meeting in Toronto next weekend. China hopes that the announcement will be enough to prevent its exchange rate policy from becoming a major issue at the G20-summit. In addition, it hopes that this will be enough to prevent China from being designated “currency manipulator” in the Treasury report that US Treasury Secretary, Timothy Geithner, has delayed to give China room to move on its exchange rate policy. Finally, there is increasing risk that punitive legislation targeting China’s exports might be approved by the US Congress later this year.

How much will China allow RMB to appreciate?

The big question is if China will allow RMB to appreciate against USD and if it does, by how much? In our view China will allow a modest appreciation. In its statements PBoC effectively rules out a major one-off revaluation by saying that the adjustment of the RMB policy will follow the principle of gradualism. In addition, PBoC does everything to tone down any expectations of a major appreciation by saying that the current RMB exchange rate is not far from equilibrium and for that reason there is no argument for a major appreciation.

This morning PBoC left its reference exchange rate against USD unchanged at 8.8275 compared to Friday. The reference exchange rate is used to fix the daily +/- 0.5% trading band. The unchanged reference rate was a disappointment. However, PBoC has since allowed CNY to appreciate further in the spot market (see chart) and overall CNY has appreciated by 0.4% against USD since Thursday. Thus on balance it appears that PBoC is allowing CNY to appreciate slightly.

We expect CNY to continue to appreciate slightly this week ahead of next weekend’s G20- summit. In our view it would be an own goal by China if it does not allow some appreciation following this weekend’s statement from PBoC. This would certainly bring China’s exchange rate policy on the agenda at the G20-summit. However, to get a clear view of how much China will allow CNY to appreciate, we will have to see how much China allows the exchange rate to appreciate after the G20-summit.

We have left our exchange rate forecast unchanged (see table on next page) even though China has decided to resume appreciation slightly faster than we expected. However, we acknowledge that the main risk now is that CNY appreciates more than we expected particularly on a 3M and 6M horizon. CNY forwards have appreciated significantly overnight. The 12M USD/CNY NDF now discounts a 3% appreciation, which is slightly less than our expectation of a 4% appreciation on a 12M horizon.

With the appreciation in CNY forwards its has become less favourable to hedge CNY expenditures. However, we maintain our recommendation to hedge CNY expenditures on a 12M horizon (or longer). This recommendation is based on our expectation that CNY will appreciate slightly more than is currently expected in the forwards but also on our expectation that volatility in USD/CNY will increase.

Market implications

The expectation that China will now allow its currency to appreciate has improved risk sentiment in the market substantially this morning. Financial markets have chosen to regard a Chinese appreciation as positive for global growth because it increases the likelihood of trade tensions between the US and China, will boost real income and domestic demand in China and let other markets increasingly benefit from China’s strong demand. We feared that the shortterm impact might be dominated by concerns about slower growth in China, because CNY appreciation would be regarded as part of monetary tightening. This has so far not been the case.

Most Asian stock markets are substantially higher this morning including Shanghai. Stock market futures suggest a positive opening for stock markets in both Europe and the US today.

As expected Asian currencies besides JPY appreciated markedly overnight with particularly KRW and MYR benefitting from China’s decision to resume appreciation. Commodity currencies have benefitted from higher commodity prices. USD in general has weakened.

For a our view on the longer term impact of China resuming appreciation for financial markets see Research – Asia: Recovery still looks strong.