Chinese Revaluation - An In Depth Look At What It Means For The Markets - Forex Market

Friday, 22 July 2005 GMT - Written by Kathy Lien, Chief Strategist

After years of speculation, China has finally dropped its decade long peg to US dollar. As we have been predicting for some time, the one major currency pair that will be impacted the most by the revaluation announcement would be the Dollar against the Japanese Yen (USDJPY) and indeed the pair slid 200 pips or points following China’s announcement.

So what did China do?

- China adjusted the RMB peg to 8.11, which is 2% higher in value against the dollar

The pegged value of the RMB has been adjusted to 8.11 from 8.31. This rather modest revaluation of 2.5% will for the most part do little to reverse or relieve the US’ burgeoning trade deficit. It does however have significant political and market implications. (See market section) Immediate pressure on China to revalue its currency should move to the backseat for at least a few weeks. However, despite the move, we would not be surprised to hear some protests from US Senators that the revaluation move was too small and that China needs to make a much more concerted effort to allow the currency to increase in value, especially since 2.5% pales in comparison to the RMB’s predicted undervaluation of 30-40%.

- The daily trading band against the dollar is still 0.3%

China is hanging onto its 0.3% percent trading band against the dollar which means that even with this move don’t except a lot of volatility in the currency pair. Also, speculators will probably stick around for a while longer which means that even though China has announced a move on its currency, the topic of revaluation and further steps by China will remain in the limelight.

- China will move to a managed float against a basket of currencies

This is the real story. China is planning to move to a managed float against a basket of currencies. Not many details have been disclosed on this front but the People’s Bank of China has written the following on their website: “the trading prices of the non-US dollar currencies against the RMB will be allowed to move within a certain band” - which will be announced later by the PBoC. We suspect that China will take an approach similar to that of Singapore, which is to float their currency against a basket of other currencies within a tight trading band while not disclosing the exact percentage make-up of the basket to prevent speculators from attempting to manipulate their currency. Given that China exports a large percentage of its goods to not only the US, but also the European Union and Japan, the basket would naturally have to include Euros as well as Japanese Yen. This in of itself could be very positive for both of those currencies. Also, if you recall, those currencies were indeed apart of the currencies that China’s internal “interbank” system was trading in May.

What motivates China to do this?

China has many reasons to want to revalue their currency. The most apparent of which is the country’s political motivation to get approval for deals such as Unocal or the new speculation that they may dropping their bid of Unocal for other US oil producers. The US’ time stamp for a move by China in August could be an unwritten agreement between the 2 countries that would pave the way for a buying spree by the Chinese government and Chinese corporations. The revaluation also makes imports cheaper for China. This comes at a critical time when commodity prices are skyrocketing. The revaluation immediately makes prices of commodities such as oil 2.5% cheaper than they were yesterday.

What does it mean for the markets?

Treasuries - China’s move has ramifications for all of the financial markets. The most significant of which will probably be in US treasuries. As the world’s second largest holder of US treasuries, China’s revaluation and move to a basket float significantly reduces their need for US treasuries and could potentially take away a big buyer from the market. If this is the case, it will cause bond prices to slide and long-term yields to rally, which could offset some of the additional pressure on the Federal Reserve to continue raising rates. If China even begins to dump US treasuries, we could see the “yield curve conundrum” begin to fix itself.

Currencies - The reduced demand for US treasuries and the possibility of increased demand for other currencies such as Euros and Japanese Yen could be very negative for the US dollar. Right now, the dollar is holding somewhat steady against the Euro thanks to the fact that China has yet to announce the components within the managed float. Once they confirm that the Euro will be included in the basket, the single currency could skyrocket.

As for the Japanese Yen, which is the proxy for Asia strength, the currency should continue to benefit from news of China revaluation. Malaysia has already followed suit this morning by scrapping their own Ringgit peg and also adopting a managed float. Japan is quite pleased with the move and for the immediate term, it should eliminate any fears of Japanese intervention. The revaluation of the RMB makes Japanese goods more competitive on a relative basis against Chinese goods.

Stocks - The stock market should have a mixed reaction. Shares of companies such as Wal-Mart and Target have and will probably continue to sell-off because the revaluation 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. Shares of manufacturing companies that compete against China should rise along with shares of companies that are targets for Chinese acquisition. The revaluation makes its cheaper for Chinese companies to snap up US companies while at the same time possibility giving them more political sway.

Commodities - This could also be very positive for the commodity markets, with the revaluation immediately reducing the cost for commodities.

Is there more to come?

There will definitely be more to come in the world of revaluation. China has to still announce the details of their managed float against a basket of currencies. This announcement could result in another sharp move in the currency market. The 2.5% revaluation is modest at best - expect continued pressure on China to institute a larger revaluation. The managed float will allow them to gradually adjust the value of the RMB while at the same time maintaining an air of uncertainty and leg up over speculators. News of further Chinese bids on international companies should continue to flow into the market, especially since the country now has a massive amount of US dollars that may not need to be invested in as many US treasuries.