China rumbles currency markets

Written by Andrew Szabo
Wednesday, 14 October 2009 23:00

For many years, the U.S. Treasury has taken the position that China artificially maintains its currency (called the Renminbi, or RMB) at a low value in order to give its exporters a competitive edge, making Chinese exports cheap to overseas buyers while keeping imports expensive in China.

Such a “cheap RMB policy” might be impractical to maintain, if the RMB were a free-floating currency, like the U.S. dollar, the yen or the euro. Instead, the Central Bank of China maintains a “crawling peg” regime based on a target valuation.

Obviously, a cheap currency is not China’s only advantage. Chinese exporters benefit from a vast pool of cheap labor, a large cadre of skilled and highly educated workers, long pent-up entrepreneurial energy, official export subsidies and tax incentives, and (in the case of state-owned enterprises) favorable access to bank credit. Moreover, one element of most exports is imported content. Nevertheless, by objective measures, the RMB probably is undervalued, perhaps by as much as 40%. For this reason, it would make a lot of sense for an investor to long the RMB and short the U.S. dollar, although this trade is not easy to put on for a foreign investor.

China now holds about 2.5 trillion dollars equivalent in central bank reserves, of which about two-thirds are in dollar assets. These investments include primarily U.S. sovereign and agency obligations, but also U.S. commercial bank deposits, corporate bonds and stocks.

In early March, Chinese Premier Wen Jiabao said, “We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.” (Source: ForexBlog.org, 3/13/2009.) This statement sent shivers through the market for U.S. Treasury debt, as in recent years China has been the foremost central bank buyer at Treasury auctions.

However, a couple of weeks after Wen Jiabao’s statement, China’s top foreign exchange official, Xu Xiaolian, affirmed that treasuries are “an important element in China’s investment strategy for its foreign-currency reserves.” She added, “We will continue this practice.” (Bloomberg News Service, 3/23/2009).

More recently, in early July, the People’s Bank of China announced on its Web site that it would allow companies to use RMB to settle cross-border trades, while keeping their right to export tax rebates. It will also encourage its commercial banks to offer RMB settlement services. “Companies in China and neighboring countries are facing relatively huge risks of exchange-rate fluctuations because of big swings in the U.S. dollar, the euro and other major settlement currencies,” the Central Bank statement explained. (Source: Bloomberg News Service, 7/2/2009). Some economists view this move as a step toward making the RMB a global currency.

Finally, the Chinese have expressed the aspiration for a new international reserve currency, analogous to International Monetary Fund “Special Drawing Rights” (based on a basket of international currencies). Indeed, I believe we are going to see a major realignment of international currencies. The U.S. is in the process of losing its status as the sole international reserve currency, and this will entail some arduous effects for both our government and our consumers.

Next week: China buys natural resources as a “store of value.”

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment adviser. Questions, call 531-2877 or e-mail This e-mail address is being protected from spambots. You need JavaScript enabled to view it . Previous columns may be found at Blog.GreenwichFinancial.com.