China Backpedals on the Yuan

Last week we drew attention to the strange behaviour of Chinese officials, who pushed the yuan downward against the dollar while their trading partners were calling for the Chinese currency's appreciation. This shift occurs as China is clearly trying to diversify its investments, as exemplified by the hike in its allocation in government debt from the zone: Y1.7 trillion in Japan in the first seven months of 2010, up from just Y255.7bn for all of 2005, and $2.11bn in South Korea. At the same time, China has reduced its investments in US debt by $8.95bn to $844bn. (La Chine diversifie ses réserves de change; The Real Drivers of Diversification in China’s FX Reserves). This also surely explains a big part of the yen's strength vis-à-vis the dollar and the euro. On the basis of the latest statistics published in the China Securities Journal, this is the current breakdown of currency reserves: dollar 65%, euro 26%, pound sterling 5%, yen 3%. The main reason (in their eyes) for these changes in currency reserve allocations is the fear, as expressed on numerous occasions since 2008, but more and more clearly in recent weeks, that the dollar will lose its status as the world's reserve currency (too much of the Fed's QE?), leading to a significant decline in its value. PBOC governor, Ms Hu Xiaolian, has made the latest pronouncement in this vein: “My view is that the Yuan doesn’t have a key role to play in rebalancing bilateral trade between the U.S. and China. I don’t think excessive argument and criticism on this issue will help”. (WSJ 1 Sep 2010) "Once a reserve currency's value becomes unstable, there will be quite large depreciation risks for assets. A diversified international currency system will be more conducive to international economic and financial stability.” (China Finance, 6 Sep 2010). In reality, you can already read the same views in Ms Xialian's speech of 15 July before the PBOC: “Three Characteristics of the Managed Floating Exchange Rate Regime.” However, the yuan's recent depreciation vis-à-vis the dollar hardly went unnoticed in the United States where it sparked an immediate reaction from Robert Hormats, under secretary of State for economic, energy and agricultural affairs: ‘U.S. Official Warns of Backlash Against China’. “A lack of action by the Chinese to address U.S. concerns about currency issues and intellectual-property protections could encourage a more protectionist agenda on Capitol Hill.” "We're likely to see some legislation offered that would be adverse to Chinese interests if more steps aren't taken.” All this in an already tense context, as Larry Summers (Director of the National Economic Council) and Thomas Donilan (Deputy National Security Advisor) travel to China to discuss all these highly sensitive issues. They will not only talk about the yuan, but also about China's anger at US involvement in the South China Sea and US concerns about Iran. ‘Bumpy months ahead for U.S. and China’ So surprise, the yuan's controlled depreciation last week has abruptly moved upward, just in time for Mr Summers' visit. Here is an updated graph comparing the yen and the dollar. Yuan and yen vs the US dollar China back-pedals a bit…

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