March 12, 2010

China’s currency peg - How much longer will it last?

Discussions about China’s currency peg have been surfacing every so often in recent years.  When convenient, US politicians have been pointing a finger at a manipulated currency rate, as if all economic troubles could resolve, were it not for the “artificially undervalued” currency.  This week, the US president himself called on China to institute a “more market-oriented” exchange rate. 

The issue is of course very complex and considering China’s multi-trillion Dollar US holdings, any change in its currency policy could have massive repercussions for their domestic economy.  In 1994, China initiated a gradual appreciation of their currency which came to a halt during the financial crisis.  China must now balance its need to keep domestic inflation under control with an equally challenging task to manage its huge US Dollar exposure. 

Take your pick as to what would be the lesser of two evils.  The market seems to favor a gradual and managed appreciation of the Yuan against the Dollar.  As the Financial Times reported this week, Trading in forward CNY contracts factor in an appreciation of about 2.8% over the coming year.  Given the recent Chinese inflation numbers of +2.7%, that figure seems to correlate closely with the implied currency adjustment sometime later this year. 

Putting a possible revaluation into context however, the roughly 15% adjustment to values prior to 1994, which appears closer to the true value of the Chinese Yuan, seems far and elusive at this point.  If estimates are correct that China is holding over $2 trillion in US assets, we are looking at an implied loss of about $300bn, an amount big enough to raise more than a few eye brows...


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