The Yuan Story

Today’s fall in Asian major currencies prompted a decrease in the Chinese yuan against the U.S. dollar. The Chinese currency dropped 0.1 percent to 7.5655 against the dollar at 5:30 p.m. in Shanghai from yesterday’s close of  7.5581. Despite taken off the fixed-exchange rate against the dollar in July 2005, the Chinese central bank sets the yuan against a basket of currencies. The currency is not on a peg, but more correctly on a band with some limited freedom of movement.

The only problem is that no one knows for sure what the currency basket is composed of. The Chinese are very secretive about this aspect of their monetary policy. Tim Shea, currency analyst at FXCM, believes the basket is 40 percent U.S. dollar, 20 percent euro, 20 percent yen, 10 percent AUD, and 5 percent ringgit. The biggest worry for the Chinese government is the yuan appreciating too quickly.

It was clear today that the People’s Bank of China lowered the yuan in response to its neighboring counterparts. If the yuan gains too much against the other regional competitors, Chinese exports will become less competitive in the global market. Tetsuo Yoshikoshi, a market analyst at Sumitomo Mtsui Banking Corp., states: “Yuan’s decline is in line with the region and the broad dollar strength.” He also reports the yuan’s midpoint has been reflective of overnight U.S. dollar movement recently. This finding is indicative of a currency basket populated mostly by the US currency, but that still allows room for Asian currencies.

Despite U.S. political pressure, the People’s Bank of China has been keeping the yuan appreciation rate at a minimum, just enough to keep a stable, high-paced economy running. The central bank has been able to control the currency by buying large sums of U.S. dollars. This in turn has brought the foreign-exchange reserves to a record high. Against the dollar the yuan is in fact only allowed to move by 0.5 percent, being held on a so called central parity rate. Other than the yuan already being tightly controlled by the central bank, only a select number of financial institutions can trade the currency under a special license in Shanghai. The fact is, it is very difficult to get liquidity in the yuan, making it very hard to trade speculatively.

It remains to be seen whether select U.S. lawmakers can build enough support to pressure the Chinese to strengthen the yuan. With the current increase in FDA safety inspections of Chinese imports, this may already be the type of leverage the U.S. needs.