In Advance Of G-20 Meeting, China Announces Dollar Peg To End

In a statement posted on the PBOC's website late last night, the Chinese central bank has announced it will seek a flexible yuan, ending a two-year peg to the dollar. The news comes a week before the G-20 meeting at which the CNY exchange rate was set to be a key issue of debate. On the other hand, as the PBoC noted, With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist." As such, a large initial move is unlikely to occur, and the bulk of the volatility will likely strike at traded CNY forwards.

Full statement:

Further Reform the RMB Exchange Rate Regime and Enhance the RMB Exchange Rate Flexibility
In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People´s Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.

Starting from July 21, 2005, China has moved into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. Since then, the reform of the RMB exchange rate regime has been making steady progress, producing the anticipated results and playing a positive role.

When the current round of international financial crisis was at its worst, the exchange rate of a number of sovereign currencies to the U.S. dollar depreciated by varying margins. The stability of the RMB exchange rate has played an important role in mitigating the crisis´ impact, contributing significantly to Asian and global recovery, and demonstrating China´s efforts in promoting global rebalancing.

The global economy is gradually recovering. The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability. It is desirable to proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility.

In further proceeding with reform of the RMB exchange rate regime, continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies. The exchange rate floating bands will remain the same as previously announced in the inter-bank foreign exchange market.

Chinas external trade is steadily becoming more balanced. The ratio of current account surplus to GDP, after a notable reduction in 2009, has been declining since the beginning of 2010. With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist. The People´s Bank of China will further enable market to play a fundamental role in resource allocation, promote a more balanced BOP account, maintain the RMB exchange rate basically stable at an adaptive and equilibrium level, and achieve the macroeconomic and financial stability in China.
Submit Date:2010-6-19 19:00:00

Tim Geithner immediately responded to the development: “We welcome China’s decision to increase the flexibility of its exchange rate. Vigorous implementation would make a positive contribution to strong and balanced global growth. We look forward to continuing our work with China in the G-20 and bilaterally to strengthen the recovery.”

The move will likely have substantial negative developments to various sectors of the Chinese economy:

Companies focused on the Chinese market, including Beijing- based computer maker Lenovo Group Ltd. and Shanghai-based China Eastern Airlines Corp., said in March that they would gain from lower import costs and stronger consumer-purchasing power should the yuan appreciate. Textiles makers would stand to lose the most and some would “face bankruptcy” as their profit margins are as low as 3 percent, Zhang Wei, vice chairman of the China Council for the Promotion of International Trade, said in March.

Of course, in a recreation of the aftermath of the US credit bubble, the biggest losers will be private lenders, straddled with trillions in ever more worthless real estate loans, which will suddenly now become an even greater drag, due to a stronger currency. What this means, is that the rolling wave of QE will soon hit China next, after the US and Europe. Which makes sense: China's central bank is not saddled with the same gargantuan amounts of bad debts as the Fed, and soon, the ECB, which makes it a convenient last receptacle of toxic waste in exchange for one last attempt at a global liquidity pump. This will likely buy Keynesianism a little more time. In the meantime, we once again highlight the relationship between the CNY and the Chinese 30 Day Repo Rate. With this number having hit near record highs, courtesy of a recent move lower in the CNY, it only seemed inevitable that China would be forced to unlock its own interbank lending market in whatever way it could.

The question now becomes what will the aftermath of this announcement be? As the FT points out, investors are likely to read into it a little more than prudent:

“The danger is that on Monday morning everyone gets very excited and then end up being disappointed with what happens. There is very little appetite for appreciation, so in the short-term the central bank is likely to be very conservative,” said Stephen Green, an economist at Standard Chartered. “As a result, the US-China relationship could still be very tricky.”

Lastly, with less dollar purchasing by the PBoC, and also courtesy of recent foreign trade deficits, should the bank be serious in its intentions, this simply means that increasingly fewer dollars will be held in the Chinese FX reserves, which in turn will mean increasingly lower Indirect bidder (and/or Direct assuming this particular category is merely China acting covertly out of London, instead of just the Fed monetizing surreptitiously) interest will drop to the point where Primary Dealers (and UK) will be the only end purchasers of US bonds.

Either way, this is sure to play major havoc with already extremely volatile EUR, CHF, GBP and JPY pairs.