Q+A-Does China manage the yuan against a basket?
Fri Jul 16, 2010 6:45am BST
By Lu Jianxin and Koh Gui Qing
SHANGHAI July 16 (Reuters) - After China transfixed world markets by breaking the yuan's peg to the U.S. dollar last month, investors are now focusing on how the currency of the world's third-biggest economy would be controlled.
For although tensions between China and the United States over the yuan's value to the dollar have eased a notch with the latest depegging, U.S. politicians who believe the yuan is undervalued are keen as ever to see the Chinese currency rise from here. The yuan has risen 0.8 percent against the U.S. dollar since depegging and in the NDF market, it implied appreciation is 1.7 percent for the next 12 months. CNY1YNDFOR= CNYNDFOR=
But before any predictions can be made, investors need to first work out how China's secretive new currency regime works, and key to that is understanding whether the yuan is managed against a basket of currencies.
IS THERE A BASKET RIGHT NOW?
In theory, yes, but many investors doubt it.
Since the yuan's revaluation in July 2005, China has always said the yuan is managed against a basket of currencies. It said so again on June 19 after breaking the yuan's dollar peg.
Yet, many analysts believe the basket does not exist, and that the yuan is still pegged to the dollar in reality.
Nizam Idris, a UBS analyst in Singapore, said he monitored the yuan for a period of three months between 2005 and 2008, and a regression test showed the dollar explained 98 percent of the yuan's moves.
"I don't believe they had a basket in 2005 and I still don't believe they have a basket now."
SO WHAT IF THERE IS A BASKET?
If the yuan is really managed against a basket, the biggest rub is that the yuan could drop against the dollar and yet still rise when measured against other currencies.
This is because if China's central bank decides to keep the yuan stable against a basket, its gains against one currency are offset by losses against another.
A basket is usually made up of currencies of a country's biggest trading partners. In China's case, the dollar and euro should account for the bulk of the basket.
So if the euro EUR= resumes its drop due to Europe's debt problems, the yuan should rise against it. Such strength could then be offset by losses against the dollar.
In a scenario analysis, Goldman Sachs concluded that if China opts to keep the yuan's value stable against a basket, the yuan could drop over 3 percent against the dollar in three months.
But many analysts believe this is not viable in practice.
The United States is still pressuring China to let the yuan rise, and China, on its part, would loathe to waste the political capital earned from the depegging by letting the yuan slip now.
So why does China insist there is a basket then?
Analysts said perhaps China genuinely wants to move to a basket currency regime some day as it opens up its capital account. But for now, its hands are tied.
HOW WOULD A BASKET WORK?
China has said before the dollar, euro, yen JPY= and won KRW= are the main currencies in the basket.
Others include the Singapore dollar SGD=, the pound GBP=, the Malaysian ringgit MYR=, the rouble RUBUTSTN=MCX, the Australian dollar AUD=, the Thai baht THB= and the Canadian dollar CAD=.
Since China offers only sketchy details on the basket, many investment banks have resorted to designing their own hypothetical yuan basket.
Goldman Sachs designed a basket where dollars accounted for 24 percent, the euro 20 percent, and the yen 19 percent.
Bank of America-Merrill Lynch's basket had the dollar accounting for 40 percent, the euro 16 percent, and the yen 12 percent.
Given Singapore is the only central bank in the world to manage its currency against a basket, its "basket, band, crawl" system is usually cited as a model for China.
The central bank controls the Singapore dollar by managing it against a basket of currencies of its top trading partners. The exact constituent currencies in the basket are kept a secret.
Every day, the central bank allows the Singapore dollar to "crawl" about within an undisclosed band. When the Singapore dollar is at the edge of either sides of the band, the central bank intervenes to buy or sell the currency to nudge it back.
While this model may work for China for now, some analysts said it is not tenable in the long run as China would need to forsake interest rates as a policy tool. That is not practical if domestic demand is to drive more of China's future growth. (Writing by Koh Gui Qing; Editing by Jan Dahinten)
Fri Jul 16, 2010 6:45am BST
By Lu Jianxin and Koh Gui Qing
SHANGHAI July 16 (Reuters) - After China transfixed world markets by breaking the yuan's peg to the U.S. dollar last month, investors are now focusing on how the currency of the world's third-biggest economy would be controlled.
For although tensions between China and the United States over the yuan's value to the dollar have eased a notch with the latest depegging, U.S. politicians who believe the yuan is undervalued are keen as ever to see the Chinese currency rise from here. The yuan has risen 0.8 percent against the U.S. dollar since depegging and in the NDF market, it implied appreciation is 1.7 percent for the next 12 months. CNY1YNDFOR= CNYNDFOR=
But before any predictions can be made, investors need to first work out how China's secretive new currency regime works, and key to that is understanding whether the yuan is managed against a basket of currencies.
IS THERE A BASKET RIGHT NOW?
In theory, yes, but many investors doubt it.
Since the yuan's revaluation in July 2005, China has always said the yuan is managed against a basket of currencies. It said so again on June 19 after breaking the yuan's dollar peg.
Yet, many analysts believe the basket does not exist, and that the yuan is still pegged to the dollar in reality.
Nizam Idris, a UBS analyst in Singapore, said he monitored the yuan for a period of three months between 2005 and 2008, and a regression test showed the dollar explained 98 percent of the yuan's moves.
"I don't believe they had a basket in 2005 and I still don't believe they have a basket now."
SO WHAT IF THERE IS A BASKET?
If the yuan is really managed against a basket, the biggest rub is that the yuan could drop against the dollar and yet still rise when measured against other currencies.
This is because if China's central bank decides to keep the yuan stable against a basket, its gains against one currency are offset by losses against another.
A basket is usually made up of currencies of a country's biggest trading partners. In China's case, the dollar and euro should account for the bulk of the basket.
So if the euro EUR= resumes its drop due to Europe's debt problems, the yuan should rise against it. Such strength could then be offset by losses against the dollar.
In a scenario analysis, Goldman Sachs concluded that if China opts to keep the yuan's value stable against a basket, the yuan could drop over 3 percent against the dollar in three months.
But many analysts believe this is not viable in practice.
The United States is still pressuring China to let the yuan rise, and China, on its part, would loathe to waste the political capital earned from the depegging by letting the yuan slip now.
So why does China insist there is a basket then?
Analysts said perhaps China genuinely wants to move to a basket currency regime some day as it opens up its capital account. But for now, its hands are tied.
HOW WOULD A BASKET WORK?
China has said before the dollar, euro, yen JPY= and won KRW= are the main currencies in the basket.
Others include the Singapore dollar SGD=, the pound GBP=, the Malaysian ringgit MYR=, the rouble RUBUTSTN=MCX, the Australian dollar AUD=, the Thai baht THB= and the Canadian dollar CAD=.
Since China offers only sketchy details on the basket, many investment banks have resorted to designing their own hypothetical yuan basket.
Goldman Sachs designed a basket where dollars accounted for 24 percent, the euro 20 percent, and the yen 19 percent.
Bank of America-Merrill Lynch's basket had the dollar accounting for 40 percent, the euro 16 percent, and the yen 12 percent.
Given Singapore is the only central bank in the world to manage its currency against a basket, its "basket, band, crawl" system is usually cited as a model for China.
The central bank controls the Singapore dollar by managing it against a basket of currencies of its top trading partners. The exact constituent currencies in the basket are kept a secret.
Every day, the central bank allows the Singapore dollar to "crawl" about within an undisclosed band. When the Singapore dollar is at the edge of either sides of the band, the central bank intervenes to buy or sell the currency to nudge it back.
While this model may work for China for now, some analysts said it is not tenable in the long run as China would need to forsake interest rates as a policy tool. That is not practical if domestic demand is to drive more of China's future growth. (Writing by Koh Gui Qing; Editing by Jan Dahinten)