Forex Investment and Currency Trading

There has been much recent speculation that China has changed its FX policy and no longer wants a fast appreciation of the Chinese yuan (CNY). People who have this view use the recent consolidation in USD-CNY to support their case. However, a more detailed examination of CNY trading patterns against China’s major trading partners suggests that CNY appreciation has accelerated rather than slowed – against other currencies than the USD. This leads us to the view that the People’s Bank of China (PBoC) may now be managing the CNY on a NEER (Nominal Effective Exchange Rate) or trade weighted basis rather than just against the USD – as the authorities promised when they de-pegged from USD on 21 July 2005. In fact, the PBoC is also probably looking closely at the Real Effective Exchange Rate (REER) as well. Markets have also been speculating that the PBoC may consider the 7.00 level on USD-CNY as a key psychological barrier – in much the same way as USD-CNY was made to trade around 8.00 for quite some time before resuming the downtrend. However, even if this is the case, the CNY has appreciated in real terms while the market has focused largely on USD-CNY.

The fundamental case for managing the CNY on a NEER/REER basis is strong. Fighting inflation
remains the number one policy priority for China. Both April PPI and CPI came in higher than
expected. Food and energy prices continue to soar. Beijing is also caught in the trap between rising inflation and slower growth, but the authorities are well aware of the dangers of allowing inflation expectations to become embedded. Although the authorities have not raised interest rates this year, they have implemented a quota, which is biting. The PBoC has just hiked reserve requirement again. Moreover, the last G7 meeting explicitly called for faster CNY appreciation on a trade-weighted basis. Since the start of April, most key trading partner currencies have fallen against the CNY, in the case of the Japanese yen (JPY), Indian rupee (INR) and South Korean won (KRW) by over 5%. CNY remains a highly managed currency. This suggests CNY appreciation remains a key policy priority, but on a NEER basis rather than just against the USD. As such, USD-CNY trading is increasingly a function of the overall USD trend, as much if not more than a reflection of overall CNY strength.