Treasury Today Country Profiles in association with Citi

ECR Research logo

Global market overview – April 2010

With speculation rife over the future of China’s currency, what are the wider-reaching implications for a revaluation of the yuan? In this month’s Market View, we examine the potential impact of yuan appreciation on the EUR/USD exchange rate.

The yuan and its implications for EUR/USD

Recently the question of whether – and if so, when – China will revalue its currency and what the implications for EUR/USD are, has been hotly debated. We believe that a revaluation could have major implications in China, but also that there may be important developments elsewhere that will affect the EUR/USD.

Chart 1: After having adopted a managed float since 2005, China reintroduced the dollar peg in 2008
Chart 1: After having adopted a managed float since 2005, China reintroduced the dollar peg in 2008

Source: Reuters EcoWin/ECR

After having moved its fixed exchange rate regime, or ‘dollar peg’, into a managed floating one in 2005, the Chinese authorities have reintroduced the peg ‘unofficially’ since the economic downturn of 2008, albeit at a lower USD/CNY exchange rate. By buying US dollars and selling Chinese yuan for amounts equal to the level of capital inflows, the People’s Bank of China (PBoC) keeps the yuan artificially low against the US dollar. In doing so, it attemps to maintain exports at high levels in order to fight the risk of unemployment caused by the worldwide economic and financial crisis.

Recently, US authorities – from central bankers to the President himself – have put more and more pressure on China to let its currency appreciate as they argue that the yuan is undervalued. If the appreciation were to happen, the US would be able reduce its trade deficit with China and the rest of Asia, thereby narrowing its huge current account deficit. At the same time, China’s current account surplus would decline and the country would be able to develop a more consumption-based economy. But what consequences will this issue have for the – arguably more interesting – exchange rate of the US dollar versus the euro?

Forced appreciation

There is a difference in opinion on what the US should do next. On the one hand some say that even more pressure is needed to force China to let the yuan appreciate. For example, the US Treasury department has to issue a report twice a year that comments on countries that manipulate their exchange rate to the US dollar for competitive purposes. To date, it has not mentioned China’s exchange rate regime. The next report is due on 15th April (not published at the time of writing), and taking an official stance on China this time will add to the pressure already in place. The US could also implement more extreme protectionist measures across the board, against Chinese imports for instance, to enforce an appreciation of the yuan.

Some analysts think that should the US succeed in doing so, the Chinese will start a massive sell-off of their enormous US dollar reserves because of increased tension between the two countries. This would drive up long-term US interest rates and cause the dollar to collapse. Others agree with the assumption that a forced appreciation of the yuan will trigger a sell-off of US Treasuries by China, but that this can be fully or partly offset by the Federal Reserve, which is able to act as an alternative to China as a buyer of Treasuries. As such, long-term interest rates will not increase that significantly. The dollar will probably fall somewhat against the euro, but isn’t this exactly what the US needs right now in order to narrow its current account deficit? Either way, in our opinion, selling US assets is a dollar negative and puts upward pressure on the EUR/USD exchange rate.

Voluntary appreciation

While there are those who believe that increased pressure on China to enforce an appreciation is needed, others take a completely different approach. History has taught that China just isn’t that susceptible to pressure from Western countries. It might be more sensible to let the discussion on the Chinese exchange rate rest for a while. As the Chinese economy is showing signs of overheating, the authorities will have to tighten policy at some time in the near future. Compulsory commercial bank reserves have already been raised.

We are witnessing the first steps towards cooling down the booming economy, as this effectively brings down the amount of money that is available to lend to companies. Some analysts are already speculating about what would be the first interest rate rise by the PBoC in over two years.

Another tightening measure could be an appreciation of the yuan. This will limit Chinese exports to the US and thereby Chinese economic growth. This would be a voluntary appreciation, which implies no increased tension between the US and China and, consequently, no massive sell-off of US Treasuries. Such an appreciation is already largely discounted for in the financial markets, so we do not believe this will have major implications for EUR/USD.

However, there is a catch: increasing bank reserve requirements, raising interest rates and appreciating the yuan might mean too much tightening at once. The Chinese economic growth will be too low for China to be considered the growth engine of the world. This will cause increasing rumour in financial markets, which in the past has proven to be positive for the dollar, putting downward pressure on EUR/USD as it decreases risk appetite.


Although these scenarios might come into play over the longer term, we are confident that for the short to medium term, factors other than a yuan appreciation are more important for EUR/USD. We believe the focus now should be more on public finances in the European economies. In this respect, Greece is just a first example.

Chart 2: China has begun tightening by raising compulsory reserves, but for now interest rates are kept low
Chart 2: China has begun tightening by raising compulsory reserves, but for now interest rates are kept low

Source: Reuters EcoWin/ECR

Markets are already worrying about countries like Spain and Portugal, but, in our opinion, they should not forget about the stronger EMU members as well. As the ‘ageing problem’ (due to the baby boom after World War II, the elderly will soon make up a larger share of the total population. This will require higher government outlays, while government revenues decline) will also soon start to become reality, all EMU countries will have to tighten fiscal policies. This will put downward pressure on economic growth, meaning that the ECB will not think about raising policy rates for a while.

In the US on the other hand, growth is accelerating due to heavy cost-cutting in the corporate sector. Inventories, hiring and investments were scaled back to prepare for plummeting demand, but because of the enormous fiscal stimulus, demand was much higher than expected. A catching-up process can be expected, increasing economic growth in the coming months. This will in turn feed market speculation around monetary tightening by the Fed. Together with the expectation that the ECB will keep rates low for a longer period of time, this puts downward pressure on EUR/USD. Therefore in the coming months to quarters our target for the EUR/USD exchange rate is 1.20.