John Mauldin
Last week I said that for this week's letter we would look at the US trade deficit and China, and in particular the possible revaluation of the currency and its effect upon the trade deficit. China obliged by revaluing the yuan (Renminbi). This is both more, and less, than it seems.
Let's first look at what China did. They allowed the yuan to rise by 2%, with a daily 0.3% trading band based on the price of the previous day. While in theory this could allow for a significant price increase over a period of several months, in practice it is unlikely to do so. Allowing the yuan to rise too rapidly would be highly destabilizing to the Chinese economy. You can take it to the bank, even an undercapitalized Chinese one, that the Chinese government will do everything in its power to maintain stability.
Further, instead of pegging the yuan to the dollar, it is now going to be pegged to a basket of currencies. Because it is a basket reference rate, it will be possible for the yuan to both rise and fall against the dollar. Can you imagine the consternation of Congress if the dollar rises against the yuan? Let's look at how that could happen.
"The basket is likely to be heavily dominated by the USD. Using China's trade weights, normalized, a five currency basket would have the following weights: USD (27%), JPY [Japan](31%), HKD (Hong Kong] (24%), EUR (15%), and GBP [Great Britain](4%). The hard dollar pegs (USD and HKD) account for close to 50% of the basket. If you consider the JPY as a soft USD peg, the weight on the dollar could be as high as 80%. This means USD/RMB will still be very 'docile', with the index being 'sticky' relative to the USD." (Morgan Stanley)
In essence, only 20% of the potential basket proposed by Morgan Stanley would actually float in any real sense. If the euro and the British pound were to sell off against the dollar it would cause the value of the basket to fall relative to the dollar, and thus would have the effect of lowering the price of the yuan. This could be a real scenario, as the euro and the whole union are now in a great deal of uncertainty, not to mention really slow growth. The markets hate both.
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