Thoughts on the RMB Repeg

Whiskey & Gunpowder
by Mike "Mish" Shedlock
Aug 2, 2005

On July 21, China repegged the RMB to a basket of currencies.

On July 20, I wrote in "China Calls U.S.'s Bluff":

"Many were betting on a repeg by Autumn 2004, then January 2005. January became June as a trader I generally trust "guaranteed" me it would happen. Oops. Then the bets shifted to August. I would say the already poor odds of a RMB repeg by August have likely gone out the window. Eventually China will float, but it will be at a time of their choosing, not ours, and when they do, we might not care for the result, either.

"Note: If enough hot money flees China soon enough, possibly we see some movement. I just doubt this is the time. At some point, I will likely be wrong, but it sure seems to me the smart money has been betting against it."

Well, one day later we did see "some movement," and as I suggested, I would eventually be wrong. I just never thought it would be one day later.

There are a lot of articles out there about this, so let's review one straight from the horse's mouth.

Here is the official "Public Announcement of the People's Bank of China on Reforming the RMB Exchange Rate Regime":

"July 21, 2005

"With a view to establish and improve the socialist market economic system in China, enable the market to fully play its role in resource allocation as well as to put in place and further strengthen the managed floating exchange rate regime based on market supply and demand, the People's Bank of China, with authorization of the State Council, is hereby making the following announcements regarding reforming the RMB exchange rate regime:

"1. Starting from July 21, 2005, China will reform the exchange rate regime by moving into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. RMB will no longer be pegged to the U.S. dollar, and the RMB exchange rate regime will be improved with greater flexibility.

"2. The People's Bank of China will announce the closing price of a foreign currency such as the U.S. dollar traded against the RMB in the interbank foreign exchange market after the closing of the market on each working day, and will make it the central parity for the trading against the RMB on the following working day.

"3. The exchange rate of the U.S. dollar against the RMB will be adjusted to 8.11 yuan per U.S. dollar at the time of 19:00 hours of July 21, 2005. The foreign exchange designated banks may since adjust quotations of foreign currencies to their customers.

"4. The daily trading price of the U.S. dollar against the RMB in the interbank foreign exchange market will continue to be allowed to float within a band of +/-0.3% around the central parity published by the People's Bank of China, while the trading prices of the non-US dollar currencies against the RMB will be allowed to move within a certain band announced by the People's Bank of China.

"The People's Bank of China will make adjustment of the RMB exchange rate band when necessary according to market development as well as the economic and financial situation. The RMB exchange rate will be more flexible based on market condition with reference to a basket of currencies. The People's Bank of China is responsible for maintaining the RMB exchange rate basically stable at an adaptive and equilibrium level, so as to promote the basic equilibrium of the balance of payments and safeguard macroeconomic and financial stability.

OK, so China moved to a "managed floating exchange rate regime" against a "basket of currencies," with an initial adjustment of 2% against the U.S. dollar that is "allowed to float within a band of +/-0.3%."

No one knows the precise makeup of the basket. There is no timetable for further revisions, so the initial 2% adjustment is more symbolic than anything.

Kathy Lien on Daily FX offers "An In Depth Look" at what the Chinese revaluation means for the markets:

"China will move to a managed float against a basket of currencies

"This is the real story. China is planning to move to a managed float against a basket of currencies. Not many details have been disclosed on this front, but the People's Bank of China has written the following on their Web site: 'The trading prices of the non-U.S. dollar currencies against the RMB will be allowed to move within a certain band' -- which will be announced later by the PBoC. We suspect that China will take an approach similar to that of Singapore, which is to float their currency against a basket of other currencies within a tight trading band while not disclosing the exact percentage makeup of the basket, to prevent speculators from attempting to manipulate their currency. Given that China exports a large percentage of its goods to not only the United States but also the European Union and Japan, the basket would naturally have to include euros, as well as Japanese yen. This in of itself could be very positive for both of those currencies. Also, if you recall, those currencies were indeed apart of the currencies that China's internal 'interbank' system was trading in May."

Lien also offered this commentary on Treasuries:

"Treasuries -- China's move has ramifications for all of the financial markets. The most significant of which will probably be in U.S. Treasuries. As the world's second largest holder of U.S. Treasuries, China's revaluation and move to a basket float significantly reduces their need for U.S. Treasuries and could potentially take away a big buyer from the market. If this is the case, it will cause bond prices to slide and long-term yields to rally, which could offset some of the additional pressure on the Federal Reserve to continue raising rates. If China even begins to dump U.S. Treasuries, we could see the 'yield curve conundrum' begin to fix itself."

Treasuries are interesting because I was just debating Mark Hulbert of MarketWatch on whether or not there was a "A New Conundrum in Treasuries":

Mr. Hulbert was in a conundrum because, "The bond market has fallen markedly over the past month even while bond investors appear to have become less concerned about inflation."

I thought there was no conundrum and listed the following three reasons:

1) In the wake of capitulation by Bill Gross and Stephen Roach (the newest Treasury bulls), some sort of snapback should be expected. I went neutral on Treasuries shortly after Gross's capitulation.

2) Perhaps the Treasury market is looking forward to the next Fed pause. I think at least a short-term sell-off is likely when the Fed pauses, and then again when the Fed first cuts. Mish, did you say "cut"? Yes, I said cut.

3) Corporate bond investors have gotten insanely greedy lately. Investors are chasing any little bit of extra yield they can find. As a topping process in this greed, there is an increased risk preference for junk bonds versus Treasuries. Even the riskiest of junk has been receiving very healthy bids. Eventually, this insanity in junk will unwind, and there will be a mad rush (a repricing, if you prefer that term) back into Treasuries and away from risk.

Hmmm...

Looks like we have a fourth reason that did not occur to me yesterday:

4) China to repeg to a basket of currencies.

Mark, If you happen to be reading this, I am 100% sure your conundrum is now resolved. I would guess that although all four items played a part, the order of significance is 1,4,2,3 -- perhaps 4,1,2,3 -- but I have little doubt that the capitulation of Gross kicked it off. Did someone know about the repeg? Nah, can't be. That never happens, right, Mark?

Market futures sure were wild after the revaluation announcement, with a huge gap up premarket (any S&P stops were likely hit) followed by a huge gap and a cr*p decline, followed by a midday rally and a tank job into the close. Is that enough excitement for everyone? Perhaps today is the start of a downside reversal, given that the stops above have all been cleared out.

Gold was acting weirdly the day before the repeg, on nothing that I can really point to in particular. But just before the gold close, I thought gold was acting stronger than I expected, so I bought deep ITM DEC calls.

We are very close to the seasonal buying period (normally, I get in at the end of July). This was a "just in case" type of play (and to be honest, nowhere near a full position). A couple of people on The Motley Fool and Silicon Investor bought in as well. Let's see if this is a head fake or the real deal this time.

The No. 1 big question now is, "What is priced into Treasuries?"

Housing is stalling in a number of localities, inventories are building, but most importantly, people buying 1-year, 2-year, or 3-year adjustable mortgages or LIBOR-based loans near the interest rates lows are going to start feeling some heat. If Treasuries continue to sell off, look for pressure not only on housing, but financial and retail sector stocks as well.

Note that although Treasuries fell hard across the board today, the 5-year, 10-year, and 30-year all fell about the same amount. There has been no significant widening of the yield curve, and if anything, the spreads have tightened further over the last couple of weeks.

The five-and-dime spread is a mere 20 basis points and the 10-30 spread is under 22 basis points. That is not a lot of difference for what seems to be a lot of extra risk. If Greenspan hikes twice more, I think the yield curve inverts somewhere.

Again, this should not be good for equities, but there is still amazing amounts of liquidity sloshing around (and there likely will be until housing breaks). Guess we will see.

The No. 2 big question now is, "Did this placate the U.S. Congress, and, if so, for how long?"

On the surface, this repeg did nothing. It is symbolic only. Two percent is peanuts when Congress thinks the RMB is 30-40% undervalued.

I have to tip my hand to China. This was a smooth operation designed to give as little as possible, forcing out as much hot money as it could in the interim. I proposed weeks ago for China to repeg 1% higher when they do it. Perhaps that would have been too big a slap in the face to the United States.

"Elroy Jetson" on Silicon Investor writes, "It's the big grand opening of absolutely nothing -- complete with spotlights and a band." I happen to agree.

Nonetheless, it likely did buy China time on silly tariff legislation. In that end, it was not useless. I offer the following as proof that China may have placated the United States: "China's Move Is Good First 'Baby' Step, Schumer Says":

"A top congressional critic of China's trade policies said China's announcement that it would let the yuan float a bit was a 'good first step, albeit a baby step.' Sen. Charles Schumer (D-N.Y.), said the move 'is smaller than we had hoped, but to paraphrase the Chinese philosophers, a trip of a thousand miles can well begin with the first baby step.' Schumer has sponsored legislation that would impose significant tariffs on Chinese imports unless it allows its currency to float freely on global markets."

The No. 3 big question is, "How much hot money left China, and if it did, how fast will it return?"

I was fortunate enough to have a chance to talk to Paul Kasriel at the Northern Trust today. We were discussing today's events. Neither of us knows if hot money was forced out of China before this action. I suggest that China forced out as much as it thought that it could. But quite frankly, other than China, who could possibly know?

Looking ahead, how fast will hot money flow back into China? Again, no one knows. The faster it does, however, the more inflationary pressures will build in China. If China reacts by raising interest rates, that just might magnify China's problem.

Short term, it seems we may have dodged a protectionist bullet. We will find out soon enough.

Long term, a 2% RMB change, a 5% or even a 20% change, is not going to do the United States one bit of good toward rebuilding of a manufacturing base in the United States. In fact, I doubt it will have any affect even on stemming the tide of outsourcing, not with a 20-1 wage differential.

Not only will it not stop outsourcing or improve exports, but it will probably do little to address the U.S. current account balance. Long term, it bought China some time, so later on down the road, China will be prepared to float the RMB at a time of its choosing, not ours.

In the meantime, the bands play and the trumpets blow as if this will solve some problem or other.

I am not really trying to make light of this news. It was a significant event. Acting to prevent a global protectionist nightmare in and of itself was significant. It does solve a problem as well: China's.

China took a step closer to floating the RMB, and this should quell the discussion as to whether or not China is a "currency manipulator." It may put some pressure on the US dollar, but that is by no means assured in the long term. As long as the United States is hiking, the U.S. dollar is likely to have a decent bid.

Perhaps that is one reason China acted now. If so, China's timing was perfect. Acting now, before the Fed pauses on a housing bust, was a very good move. Indeed, Stephen Roach proclaims "An Awesome Move by China":

"China's long-awaited currency adjustment is unambiguously positive for the global economy. Yes, it is a first step -- and a tiny one at that. But it qualifies China as an active participant in the global adjustment process. Up until now, the Chinese were on the outside looking in, insofar as global rebalancing was concerned. That was a recipe for increased trade frictions and protectionism -- a hugely destabilizing possibility for an unbalanced world. China's move on the currency front diminishes those risks and could well provide an important kick-start to an increasingly urgent global rebalancing.

"I applaud China's action for three reasons: First and foremost, it derails Washington's protectionists and the serious threat they posed to geopolitical stability. Admittedly, a 2% revaluation of the renminbi stops well short of the 27.5% adjustment stipulated by the proposed China Currency Act (S. 295) sponsored by U.S. senators Schumer and [Lindsey] Graham [R-S.C.]...

"A second reason why this action is a plus is that a small currency adjustment does little damage to China export competitiveness. China has already taken actions to cool off its overheated property sector, and it does not want to risk overkill by crushing exports...

"Thirdly, China's new currency policy is a much more stable arrangement for the world financial system. From the Chinese perspective, it will help relieve the tensions that have been building from failed sterilization tactics -- the inability of China to issue enough domestic debt to offset the massive purchases of U.S. Treasuries required by the now-abandoned dollar peg. This was leading to excess money and credit creation -- underscoring the mounting risks of inflation and/or asset bubbles.

Roach concludes:

"Let's give credit where credit is due -- always a hard thing for the world when it comes to China. My advice is to look at what now lies ahead: Do not focus on the July 21 action as the end, in and of itself. While this first move was small and belated, China's currency adjustment is emblematic of an endgame that could be a linchpin to long overdue global rebalancing. This is awesome news for an all-too-precarious world."

Indeed, one has to tip the hat to China for when they did it, how they did it, and with how little the initial impact was.

Will this pressure interest rates in the United States? Treasury and U.S. dollar bears sure think so. They came out of the woodwork to celebrate the demise of U.S. Treasuries and the dollar.

The initial response was mild: 10 basis points on the 5-year, 10-year, and 30-year notes. Significant, but hardly a panic collapse. One day after the event, at least as I am currently typing, Treasuries have gained half of that back.

The yen moved about 2.5% on the news, but I see it has given back 0.5% of that. The U.S. dollar index is up about 0.5% at the time of this writing as well. At least as of now, we have not seen any significant follow-thru in relation to what everyone seems to be expecting.

Is this a lull before the storm? Possibly, but if China moves slow enough, perhaps there is no storm. Indeed, perhaps we have already seen the bulk of the reaction with a near-50 basis point jump in the 10-year note from Bill Gross' capitulation to the spike on the RMB announcement.

If that is indeed the case, Treasury bears shorting here after this significant move in rates over the past month or so just might be setting themselves up once again to have their heads handed to them.

Regards,

Jul 25, 2005
Mike Shedlock "Mish"
email: Mish

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