China's 'First Step' May Be Last for a While

The People's Bank of China seeks to dampen speculation it'll be revaluing again anytime soon.
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Four days after jolting world markets with a first symbolic step toward revaluing the yuan, China on Tuesday sought to dampen speculation that more action is on the way.

The People's Bank of China (PBOC), in a terse statement meant to convey more the opacity of a central bank than clarity on policy, said that last week's 2.1% revaluation of the yuan against the dollar must not be viewed as a first step nor as signaling that there will be further adjustments.

"Some foreign media have misunderstood the content of the foreign exchange reform, with some even thinking that the 2.1% is just an initial adjustment," the PBOC said in a statement. China's exchange-rate reform will be carried out "gradually," which does not mean a "gradual revaluation of the exchange rate level," it said.

Chinese officials in recent days have expressed concerns that speculators could create unwanted currency pressures should the central bank's policy become too predictable.

"No central bank in the world wants to be seen as being predictable," says Ashraf Laidi, currency strategist at MG Financial Group. "China will get us used to the notion that nothing will happen and then will surprise us with the next move."

After allowing the yuan to trade at 8.11 against the dollar (a 2.1% appreciation from the longstanding 8.28 peg) last Thursday, China will eventually let its currency rise to 7.89 by December and to 7.5 vs. the dollar by the middle of next year, Laidi predicts.

For the moment, markets seem to be playing along as China signaled that currency reform would be a long drawn-out process. The yen, which had gained over 2% last Thursday, has given back most of its gains since; the dollar was recently trading up at 112.29 yen vs. 111.43 late Monday. In theory, a stronger yuan would encourage regulators in Japan (among other Asian nations) to allow their currency to appreciate against the dollar without fear of losing competitiveness vs. China on exports to the U.S. But the yen has retreated since Thursday, in part, because Bank of Japan officials have said they will intervene if the yen were to rise abruptly.

U.S. Treasuries likewise advanced Tuesday -- the benchmark 10-year bond was recently up 3/32 and its yield was down to 4.24% -- after the PBOC statement. U.S. bonds have been under pressure since last Thursday on expectations that China would purchase fewer dollars to manage its new currency regime. China has been recycling its excess dollars into U.S. Treasuries, becoming the world's largest holder of U.S. debt behind Japan.

But any speculation about what to expect will be stifled by Chinese monetary authorities. "Whatever the PBOC says, it can't give too much away," says ABN Amro currency strategist Peter Frank. "But eventually, they'll have to provide a real policy objective that's linked to a policy with economic targets on inflation or GDP growth."

The yuan move last week came on the heels of China announcing strong second-quarter growth, which may imply that concerns about inflation are mounting.

Yet in its Tuesday statement, the PBOC said that the new yuan level at 8.11 to the dollar reflects fundamentals of the Chinese economy and is what's needed to adjust its trade surplus.

"These obviously are just a few wooly linkages, with no flesh on them to clarify their policy," Frank says. "I think that they will do so over the next nine months, but for now the market can't expect much" in terms of clarity on the PBOC's intentions.

According to David Powell, currency analyst at IDEAGlobal, the visit of Chinese president Hu Jintao to the U.S. in September will provide the next opportunity to see some moves in the currency.

"They could allow

a further yuan appreciation just two weeks before and thereby say to Congress, 'Look, we've been showing good will,'" he says. "But it's likely that the pressures from Congress won't decrease that much."

Indeed, most currency strategists don't expect that a 2% move will be enough to completely cool down anger in the U.S. Congress and in Europe about the artificially low value of the yuan, which has given Chinese exports a huge cost advantage.

"The beauty of the

new currency regime is that it gives China the liberty of

how much of a yuan move they allow and for how long they allow it," Powell says.

That should keep speculators and the market at large guessing for a while. The stakes of the yuan's revaluation being so crucial for the global economy, there's going to be a lot of efforts between China, the U.S., Japan and Europe to make sure the process is managed properly.

"Having several gradual moves over the next year will be more friendly to Chinese exporters and the U.S. economy and it will improve diplomacy on the world scene," says MG Financial's Laidi.

Of course, the best laid plans of mice and men often go awry -- central bankers most certainly included.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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