-- Posted Wednesday, 27 August 2008 | Digg This Article | Source: GoldSeek.com
The Morning Gold Report by Peter A. Grant
Aug 27, a.m. (USAGOLD) -- It’s been slightly more than three years since China freed the yuan from its peg to the dollar. From the early 1990s until July of 2005, the USD-CNY exchange rate was fixed at 8.27, giving China a distinct and consistent advantage when it came to international trade.
The US was, and continues to be, the major consumer of goods manufactured in China. The artificially weak yuan resulted in the US trade deficit ballooning, while China amassed a monster trade surplus and considerable dollar reserves. In the years leading up to the float of the yuan, China was under considerable political pressure from the west.
Don’t get the wrong idea though; the yuan is far from being free to find its proper value based on the fundamentals. The People’s Bank of China (PBoC) utilized a tightly managed float system to keep exchange rates from fluctuating too widely. Each business day the PBoC establishes a central parity rate for the yuan based on a basket of currencies. Today’s parity rate against the dollar was set at 6.8415. The yuan is only allowed to fluctuate 0.5% on either side of that parity rate.
Since the yuan was de-pegged from the dollar on 21-Jul-05, the currency has appreciated 17% against the dollar. China’s growth rate warrants substantially greater currency appreciation. However, a stronger yuan cuts into China’s already weakening export business.
While China seeks to spur domestic demand for its goods, it remains extremely reliant on exports as a means of growing the economy and creating jobs. As we discussed in yesterday’s report, China is faced with the daunting task of generating 10 million new jobs each year. The PBoC faces rather significant policy and political hurdles to facilitate that goal.
At this point the central bank must keep the yuan suppressed to the point where Chinese manufactured goods are still attractively priced, despite waning demand resulting from a contracting global economy. At the same time, they don’t want to risk trade sanctions from their biggest customers in the west who consistently point out that the yuan is undervalued and that their own export markets are suffering.
According to a recent Ambrose Evans-Pritchard article in The Telegraph, the PBoC has found some rather creative ways to manipulate the USD-CNY rate. It seems that Chinese banks are required to hold excess reserves in dollars rather than yuan. Since March, the central government has raised the reserve requirements five times.
Reserve requirements are now 17.5% of total lending. As the banks seek to acquire the mandated reserves it has the effect of lifting the dollar and suppressing the yuan, offering relief to China’s softening export market. Meanwhile the firmer dollar makes US goods more expensive for foreign buyers.
US exporters saw some relief in recent months as a result of the sharply weaker dollar, but much of that is being reversed out as the dollar has climbed. Yet there doesn’t seem to be much protest from the US regarding China’s efforts to weaken the yuan again.
This might be explained by the fact that there are political gains to be had. The dollar has firmed significantly in the last month and a half, meanwhile exporters are still reaping the benefits of recent record lows in the dollar. Headlines that can simultaneously tout a firmer dollar and a narrowing trade deficit certainly provide some benefit to the incumbent party.
Look for the trade and exchange rate rhetoric to start up again in earnest after the November election. That’s when things could get very interesting. Just be aware that China is going to come to that bargaining table wielding an enormous amount of clout as one of the primary financers of America’s massive debt.
The US may ultimately seek to weaken the dollar further to protect gains in exports. However, one can expect China to doggedly defend its exporters as well by continuing to suppress the yuan. To quote another recent excellent article by Mr. Evans-Pritchard: “What we are about to see is a race to the bottom by the world’s major currencies as each tries to devalue against others in a beggar-thy-neighbour policy to shore up exports.”
Whether that ‘race to the bottom’ is about to begin, or is already underway, the ones holding the pieces of paper with the colorful pictures are the ones who suffer, not the ones who issue those pieces of paper. Physical gold ownership is your best chance to reach the finish line with at least a portion of your wealth intact. That is why we at USAGOLD strongly believe that gold is a necessary and permanent component in the modern portfolio.
Gold is bedrock.