Forex Blog: Currency Trading News & Analysis.

February 25th 2008

Commentary: Yuan et al Must Appreciate

Although the Chinese Yuan is ostensibly allowed to fluctuate in value, the reality is that the size of its fluctuations and the pace of its appreciation are tightly controlled by China’s Central Bank.  Since its currency is still effectively fixed to the Dollar, China is severely curtailed in its ability to conduct monetary policy and must closely mirror US policy.  Same goes for the rest of Asia, excluding Japan. While US monetary policy was relatively tight, as it has been for the last five years, this necessity didn’t cause too many problems; most of these economies would have kept interest rates high irrespective of the US.

Since the Fed began loosening monetary policy over the last six months, however, many of the emerging economies in Asia, especially China, have been forced into a bind.  On the one hand, lowering interest rates is exacerbating the problem of inflation.  On the other hand, they want to keep their currencies stable so as not to limit economic growth.  In short, Central Banks must determine which is more important: fighting inflation or promoting growth. According to some economists, these economies are so strong, having grown by nearly 10% collectively last year, that they can afford to slow down, if it will result in greater price stability.  But the only way to stabilize prices is to drastically raise interest rates, which will put even greater pressure on their currencies to appreciate.

In addition, the Central Banks of Asia have amassed a staggering $4 Trillion in foreign exchange reserves.  In the past, this has been a neutral, sometimes profitable activity.  Since the Fed began cutting rates, the interest rate differential has been turned upside-down such that Central Banks are now losing money on each unit of local currency they sell in exchange for Dollars.  According to one analyst, over $160 Billion has been lost since July 2006, and those losses will mount with each additional intervention.

Read More: Fed’s Lower Rates Pressure China to Strengthen Yuan

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