It’s still anyone’s guess as to if and when China will allow the Yuan (RMB) to continue appreciating. You can see from the chart below – which shows the trading history for the RMB/USD December 2010 futures contract – that expectations of revaluation have eroded steadily since December 2009. At that time, it was projected that that Yuan would finish 2009 at 6.57 RMB/USD, 4% higher than the current level. Fast forward to the present, and investors now only expect a modest 2% appreciation rise on the year.

What’s behind the change in expectations? The answer is a combination of economics and politics. On the economic side, China’s trade surplus is much smaller than in recent years, as import growth outpaces export growth. “Double-digit annual growth in exports is all but assured in coming months due to a low base of comparison in early 2009, but…sequential growth momentum went into reverse in January, with exports down 16 percent from December.” Moreover, while GDP growth appears strong, it appears tenuously connected to exports and fixed-asset investment. In addition, if the Central Bank of China raises interest rates to counter property speculation, it will have even less room to maneuver in its forex policy if it wishes to maintain high GDP growth. In terms of politics, the CCP doesn’t want to lose a crucial bargaining chip in international relations, and it also doesn’t want to mitigate the threat to its political legitimacy posed by a prolonged economic slowdown.

On the other hand, China still desires to turn the Yuan into a global reserve currency, again both for economic and political reasons. In order to accomplish such a feat, one of the prerequisites would be dual convertibility. Financial institutions and foreign Central Banks are still extremely reluctant to hold RMB currency since it’s difficult to convert into other currencies. “Citing data from the Bank of International Settlements (BIS), it [Citigroup] said the renminbi’s share in the global foreign-exchange market turnovers was only 0.25 percent in 2007, ranked 20th in the world and fifth among Asian emerging-market currencies.” This is pretty incredible considering that China’s economy is the world’s third largest, and will only change when the exchange rate regime is loosened.

While some analysts predict that the Yuan will continue rising as soon as next month – and at least by a slight margin for 2010 – the modest pace of appreciation will ensure that China’s foreign exchange reserves continue to grow. They are currently estimated at $2.4 Trillion, and while their composition is largely a secret, analysts estimate that more than 2/3 is denominated in USD-denominated assets. Recently, there was a perception that China had begun to diversify its reserves out of Dollars, as US Treasury data indicated that its Treasury purchases had all but stopped. As it turned out, China had merely moved to conceal its purchases by conducting them through a UK Bank.

The biggest threat to the USD posed by China is not an end to the RMB peg – for such is unlikely – but rather a change in its structure. Currently, the RMB is pegged directly to the Dollar, which means that the Bank of China MUST stockpile its trade surplus in USD-denominated assets, namely US Treasury securities. If the peg were to shifted to a basket of currencies, however, it would have more flexibility in the denomination of its reserves. Until then, China’s forex policy will continue to favor the Dollar.

The Wall Street Journal’s coverage of the Greek dent crisis has focused less on the crisis itself, and more on the markets’ reaction to it. With headlines like “Hedge Funds Try ‘Career Trade’ Against Euro” and “Speculators Bet Record Amount Against Euro For 4th Week” and “Europe Trouble, U.S. Opportunity” – among others – the WSJ has identified a collapse in the Euro (mainly against the Dollar) as one of the most prominent (and profitable!) strategies for exploiting the crisis.

As I mentioned in the last post (”Understanding the Greece Situation“), the debt crisis has become self-fulfilling, not only for Greece, but also for the Euro. In other words, as perceptions abound that Greece is insolvent and the Euro is doomed, Greek bonds and the Euro have lost value, which only makes the crisis worse. It seems that speculators are taking advantage of this phenomenon by making large bets against the Euro. In fact, large is an understatement, as the net short positions against the Euro now total a record $12 Billion, according to the closely watched Commitment of Traders report.

Some analysts have taken such information at face value, noting that “The fact that the shorts got even shorter when they were already at extreme levels highlights just how negative the sentiment is toward euro.” On the other hand, there is evidence (and some degree of admission) that large speculators are now acting in concert to bring down the value of the Euro. The WSJ reports mention private meeting between hedge funds managers and investment banks helping their clients bet against the Euro using derivatives. For those that are skeptical that speculators could really influence currency markets, consider that one man – George Soros – single-handedly forced a devaluation of the Pound in 1992, and made $1 Billion in the process. While the Euro is certainly bigger than the Pound ever was, there are more people watching it than ever, and when there is money to be made -  hundreds of billions of dollars in this case – it isn’t inconceivable that the Euro could suffer a similar fate.

Already, there is evidence that this strategy is working, as the Euro has fallen 10% in less than three months, which is unbelievable for a currency whose daily trading volume is estimated at $1.2 Trillion. In fact, one popular options trade is based on the the Euro falling to parity against the Dollar. Once unthinkable, such a possibility now faces odds of “only” 1 in 14 (based on options premiums), compared to 1 in 33 in November. On the one hand, it’s frustrating to accept the market power that these speculators have. But emotion has no place in (forex) trading, and standing in the way of momentum would be costly.

On the other hand, Euro fundamentals remain strong. To be sure, a currency is only as strong as its constituent parts, and the fact that a handful of EU member states have shaky finances certainly cannot be dismissed. At the same time, the fact that such currencies have no direct control over the Euro is just as important. Before the inception of the Euro, currency traders would be justifiably concerned that a country in a similar position to Greece would deliberately devalue its currency (by printing money) in order to devalue its debt and make it more manageable.

Now, this would be impossible, since the Euro is controlled by the European Central Bank, over which Greece has no power. The current crisis in Greece notwithstanding, “The European Central Bank’s (ECB) resolve to maintain sound money is…important. This is especially true for the ECB, which has a single mandate—price stability—unrelated to fiscal problems.” While there is legitimate concern that the ECB will be forced (or voluntarily) print more money to fund bailouts of bankrupt EU member states, this doesn’t seem very likely, given the history of the ECB. Its monetary policy has always been quite conservative, and it’s no wonder that the Euro has come to be seen as a viable alternative to the Dollar.

In my opinion, the decline in the Euro is mostly baseless, and if it were to continue, it wouldn’t represent the prevailing of logic. Then again, logic is not exactly a word that I would apply to the forex markets, now or ever.

With this post, I want to try to clarify the Greek fiscal crisis. The problem is that it’s not clear exactly how serious the problem is, because most of the media coverage of the crisis has been directed towards the financial markets’ perception of it, rather than its underlying fundamentals. In the end, I think it’s important to understand both.

The Financial Times published a great timeline that shows perception and reality side-by-side. While there were certainly other important developments that bear in Greece’s fiscal position (in addition to those listed below), you can see that financial markets are basically making their own reality. For example, there was hardly a response to the October announcement that Greece’s budget deficit would be 12.7%, which was 5% higher than earlier estimates. In fact, the markets only became bearish on Greek debt after it the government announced that it would try to bring the debt down to 9.4% through various measures.

Apologists for the markets would be right to wonder why investors should be inclined to believe the government of Greece when it said it could control the budget deficit. Fair enough. Still, one has to wonder why the markets suddenly started worrying about Greece’s fiscal problems, when only a couple months ago, the possibility of a whopping 12.7% budget deficit barely caused investors to blink. Besides, the credit crisis has been raging since 2008, which means the markets have had plenty of time to digest the implications of recession for Greece’s fiscal position.

These days, where is a financial crisis, chances are derivatives are not far removed. As credit default swap spreads (i.e. the cost of insuring against default by Greece on its loan obligations) have risen, so have concerns that this is a bona fide crisis. “It’s like the tail wagging the dog…There is a knock-on effect, as underlying positions begin to seem riskier, triggering risk models and forcing portfolio managers to sell Greek bonds,” said one portfolio manager. From this perspective, it almost looks like this “crisis” is being completely manufactured by speculators for the sake of profit. Summarized another analyst, “It’s like buying fire insurance on your neighbor’s house — you create an incentive to burn down the house.”

To be fair, Greece also played a role in derivatives speculation, and on some level, it was even more nefarious than the speculators. Assisted by Goldman Sachs (who is now betting on Greek default [how un-ironic that is!]), Greece entered into a series of swap agreements last decade, which it used to conceal its true debt burden. “By using an historical exchange rate that didn’t accurately denote the market value of the euro, Goldman effectively advanced Greece a €2.8 billion loan. Under EU accounting rules—which were tightened in 2008—Greece wasn’t obliged to include the loan in overall public debt on its books.” Now that those transactions have been uncovered and the truth is coming to light, financial markets are rightly re-evaluating the risk of further lending to Greece.

There is no question that Greece’s debt problems are serious. As to whether labeling it a crisis is necessary, that depends on your standards. Greece ranks near the top of the list on a variety of individual “debt sustainability” criteria. At 94.6% of GDP, it’s net debt is among the highest in the world. Its projected 2010 budget deficit is also high, though not the highest. Its cost of borrowing is also significantly higher than projected GDP growth, which means that net debt will continue to grow until a budget surplus can be produced. When you average these measures together, it appears that Greece’s debt problems are the most unsustainable of any country in the world. But this is hardly news.

On the other hand, the weighted average of the maturity of Greek debt is 7.7 years, well above average, and plenty of time (relatively) for Greek to sort through this mess and secure new lenders. Towards the latter end, it has hired a former bond trader to head its debt management agency. In order to improve its fiscal position, it has announced a series of austerity measures, including budget cuts, tax increases, wage cuts for public-sector employees, and stricter laws against tax evasion.

At this point, a ratings downgrade looks inevitable, and some analysts think the crisis has already become self-fulfilling. As borrowing costs rise, it only makes it more likely that Greek will default, which causes rates to rise further, and so on. On the other hand, Greek politicians are being forthright about their position (”Greece’s finance minister, George Papaconstantinou, remarked this week: ‘People think we are in a terrible mess. And we are.’ “) and have a plan for rectifying the situation. There is cause for skepticism here, but also for hope. And that goes not just for Greece, but also for the Euro.