Revaluation of the yuan bad news for the Aussie dollar

PRESSURE has been building on China to let its currency, the yuan, appreciate against the US dollar, to which it is pegged. This week, these calls only intensified after China posted strong trade data, putting the country firmly on course to usurp Germany’s position as the world’s number one exporter.

But while Beijing so far remains resolutely attached to the dollar peg, there are signs that China is beginning to loosen controls. The government last week approved a trial period for short selling and margin trading as well as a launch of stock index futures. With steps towards liberalisation being taken elsewhere, will the state also move towards a floating currency in the coming months?

If the undervalued yuan is to float, then it will need to appreciate and recent measures suggest that some form of this will occur in 2010. Yesterday the central bank raised the ratio of bank deposits that must be held in reserve by 50 basis points. This is the first change since June 2008. It was a significant move on the part of the People’s Bank of China, says Ian Stannard, senior currency strategist at BNP Paribas, who now thinks that a yuan revaluation might come earlier than previously expected. Traders had forecast the second half of 2010.

“We are starting to see a few tightening measures creeping into Chinese monetary policy – they have allowed yields to push higher and we are seeing a creep towards higher interest rates,” he says.

Any tightening of monetary policy or revaluation of the yuan will put pressure on the commodity currencies, says Stannard, because China is their biggest market. Indeed, the Australian dollar lost 0.7 per cent yesterday on the back of the announcement and Stannard warns that investors definitely should be cautious.

In contrast, Europe might do well if and when the Chinese change their currency policy stance, says Currencies Direct’s Mark O’Sullivan. The yuan peg has given Chinese firms a competitive advantage in exporting to the Eurozone and the euro has strengthened considerably against the US dollar. A revaluation of the yuan – or indeed an implosion of a Chinese asset bubble – should see the euro weaken.

But until the Chinese start reassessing their foreign exchange policy, O’Sullivan says that the big winners in terms of currency pairs will be the commodity currencies against the greenback – in particular the Aussie dollar – which has benefited from switching its exports from Japan to China over the past decade.

So for now, Chinese FX policy means that going long on commodity currencies will be a winning trade. But for Aussie bulls, just be aware that any further steps to tighten from Beijing will see pullbacks.