27 January 2012 – Macro Insight




Macro Insight: China’s Yuan-O-Matic

The US Treasury recently reaffirmed that China is not manipulating its currency. Perhaps so. But over the past decade the yuan has moved against the dollar with an algebraic precision that nevertheless betrays a heavy hand by the central planners in its currency market.

Technically, China resumed a managed float in mid-2010 that allows the yuan to move within a narrow range around a basket of currencies. Chinese officials have indicated that the basket includes dollars, euros, yen, won, and several other international currencies.

Since mid-2010, while there have been short lulls in the strengthening and even a few modest reversals, the yuan’s revaluation (the blue line in the chart) has been remarkably steady. On average, the central planners have been increasing the yuan’s value nearly a tenth of a fen each day (or 0.000887 yuan). The regression equation in the chart (the pink band) has a near-perfect r-squared of 0.98. Unless Beijing’s policymakers shift course, the currency will strengthen to 6 yuan to the dollar by next November, just in time for the US presidential elections and stronger than currently priced into the futures market.

The yuan has been just as predictable in earlier years too, it’s just the equation that has changed. In 2009-10, China pegged the yuan firmly to the dollar, as it had in the first part of the decade, leaving a flat line. However, from 2005 until the financial crisis of 2008, China’s revaluation policy had an extra dimension. While the daily change was not constant, it steadily accelerated in clockwork fashion, picking up the pace a little bit each day. In that period, the polynomial regression yields a curve (the red band) with an r-squared of 0.99.

Just where the yuan should really be is anyone’s guess. Many economists look to purchasing power parity and believe the yuan remains deeply undervalued; others argue the opposite. Politically, many of China’s trade partners contend that an undervalued yuan gives it an unfair trade advantage; China says its trade surplus is already shrinking and some officials are hinting that the yuan has strengthened enough. Ultimately, at least for now, the value of the yuan is going to be what the central planners say it is. While China has made great strides toward the market in the last thirty years, unleashing powerful engines of growth and prosperity, when it comes to the currency market the best policy for investors remains: don’t fight the Red.



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