How will it play out? PART 1

From experience, a big real-money move like this will continue in the same direction, breaking the previous trend and invalidating the old support levels. But this time the Euro high over previous resistance was only an anomaly, and it doesn’t show up because the chart was taken as
a 5 a.m. ET snapshot of the currency market, excluding daily highs and lows. If it was a real-money move, it fizzled; by the next day, the price was back in the old range. The currencies failed to hang on to gains and the Swiss franc, Euro, and yen all fell back in the first few days after the announcement. This is quite confusing. Where’s the follow-through?

The answer lies in what might be called “analytical gridlock.” The Chinese revaluation is a unique event in international financial history. Never before has a developing country of such size and economic power shifted policy from a dollar peg to a managed float, and never has the stake been so big. And the “experts” are of two minds about what it means.

The old consensus that the dollar must fall was put under the microscope and proved to be unconvincing. Or perhaps some pro-dollar real money came into the picture. It’s possible to review a few of the issues, but it may not be possible to come up with a decisive forecast at the end of it. In the end, we will know the winner of the analysis contest by which gets broken first, support or resistance.

First, the revaluation was prompted by the loud talk of the U.S. and the somewhat softer talk of the Europeans and Japanese. Treasury Secretary John Snow made the first demand at a G7 meeting in the Middle East in September 2003, so the subject has been on the table for a very long time. The crisis point came when the U.S. Senate passed a first-step resolution to consider a bill imposing a 27.5-percent tariff on all Chinese exports to the U.S.

To head off that outcome, the U.S. sent a special envoy to China for at least three week-long high level meetings with the Chinese. Nobody wanted the tariff outcome, and the Chinese president was scheduled to visit the U.S. in September. It would have been a diplomatic nightmare to receive him while a massive tariff was on the agenda, but the administration would have to admit that in the U.S. system, Congress has the right to take its own initiatives regardless of what the administration may want for diplomatic purposes, putting the ball in China’s court. Therefore, it was sensible to expect action over the summer, and yet few people felt they could forecast the timing because of Chinese complaints they resented being bullied and would operate on their own time table.

And yet a 2.1 percent revaluation is hardly sufficient to keep the Congressional critics from presenting their ruinous tariff bill on another occasion. A Chinese central bank official told the press that obviously 2 percent is not sufficient to solve the trade imbalance with the U.S., but it “will buy time for industry reforms.”

Time, of course, is a relative concept. The Chinese may be measuring in years while the U.S. Congress is measuring in months. So the big question is how much will future changes be? Technically the renminbi can vary 0.3 percent per day from a central rate, so over the course of 10 days, it could rise by 3 percent. No one actually expects this degree of change.

One China expert says we may expect a 7-percent total revaluation by year end and a total of 15 percent by the end of 2006.

There are two issues here. The first is that 7 percent is not a lot and even 15 percent over 18 months isn’t a big change. Merchandise trade with China will hardly be dented by levels like this.

In the same line of reasoning, China will be earning almost as many dollars as it was before, and since the new basket of currencies must contain a high ratio of dollars, it will still be buying U.S. Treasuries and other official paper for its reserves in roughly the same amounts.

In other words, the revaluation changed almost nothing. China was the biggest buyer of U.S. government securities in the 12 months ending May 2005, when its accumulated Treasuries totaled $243.5 billion, the second biggest official holder after Japan. Asian central banks and private investors owned more than half of the $2.03 trillion of Treasuries held by foreigners, out of the roughly $4.03 trillion in marketable U.S. securities outstanding. Whether the revaluation is 2.1 percent or 15 percent, China is still a major player in the capital flow picture. They have the same stake in preserving the value of their asset, which we call the Golden Goose argument (see “The Golden Goose Rule,” Currency Trader, February 2005).