G7 calls for Yuan flexibility

The G7 Industrialized nations recently called on China to afford the Yuan increased flexibility. Many pundits likened the comments to similar exhortations made several years ago (regarding increased Euro flexibility). After that announcement, the USD declined over 10% against most major currencies within one year’s time. Will a similar fate befall the USD this time around? It seems likely, as the G7’s comments may ultimately pave the way for equally serious words of encouragement by America’s Treasury Department, in its semiannual currency report. AME Info reports:

For the very first time ever, China has been mentioned directly by the G7, reflecting their increased concern over the past few months.

Read More: Dollar Slides as Pressure Increases on China to Revalue- Will it Matter?

WTO advises China to revalue

Last week, the World Trade Organization (WTO) became the most recent addition to the chorus of voices calling for revaluation of the Yuan. The most prominent advocates of Yuan revaluation, which include the United States, European Union, Japan, and the International Monetary Fund had previously invoked the correction of global imbalances as the prime justification for reform. The WTO, in contrast, is encouraging revaluation on the grounds that it will enable China to conduct an independent monetary policy and control inflation. The Financial Express reports:

The yuan on Wednesday rose the most against the dollar since a revaluation in July, following speculation that pressure from US President George W Bush and strengthening Asian currencies will force China to allow faster gains.

Read More: WTO urges China to make its currency more flexible

China eliminates forex quotas

This week, China announced it would officially do away with caps on capital outflows. Previously, a business or retail investor wishing to exchange Yuan for foreign currency had to petition the government to do so. Moreover, the amount of currency that could be exchanged was capped at a low value. With this latest move, China has signaled that it is ready to move towards a floating currency system, in which individuals would be free to buy and sell as much Chinese currency as they wished. In the short run, this should help to reduce some of the upward pressure on the Yuan. Xinhua News reports:

The government…made it easier for individuals and firms to buy foreign currency and invest abroad, including allowing domestic banks to invest in financial products outside the mainland.

Read More: Nation to abandon forex quotas for investments

Foreigners continue to purchase US assets

One of the most fundamental principles of macroeconomics dictates a nation’s currency should depreciate when its current account balance is negative, in order to induce foreigners to buy its products and services. What happens when foreigners substitute their purchase of goods and services for stocks and bonds? This is precisely the question that economists and currency traders have been asking themselves for years, as the US current account deficit has ballooned while foreigners continued to purchase American assets. According to the most recent data, foreigners are on pace to buy nearly $1 trillion of American debt and equity this year. This number has remained fairly constant and suggests the USD will remain buoyant until demand for US assets declines.

Read More: Foreigners Flock to U.S. Securities

Markets assume gradual Yuan increase

This week, Hu JinTao, Prime Minister of China, will visit the United States for the first time since he assumed power. As you probably guessed, the Yuan will be a hot topic of conversation between Chinese and American officials. It bears mentioning that American politicians continue to call for a 25% increase in the value of the Yuan, as economists feel the Yuan is undervalued. However, forex markets reflect slightly different expectations with regard to the path of the Yuan. Specifically, Yuan currency futures indicate

US trade data is pleasant surprise

As far as currency traders are concerned, trade data is the most important in the spectrum of economic indicators. Economic theory suggests a nation’s currency should appreciate when its balance of trade is positive, and vice versa. Accordingly, when the monthly report on US trade data revealed a decline in the US current account deficit, dollar bulls rejoiced. In fact, the deficit narrowed by 4.1%, its largest drop in several months. However, pessimists are predicting that next month’s data will reveal a sharp expansion in the deficit, in order to compensate for this month. AFX News Limited reports:

For the long term, many analysts think structural considerations will become more of a concern to currency markets especially as the US Federal Reserve is expected to call a halt to its rate hike cycle by the summer.

Read More: Dollar wins brief respite from better than expected US trade data

EU calls for Yuan appreciation

It’s official: the US is no longer alone it its exhortation of China to further revalue the Yuan. In a press conference held earlier this week, the Finance Minister of Austria (the nation that currently holds the rotating presidency of the EU) suggested that the Yuan must be allowed to appreciate. He argued that such a step was not only in the long-term of interest of China, but would also help correct global economic imbalances.

Laws of Economics may soon catch up with Dollar

This year, the US current account deficit is projected to reach $800 Billion, an astounding 7% of GDP. If current trends continue, the deficit will jump to 13% of GDP by the end of the decade. Moreover, this year will probably mark the first ever that the net US return on foreign investment will be less than the money earned by foreigners on US investments. For this trend to be reversed will require a massive depreciation in the value of the USD. Unfortunately the US is tightening monetary policy at a faster rate than the rest of the developed world, which renders such a reversal unlikely. The Economist reports:

Not only is the yen relatively weak in nominal terms, but falling prices in Japan have made it even more competitive.

Read More: The Yen also Rises

China’s forex reserves to grow by $100 Billion

While the last few months have witnessed rising talk of forex reserve diversification, China seems intent on preserving the status quo. Representatives from China’s Central Bank recently announced that the nation’s foreign exchange reserves, which are already the largest in the world, would likely grow by at least $100 Billion in 2006. This is due both to the soaring current account surplus and the vast sums of foreign capital that continue to be invested in China. Further, the bulk of these new reserves will likely be held in USD-denominated assets, which are valued for their liquidity. Forbes reports:

Xinhua quoted Cao as saying that it would be unwise for China to sell off its dollar assets because they are still the most reliable assets in the world.

Read More: China forex reserves to rise by at least 100 bln usd in 2006