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Foreign Exchange

Chinese soft landing set to undermine euro

The biggest casualty in the currency market from the slowdown in China is likely be the euro as the country has less need to diversify its reserves away from the dollar.

China’s government has cut its growth target from 8% to 7.5%, well below the 10.7% average pace recorded during the past 10 years. At the same time, Zhou Xiaochuan, governor of the People’s Bank of China, said the renminbi was now “close to an equilibrium level” and that its trading range could be “appropriately widened”.

Since 2001, China’s FX reserve growth has been negatively correlated with the Bank for International Settlements’ real effective exchange rate for the renminbi.

China’s move to allow the renminbi to appreciate gradually since 2005 has had the effect of shrinking China’s trade surplus from a peak of 10% of GDP to 3% and lessening the need for China to plug the balance of payments surplus through FX intervention.

Although China’s FX reserves, which stand at $3.2 trillion, are up from a year ago, they are down from August. As Peter von Maydell, head of FX strategy at Credit Suisse, points out, reserve growth has already slowed to less than export growth, while FX reserves as a percentage of GDP and China’s import coverage have been trending downwards for the past three years.

 China's FX reserve growth negatively correlated with CNY REER

 
 Source: Credit Suisse, Bloomberg

All this has led to a quietening down in G7 and International Monetary Fund criticism of China’s currency policy in recent quarters.

“Indeed, there have been numerous media stories about China now being overvalued from a labour cost perspective and firms moving low-end manufacturing activities back to the United States or to other countries with lower unit labour costs,” says Von Maydell.

The main implication for G10 FX is, of course, that China will have less need to sell dollars against the euro or other currencies to diversify the composition of its reserves since it is receiving fewer dollars in the first place.

Although the exact composition of China’s currency reserves is a state secret, it is thought to hold about 65% in dollars and 25% in euros, with the rest in sterling and yen. There has also been speculation that China has been adding Australian dollars to its stockpiles and the currencies of other emerging-market countries in Asia.

However, some recent reports have suggested that China’s dollar holdings could be as low as 54%, reflecting a recent push by Beijing to lower its dependency on the debt-ridden currency.

“Market speculation about reserve manager buying of euros or Australian dollars is likely to become less commonplace, except where it refers to oil-producing nations that are still enjoying positive revenue surprises due to the oil price,” says Von Maydell.

For the euro in particular, the absence of Chinese support through lessened reserve diversification could have a huge impact.

“It has been one of our core observations that the only times that the euro has come under sustained pressure over the past 10 years has been when Chinese FX reserve growth has been stagnating,” says Simon Derrick, head of FX strategy at Bank of New York Mellon.

Indeed, that was true in late 2008 and the first half of 2010, as well as through the second half of 2011. During the third quarter of last year, China’s reserves grew by just $4.2 billion, driven by a close-to-$61 billion fall in September.

That coincided with the collapse in EURUSD from above $1.45 to below $1.32 by the start of October. As China’s reserve shrank by $20.5 billion in the fourth quarter, EURUSD remained under pressure.

The result is that, as Derrick notes, if Chinese FX reserve growth is petering out, it will also see a drying up of demand for the euro, allowing the single currency to find a more realistic level.

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