In trying to assess the swings in emerging market (EM) currencies and the Australian dollar, which given its export links to China is highly sensitive to developments in Beijing, markets have focused on US monetary policy.
However, recent price action has closely matched the recent rise in Chinese interest rates.
Greg Gibbs, FX trading strategist at RBS, says it is unclear what is driving the tightening of monetary conditions in China. Indeed, he notes there has been little upward pressure on rates elsewhere in Asia during the past month and longer-term yields in the US, while up, are still below the highs of early September.
If [Chinese] rates are rising further out the curve, it suggests either there are rising inflation risks or increasing premiums for lending longer term that may relate to concerns over high levels of outstanding debt, says Gibbs.
Either way it suggests there is an increasing reluctance to extend longer-term credit, and this may slow the growth outlook.
|Chinese swap rates rising independently of the US or Asian rates|
|Source: Bloomberg, RBS|
Gibbs suggests part of the rise relates to plans for financial deregulation set out in Chinas third plenary session.
Those include removing the caps on deposit rates and promoting smaller financial institutions, which could remove the captive low-cost funding that banks enjoy. The risks include higher interest rates and a stronger renminbi.
The timetable for those plans is unclear. However, since the plenum, more detail from the Peoples Bank of China (PBoC) suggests it is eager to open the current account and allow the renminbi to be more influenced by market forces.
Indeed, Yi Gang, PBoC deputy governor and head of Chinas State Administration of Foreign Exchange, said on Wednesday the country was rethinking the strategy that has seen it build up $3.6 trillion in foreign-exchange reserves.
Its no longer in Chinas favour to accumulate foreign-exchange reserves, he said. The marginal cost of accumulating foreign-exchange reserves has exceeded the marginal gains.
Kit Juckes, head of currency strategy at Société Générale, says the comments beg the question of who tapers first: the PBoC or the Federal Reserve?
He says estimates of Asian central bank purchases of US treasuries on yields are of the order of 40 basis points to 50bp, and the result has been to depress the dollar and dollar-linked currencies against other assets such as the euro, yen and gold.
Even a hint of a turn in that trend is worth paying attention to, says Juckes.
Neil Mellor, currency strategist at Bank of New York Mellon, goes further, saying the potential exit by China from foreign-exchange management, and hence reserve accumulation, could be a truly seminal moment in financial history.
He says Chinas active management of the renminbi has been a source of stability for China and the cornerstone of its 8% to 10% growth rates.
However, while once it served a symbiotic US-Sino relationship that saw China recycling its dollars to mitigate a shortfall in US savings, says Mellor, it soon gave way to some serious financial imbalances, inevitable trade frictions and Hobsons choice for China: move towards currency liberalization to cease growing its reserves.
Mellor believes that has important implications for the euro, given his belief that the fate of the euro during the past decade has been largely determined by reserve accumulation and diversification by central banks.
He says in the early millennium, and with EURUSD at a post-launch low, a European Central Bank petition implored Beijing to utilize the euro as a reserve currency.
It apparently agreed, other reserve managers followed suit and the rest is history the euros fate has broadly rested with the marginal recycling of dollar liquidity pouring into emerging markets ever since, says Mellor.
He adds if China is, and by extension fellow reserve managers are, moving to the point where they no longer accumulate large quantities of reserves, then there will be a drastically reduced pool of dollars that needs to be exchanged for euros to maintain mandated reserve ratios.
In one fell swoop, the euro would be deprived of a pillar of support that it has enjoyed for a decade, says Mellor.
Of course, timing is everything, but judging by the increasing commentary on the subject from Beijing, the case for currency liberalization in China is escalating. That would herald an era of profound change in financial markets.
Investors monitoring risk-sensitive EM currencies, the Australian dollar and even the euro, should be paying as much attention to developments in China as they are to the tapering debate in Washington.