SPECIAL EDITION-China Moves, Chapter I
Merrill Lynch Foreign Exchange Strategy Team
Bottom Line: After months of intermittent speculation, China has engaged in its first major currency regime change in years. While widely expected at some time in the future, the move today comes as a market surprise. As the upfront revaluation implied is limited, we believe that after some initial volatility and confusing market action, the market will start aggressively pricing a further move. This is likely the first of many chapters of Chinese FX regime adjustment.
Strategy: Over the near term, it is worth being long short-term volatility in any number of liquid crosses. Directionally, in the majors, short USD-JPY has the greatest potential to fully mimic the RMB move. In emerging markets, short USD-SGD and short USD-MXN have similar potential. We currently have direct or indirect exposure to these trading ideas. We still favour them at current levels.
A Historic Move in the Context of FX Markets
Today China announced the effective revaluation of the renminbi by 2% to 8.11 against the USD. Specifically, while not announced in its full details yet, USD-RMB would now likely be allowed to fluctuate in a similar tight (0.3%) band as before with the important change that the central parity would be re-adjusted every day (within the band limits and as opposed to the previous effective fixed rate regime, implying a possibly lower or higher permissible trading limit daily). Concurrently, the authorities announced that the new exchange rate regime will anchor the exchange rate to a nominal effective exchange rate basket (NEER-basket). While this basket for now remains undisclosed in the tradition of the Singaporean regime, it is clear that it will affect the ability of the USD-RMB to trade within the daily trading band. We have previously calculated a proxy for this basket regime that relies only on the EUR and JPY, along with the USD, in order to simplify calculations. We plan to initially utilise this proxy in our calculations and forecasts that relate to the RMB. What is important to remember in the first few hours and days following this historic announcement? First, while for some time now the majority of market observers (and indeed the RMB forwards) have been expecting a move by the Chinese on the currency front at some point in the 'future,' a currency move today is a surprise. Second, whether deemed insufficient or not, final or not, the Chinese move will reverberate over the rest of the FX markets and beyond. We believe it will be a mistake to dismiss it under any circumstances. China's revaluation marks the beginning of the end of the cycle of dollar weakness. However, given the timid initial move, the end of this cycle will likely play out in slow motion.