Chinese Yuan Update

There are two devleopments in China to note:

1. The yuan appreciated in the spot market earlier today, after staging a relatively large decline yesterday. At today's best dollar level, the yuan had weakened about 0.85% against the dollar over the past two weeks. It seemed that the yuan spot losses were a function of a) more stable tone in the dollar, b) participants rolling out from short dated positions to longer dated forwards, c) Chinese officials illustrating the greater flexibility does not mean a give-away to speculators in a straight line appreciation, but also greater two-way activity and wider daily ranges. As the yuan appreciated in the spot market, some of upside pressure came off the forwards. The 12-month NDF forward eased slighted and now is pricing in about 3.6% appreciation over the next year.

2. China has approved Hong Kong Monetary Authority to buy Chinese stocks and bonds. Last month China included the HKMA as a Qualified Foreign Institutional Investor. Malaysia's central bank, GSIC of Singapore, and Abu Dhabi Investment Authority have been granted QFII status. This is seen as part of China's effort to increase the internationalization of the yuan. HKMA could diversify its reserve into Chinese yuan if it desired. The HKMA's diversification out of the dollar may be a preliminary step to peg the Hong Kong dollar to the yuan. While some observers seem to be urging the HKMA to do this, officials there show no sign of even taking arguments under advisement. Instead, officials have been very adamant that the peg (to the dollar) remains. Liquidity and transparency are important from a central bank's point of view and these do not appear to have reached important thresholds in China's case yet. The talk about the HKMA breaking the peg appears to be one of the factors fueling the sharp rise in the volatility of the HKD. The 1-year reached the highest since Dec 09 last week, having trended higher since mid-Sept. Of course, the prospects of QEII in the US, when HK does not need easier monetary policy may also raise questions of the appropriateness of the dollar peg.