China Is Manipulating The Euro Higher

Back on June 19, after China announced it was abandoning the yuan’s peg to the dollar, I wrote an article saying that my suspicion was that it was doing so in order to revalue the euro higher against the yuan by bidding up the value of the euro against the dollar.

Well, it seems to be happening exactly that way.

To review, China pegged to the dollar back in mid-July 2008 just as the financial crisis was about to get into high gear as a way to protect its exports to the US. At the time, EUR/USD was trading around 1.5960 but by June 6 of this year, the pair had hit a low of 1.1876, a 25.5% depreciation of the euro against the dollar.

Now, since the yuan was pegged to the dollar, what that meant was that as EUR/USD declined, the euro was declining by an equivalent amount against the yuan, making Chinese goods far less competitive to the region.

Also, by June 6, the general consensus (based on economists and bodies such as the IMF) was that Europe was at risk of falling into a second recession due primarily to the Sovereign Debt Crisis and Austerity Programs being implemented in places like Greece, Ireland, Spain and Portugal. But even without a second recession, Europe looked set to far underperform the US and certainly the Chinese economy. Additionally, nearly every currency strategist was talking about parity and giant hedge fund traders, like George Soros, were massively short the common currency.

So, if you’re China, and you want to support exports to your biggest customer (which Europe is) you’ve certainly realized by this point that the thing to do is to start appreciating the euro relative to the yuan by appreciating the EUR/USD pair. The best way for China to do that was to drop its peg to the dollar and buy euros. Two weeks after EUR/USD declined to nearly $1.18, China decided to de-peg and allow the yuan to trade in its daily 0.05% trading band.

Of course, this move was greeted favorably by the US, who had long sought China to allow yuan appreciation relative to the dollar. The fact that it was announced ahead of the June G20 meeting, made the move look even better for the wiley Chinese.

One the next day of trading, June 21, EUR/USD opened at 1.2458. As of the close on July 15, EUR/USD was on 1.2945, a 487 pip (or 3.9%) appreciation. In the meantime, the euro as appreciated by 2.93% against CNY.

There are numerous ways for China to accomplish this but perhaps the best might be to become a buyer of European sovereign debt, primarily because it restores confidence. What is obvious is that someone is doing plenty of buying in the open market because today, Spain was able to sell bonds at a higher price (and lower rate of interest) than offered by the ECB, who announced its intention to purchase debt as the crisis deepened.

Meanwhile, the Treasury, and the Fed, is probably very happy to be seeing the dollar fall against the euro. Aside from helping exports, a falling dollar generally is accompanied by rising commodity prices, which creates a level of inflation (inflation is needed now because of the much-worse risk of deflation). And as we know, a falling dollar is also generally followed by a rise in assets like equities, which of course re-liquefies the system by creating wealth for those (like the big banks) involved.

Update July 18:

From yesterday’s WSJ:

BEIJING—Europe remains a key market for China’s foreign-reserve investments, Chinese Premier Wen Jiabao said after meeting German Chancellor Angela Merkel, adding that China will keep its macroeconomic policies stable in the second half.

Mr. Wen’s comments, carried by the state-run Xinhua news agency, echo other recent statements by China’s government reaffirming the euro’s importance. The remarks come amid concern that Europe’s debt troubles could lead China to scale back investment of its foreign-exchange reserves—the biggest in the world, at nearly $2.5 trillion—in euro-denominated assets. In May, the State Administration of Foreign Exchange, which manages China’s reserves, issued a similar statement.

On Friday, Spain was able to sell bonds in the open market at higher prices (an lower interest rates) than those offered by the ECB.

Naturally, any sign that nations such as Spain can sell debt into the open market means that investors feel confident. I suspect that China is doing plenty of buying in order to support confidence in European sovereign debt and by extension, the euro itself.