Yuan Traders: A Fresh Look at the Dollar Peg

09/16/2010 12:01 am EST

Focus: FOREX

By Julian D. W. Phillips of GoldForecaster.com

There is palpable anger in the US over the current “peg” of the yuan against the dollar. Despite promises that the yuan will rise, it remains close to where it was before China commented on its impending rise. Accusations of currency manipulation are again about to be leveled at China. The Chinese government must be thinking very carefully about the behavior of the yuan in the days to come. In the face of US anger, will the Chinese let the yuan rise? With the government encouraging Chinese investors to buy gold and developing the Chinese gold distribution system, how will investors feel if the yuan were to rise 20% - 40% against the dollar while gold falls by the same amount inside China?

Government Encourages Gold Buying

We ask you to look at the accompanying table of China's household gold savings against annual household gold savings again.


Click to Enlarge

From this table, you can see just how important gold is to the Chinese. Despite disposable income growth of approximately s 15% annually since 2000, consumption growth in the China's economy "is anemic," but private Chinese gold demand has risen 26% annually by volume in the last decade, drawing a still-greater share of the newly retained wealth. This demand is nationwide and set not just to grow, but to burgeon.

At the same time, the Chinese government has allowed more banks to import gold and to distribute and sell gold. The country is developing at double-digit growth. It's urbanizing with infrastructure springing up across the entire nation, and with it goes the gold market. The Chinese government is very conscious of keeping their people happy as this growth takes them up into a new world.

How Would a 40% Rise in the Yuan/Dollar Exchange Rate Affect the Yuan Gold Price?

But how will they feel if their own government engineers a rise in the yuan exchange rate against the US dollar? The US says that it should rise 40% to level the playing fields. A straight translation of such a rise will mean a fall in the yuan price of gold of:

Yuan 6.7597 x gold price $1,250 = Yuan 8,449.63
Yuan 4.0558 x gold price $1,250 = Yuan 5,069.75

That is a huge drop in the value of their savings. Big enough for even the most tranquil of investors to have a major sense of humor failure.

A rise of 5% would leave you a bit out of joint, but would be bearable, particularly if the gold price was rising at the time.

NEXT: Will the Yuan Rise Against the US Dollar?

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Will the Yuan Rise Against the US Dollar?

Since 2005, we have talked of the yuan coming to international markets, and it is in the process of occurring as we write. There are currently several big bank road shows touring the world advocating the use of the yuan in international trade.

Think for a moment of the pressure out there to acquire and invest in the yuan. It is enormous. In the belief that the yuan will rise to readjust and then remain strong, importers and exporters would favor holding yuan as long as possible. We believe that the receptivity will be excellent. But will that make the exchange rate rise? The Chinese know that and want that demand, but they don't want the yuan to rise and spoil their global trade.

Imagine if all non-US importers and exporters had to pay or receive a yuan price. Life would be simpler for all countries except the US. No more buying the mobile dollar. At last, a currency that is linked to a strong and growing economy. One would expect the volatility of a free-floating yuan to be low. It will be linked to a basket of China's main trading partners’ currencies, so it’d be relatively stable, one would expect. Its stability and the protection of global Chinese trade is the driving force behind its internationalization. So its exchange rate must be linked to that purpose.

For this to happen, China has to rapidly and enormously expand the amount of yuan in international markets. There would have to be a flood of yuan coming out of China. China would have to manage the exchange rate carefully to ensure that the level was as they wanted it. Of course it could go either way, so expect exchange rate management and manipulation as it settles into global currency markets.

Standing in Chinese monetary authority’s shoes, flooding the world with yuan would ensure no exchange-rate jump and perhaps even bring a chance for a fall. We therefore forecast that the yuan will not move much from current levels. Its arrival will not be quiet though!

What About Chinese Gold Investors?

The Chinese authorities have to consider not only the trade competitiveness of their exporters, which they still see as the driving force to their growth, but they also have to ensure the preservation of the value of their peoples savings.

We are reminded that the Chinese government is keenly aware of the potential for social unrest in the country. Such a savage drop in the yuan gold price would result in a devastation of savings that could become a festering sore. So we forecast that the yuan will not be allowed to rise by any significant amount. We also forecast that the yuan price of gold will not rise or fall more than it does in the US dollar at present.

The counter that will prevent this, we forecast, will be the rapid internationalization of the yuan, and in such quantities that foreign exchanges will not be inclined to raise the Yuan exchange rate.

Of more significance to the gold price is if US importers and exporters had to buy yuan to trade with China. In itself, it seems reasonable, but in terms of an attack on the dollar, we see fur flying everywhere.

Julian D. W. Phillips can be found at GoldForecaster.com

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