New China Policy Is Game Changer for FX Market

08/19/2011 6:00 am EST

Focus: FOREX

Andy Waldock

Founder, Commodity & Derivative Advisors

China’s recent actions to open up its currency and debt to institutions around the world is a landmark event that will have significant impact on the financial markets and currency traders.

Largely lost beneath the noise of the S&P downgrade of US debt and the legitimate discrepancy allowing France to maintain its AAA rating was the Peoples’ Bank of China’s actions creating new financial channels for opening up their currency and banking markets to the global economy. China is increasing the pace at which it seeks to become a globally dominant economy as it restructures the archaic financial systems that are the foundation of its stranglehold of restrictive trade and capital controls.

A basic background of Chinese policies is necessary to understand the importance of the recent developments. The Chinese international money market is basically divided into two geographic locations with separate operating governances, rules, and restrictions. The Peoples’ Bank of China controls the totality of all currency and lending practices, as well as determines fiscal policies and international debt purchases. This group, headquartered in Beijing, is the largest owner of US debt with holdings of more than $1 trillion in US Treasuries.

The primary hub of international currency trade and repatriation in the yuan is Hong Kong. Hong Kong operates in a dysfunctional family sort of way, clearly under the supervision of mainland China. However, Hong Kong develops its own international trade relations, fiscal policies, and domestic governance. Hong Kong is the eighth-largest holder of US debt with just under $120 billion in US holdings.

These two units operate at such an arm’s length that there is a large gap in the exchange rate between yuan held in Hong Kong versus yuan held in China, even though it is the same currency. China has been issuing certificates of deposit to Chinese citizens that earn a yield of 3.37%, while Hong Kong’s offering to its citizens earns only 1.6%.

China does not allow direct investment by foreign individuals, banks, or corporations, while Hong Kong does. Therefore, the primary global access to yuan currency appreciation has come through the Hong Kong financial markets. The demand for Chinese yuan and its expected appreciation is what is driving Hong Kong yields below those of China.

The issue at hand is that mainland China is easing its regulations on the Hong Kong banking markets to sell yuan-based debt to global institutions. The primary step in this process is opening the gates of yuan flows from Hong Kong back to China. This will help even out the yields between the two countries, which in turn will allow Hong Kong’s financial markets to accept much greater inflows without tremendously fueling domestic inflation.

China just issued 20 billion yuan in Treasury bonds through the Hong Kong financial markets. This is the third time in three years with the previous years’ issuances at eight and six billion yuan, respectively.

The increasing size of these auctions is a clear signal that China is rebalancing its currency portfolio and at the same time generating inroads to the global Treasury markets. Mainland China is still controlling the allocation of issuance. The allocation was preset by country and type of investor to curb outright currency speculation.

The point is that this is a game changer in the international financial markets. The strongest economy in the world is adopting Western exchange mechanisms. The more transparent their regulations become, the more competition there will be for debt issued in yuan at a time when US Treasuries and the European Central Bank become mired in the abyss of their own hubris.

We are all witnessing a currency paradigm shift in real time.

By Andy Waldock of Commodity & Derivative Advisors

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