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October 02, 2010

China May set trading ranges for all currencies by 2013

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Business Week - If China’s currency reserves were to double again in the next three years and if the foreign-exchange market grows 20 percent, as it did in 2007-2010, China would hold more than the daily trading volume in all currency instruments.

Foreign-exchange market trading in recent years has grown much less rapidly than the currency reserves of the surplus countries that still maintain fixed or managed exchange rates. Over the past three years, China’s reserves doubled to about $2.5 trillion. Brazil’s did, too, though to a more modest $247 billion. Other surplus countries such as Russia, Japan and South Korea recorded increases in the dollar value of their reserves.

Daily trading of all currency-related products in April 2010 averaged almost $4 trillion, a 20 percent increase since the previous survey three years earlier. Such a huge market volume suggests that exchange- rate levels for the currencies whose values are determined on the open markets can hardly be manipulated. Every day, euro- dollar transactions alone amount to a massive $1.1 trillion.

If China decided to actively trade its reserves, it could not only influence the exchange rate of the yuan -- as it has done so far -- but also effectively set if not the level, at least a trading range for other major currencies.

A more fundamental issue is now likely to come to the fore: The floating exchange-rate system rests not only on the Federal Reserve and other leading central banks abstaining from intervention, but also on third-party central banks holding small “ammunition.” Even if China never targets a level or trading range for the majors, its asset-allocation changes will be vital. If China’s reserves grow at the pace of recent years, a 1 percent allocation shift in its reserves in 2013 would generate a net flow into the market of $50 billion.

The net flows required to move a currency pair are much smaller than the daily trading of the market. To provide an order of magnitude, consider that the largest net speculative position recorded in euro-dollar futures in recent years was equivalent to $18 billion, or that the reported size of Japan’s recent intervention was $30 billion to $50 billion.


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