Expect a Yuan Revaluation Soon

The Euro is under attack.

As a result of problems in Greece, the massive relief package assembled by the European Economic Union to bail out the country, and economic storm clouds hanging over Portugal, Spain and others, the Euro is tumbling in value against the U.S. dollar. The Euro has declined 14.7 percent from the beginning of 2010, when it fetched more than $1.43. Some experts believe it is likely to fall further, perhaps to parity with the greenback or lower. Some even question whether the Euro will survive this crisis.

Outside of Europe, the country with the most to lose from an economically weak Europe is China. The European Union and the United States remain China’s two largest trading partners. For the first two months of this year, trade with the EU grew 34.5 percent to $65.53 billion, and with the US, it rose 25.1 percent to $49.32 billion. In order to provide much needed support in this time of crisis, expect China to re-balance its portfolio of foreign currency reserves in favor of the Euro, and to begin allowing the yuan to appreciate against the U.S. dollar in the months ahead.

Although many believe that China’s export growth is the engine driving China’s currency policy, it is likely more complicated than that. In addition to trade, China must take into account the impact any currency policy changes may have on its $2.5 trillion holdings of foreign currency reserves, as well as the relationship between the U.S. dollar and the Euro. China’s past actions with respect to its currency suggest that the country’s leaders like to keep an appropriate balance between the currencies of its two largest trading partners.

Over the past five years, there have been two notable events in China’s currency history—July, 2005 when China released the yuan’s peg to the U.S. dollar, allowing the Chinese currency to appreciate by 21 percent within two years; and July, 2008 when China once again pegged the yuan to the greenback, this time at approximately 6.8 to 1. It may be mere coincidence, but both events occurred when the dollar and the Euro were at high and low points relative to each other.

In the latter half of 2005, the U.S. dollar was at a high point against the Euro, which gave China room to release the yuan’s dollar peg. By July, 2008, when China re-instituted the peg, the dollar’s value in relation to the Euro had fallen by 38 percent from its 2005 high. At its high point in 2005, $1.17 was required to purchase a single Euro. By July, 2008, $1.61 was needed, much to the chagrin of American travelers to the Continent.

At today’s rate of $1.23 to the Euro, we are now close to 2005 levels. Assuming that China has not come to the conclusion that the Euro will be relegated to the dust bin of history and therefore not worth supporting, we are getting close to the point where China’s best interests will be served by tilting its support in favor of the Euro, as it did in 2005.

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