China’s Currency Basket: One Month Later

On June 19, the Peoples Bank of China released the yuan’s peg to the U.S. dollar, and announced that it would instead peg the yuan to a basket of currencies. China regards the composition of the currency basket as a state secret, and officials haven’t publicly disclosed what currencies are being used in the basket.

In 2005, when China last released the yuan from its dollar peg, analysts believed that the U.S. dollar, the euro, the Japanese yen, and the South Korean won dominated the basket, but that the basket also included the U.K. pound, the Thai baht and the Russian rouble. Some analysts believe that the currencies of India, Brazil, Indonesia and India have been added this time around, or had their weightings increased from levels in 2005, reflecting China’s rising trade with these nations.

Among other recent changes is a likely increase in the weighting assigned to the Australian dollar due to its position as a key supplier of industrial commodities to China.

While many are focusing on the effect of China’s new currency policy on the yuan’s relationship to the U.S. dollar, it is likely to have a far more widespread impact. Essentially, China’s new policy means that it will be shifting its portfolio of currency reserves to include more assets denominated by currencies other than the US dollar. The impact of this portfolio balancing will not only alter the value of the yuan against the dollar, but it will also likely change the value of the dollar against the other major currencies of the world.

Since June 19, the yuan has appreciated by 0.7 percent to 6.78 yuan to the US dollar. At the same time, other major basket currencies have also appreciated against the dollar. For example, the euro has now bounced back from its low of 1.19 earlier in the year and now stands at 1.2963. Since June 19, the euro has appreciated by 4.7 percent against the greenback. Similarly, the U.K. pound has appreciated by 3 percent, and the Japanese yen by approximately 4 percent, against the dollar since China went to the basket.

The United States Dollar Index (“USDX”) is a broader measure of the value of the U.S. dollar that compares it to a basket of currencies that includes the euro, yen, pound, Canadian dollar, Swiss franc and the Swedish krona. The USDX started in March 1973 with a value of 100.000. It has since traded as high as the mid-160s and as low as 70.698 on March 16, 2008, the lowest since its inception in 1973.

On June 19, the USDX was 87.0385. Since then it has declined by over 5 percent, signaling a broad decline in the value of the US dollar.

Based on the experience to date, the net effect of China’s new currency policy will be to not only weaken the U.S. dollar against the yuan, but to also cause it to lose value against the other major currencies of the world. In the short term, this may help U.S. exports become more competitive in world markets, but over the longer term, it is likely to lead to higher interest rates and higher inflation for U.S. consumers.

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