When U.S. President Barack Obama told Chinese Premier Wen Jiabao last week that the yuan’s peg to the dollar is unsustainable, he forgot to add one thing: It also threatens the world’s floating exchange-rate system.
China’s official currency reserves are simply becoming too large. The Bank for International Settlements’ triennial survey of foreign-exchange and derivatives activity, released this month, points to huge and growing trading volumes in the global currency market. But make no mistake: China and other trade surplus countries have accumulated reserves even faster in recent years. If this trend continues, China may soon set trading ranges for major currencies such as the U.S. dollar and the euro, effectively ending their free float in the market.
At first blush, the survey provides a reassuring message about the state of foreign-exchange markets: 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.
Most of the growth in the currency markets over the past three years has come from spot foreign-exchange trading, while daily transactions in options and other derivatives products contracted slightly. Those between dealers and “other financial institutions” -- including not only pension and hedge funds but also central banks -- were the main driver.
While most comments on the BIS data have focused on hedge funds as the most likely source of growth in trading volumes, a breakdown of the “other financial institutions” category isn’t available. Thus, it may well be that spot transactions with central banks was one of the key drivers.
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.
If China’s 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.
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.
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.
There has been frequent talk in recent years about consequences for the dollar if China dumps Treasuries in retaliation against U.S. protectionism. The process of reserve diversification by surplus countries (notably the BRIC nations of Brazil, Russia, India and China) away from the dollar also helped explain the long period of dollar weakness in 2002-2008.
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.
Trading volumes in currency markets will probably grow in coming years, but unless we see a generalized move toward exchange-rate flexibility, particularly in Asia, they will be increasingly driven by decisions taken in the government sector -- and certainly not in the U.S. and Europe.
It’s not a question of if, but Wen.
(Riccardo Barbieri Hermitte is an independent economist and market strategist. He was previously head of international economics and global rates and currency research at Bank of America Merrill Lynch.)
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