Dollar weight reduced

The CFETS (China Foreign Exchange Trade System) RMB Index is the basket which tracks the value of the yuan against various currencies. On the first day of 2017, its was announced that the CFETS would be decreasing the weight of the US dollar in the RMB Index.

The dollar now comprises 22.4% of the index, 4 percentage points lower than earlier. The index is now comprised of 24 currencies, 11 of which are new. The following currencies have been added:

  • South African Rand
  • South Korean Won
  • United Arab Emirates Dirham
  • Saudi Riyal
  • Hungarian Forint
  • Polish Zloty
  • Danish Krone
  • Swedish Krona
  • Norwegian Krone
  • Turkish Lira
  • Mexican Peso

These 11 combine to form 21.1% of the basket. Meanwhile, the top three currencies by weight, i.e. the US dollar (UUP), the euro and the Japanese yen, form half of the currency basket. The newly introduced South Korean won has jumped straight to the fourth spot, forming a little over a tenth of the basket.

Why the reconstitution?

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The US, especially the Republicans who are now in firm control of the Congress, have been extremely critical of China for keeping the yuan artificially low against the US dollar. Keep in mind that China pegs its currency to the US dollar instead of letting market forces determine its level.

A weaker currency makes a country’s exports cheaper in the international market, thus leading to a rise in demand for its products.

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With President-elect Donald Trump having expressed his desire to label China as a currency manipulator, one aim of the yuan basket adjustment is to reduce the importance of the US dollar in order for it to have a lesser drag on the index.

At a time when China is facing massive capital outflows, some alleviation of pressure on the yuan can project a sense of stability, thus infusing some confidence in investors.

The further diversification of the basket by adding 11 new currencies will also assist in softening it’s exposure to the US dollar as a wider diversification theoretically means lesser influence of a single currency on the index. Also, it makes a scenario where all currencies in the basket are simultaneously strengthening much less likely, which will also further protect the yuan.

In the next article, let’s look at the possible impact of this diversification.

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