The impact of revising the yuan basket

Let’s look more closely at the new additions to the CFETS (China Foreign Exchange Trade System) RMB Index as outlined in the previous article. If we go by the MSCI market classification, eight of the 11 newly added currencies belong to emerging markets (Saudi Arabia just recently lifted restrictions to foreign investments, and will not be considered for inclusion into an emerging or frontier markets index until 2018).

On the whole, ten of the 24 currency units belong to emerging nations and form 26.3% of the Index.

This newfound love for emerging market currencies is expected “to strengthen the representativeness of the currency basket” by including currencies of China’s close trading partners. However, the move looks more like a single-minded attempt to try to reduce the influence of the dollar and bring stability to the yuan after the decline seen in 2016. On a side note, currencies of two countries are conspicuous by their absence: the New Taiwan Dollar and the Indian rupee – both big trading partners of China.

Can China achieve their objective with the re-composition of its currency basket?

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The US Federal Reserve had raised the federal funds rate in December 2016. With a Republican majority and assuming economic conditions in the US do not weaken considerably, the central bank can be expected to continue on a rate tightening cycle at a much quicker pace in 2017. A rise in interest rates typically has a strengthening impact on the local currency

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The reduction in the weight of the dollar (UUP) will have a smoothening effect on the RMB Index. Furthermore, the dollar’s strength, which sharply impacts emerging market currencies, will also help the basket due to the prominence of these other currency units.

However, even with reduced weightage, the dollar will obviously remain the primary currency which investors benchmark the the yuan against. China has the right to redo its currency basket, but changing investors’ perception is beyond its control.

With the US on the rise due to its continually improving economic fundamentals, Chinese investors themselves have been moving capital into the country at increasing rates. This is one of the reasons that China has been putting capital controls in place.

The yuan may be in for a tough year especially if President-elect Donald Trump follows through as discussed in implementing measures to check the trade deficit situation with China. The CFETS will reevaluate the RMB Index once a year and intends to shuffle it again at an “appropriate time.” More palpable changes following the revision on 1 January may reveal themselves in the medium-term, but for the short-term, this will be more of a cosmetic change than anything else.

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