FAROS TRADING | Special Report
07/22/2010
The USD/Index vs USD/CNY. Causality over correlation
Yesterday's statement from China's Central Bank Deputy
Governor Hu Xiaolian marked the latest in a long line of
comments coming from China regarding the flexibility of
the Yuan and China's goals through flexibility. She said the
Central Bank would start publishing a measure of the
CNY's value regularly to help them manage the exchange
rate against a basket of currencies and not just the USD.
Hu added that the basket's composition should be
primarily based on trade weightings.
We see China's trade with the rest of the world broken
down as follows. USA 21%, Europe 19%, Japan 16%, South
Korea 11% and Taiwan 8%. All of these are approximate.
We understand China's USD assets within their foreign
exchange reserves comprise anywhere from 65 to 75%.
This means that in order for China to transition its foreign
exchange reserves from a basket of 65% USD to a more
manageable and trade-related level of 21% of reserves,
China has to sell approximately 44% of their USD reserves.
We estimate China's foreign exchange reserves as totaling
approximately 2.5 Trillion USD. This means over time
China needs to sell about 1.125 Trillion USD against a
broad range of other currencies. To put this number into
perspective, Japan holds approximately 1 Trillion USD, The
Euro-zone 700 Bio USD and Russia has approximately 450
Bio USD in reserves.
When you have this many USD to sell you never do it all at
once, and you never telegraph it to the street. Rather you
sit patiently and add liquidity when the market needs it.
This creates an ebb and flow in the marketplace. The EUR
sells off from speculative flows, only to rally the next day,
stopping out positions.
USD/JPY trades in a similar fashion... Going bid, then
selling off. If we are correct, the the steady drip provided
by China will dampen USD strength and create a trend of
USD weakness.
We have attached a chart of the USD Index and it makes
for remarkable reading. When China enacted the first
revaluation and managed float in July 2005, USD/CNY
dropped at a measured pace as did the USD Index. When
China halted the float and instead re-pegged to the USD
in July 2008, the USD Index rallied massively, and proved
very choppy. That is, up until July 2010, when once again
China said they were allowing CNY flexibility. Now the
USD Index is again moving lower, along with USD/CNY.
This is not correlation. It is causality. China is managing
the CNY against a basket of currencies, with a weighting
that requires the USD to be sold relative to other
countries. This re-balances their foreign exchange
reserves over time to a basket more resembling their
trading partners, just as Hu Xiaolian hinted.
Further transparency was provided on July 19th, 2010
when Yu Yongding, a former advisor to the PBOC
commented in the China Securities Journal. Stating that
China should reduce its holdings of the USD to diversify
risks of 'sharp depreciation'. Earlier, in May 2010 he
suggested China should allocate its reserves in line with
the weightings of SDRs, Special Drawing Rights.
In the past month we have noted China bought anywhere
from 500 Mio to 1 Bio USD of Spanish bonds. We saw
them purchase in excess of 1 Bio USD of Greek assets,
and we watched them buy approximately 6 Bio USD of
Japanese JGBs through April.
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This is more than double the record amount of Japanese

bonds that they bought over the entire year in 2005. On
July 16, 2010 The US Treasury Department reported that
China's holdings of US government bonds decreased by 32
Bio USD in May to 867.7 Bio USD. It is interesting to note
that the yield spread on 2 year swaps between the US and
Europe is at its most attractive level in months for a buyer
of European debt against US treasuries, and between the
US and Japan is at its most attractive in 15 years for a
buyer of Japanese bonds against US treasuries.

On July 6, 2010 China's SAFE, (the State Administration of

Foreign Exchange) said "As a responsible long-term
investor, China maintains a diversification strategy for the
investment of its foreign-exchange reserves." Chinese
Premier Wen Jaibao added on July 16, 2010 that "It's well
known China has abundant foreign exchange reserves. As
a responsible, long-term investor, China sticks to the
principle of having a diversified portfolio. The European
market has been, and will stay, one of the key markets for
Chinese investment."

The chart showing the effects of a flexible CNY on the USD

Index is very telling. When the CNY is flexible, the USD
Index falls in a steady manner. When the CNY is fixed to
the USD, the USD Index is volatile and has the ability to
rally. We conclude that a flexible CNY means discrete and
consistent USD selling by China across the board as it
works to re-balance its growing foreign exchange reserve
portfolio. We expect this scenario will continue for some
time to come. The US used to call for a stronger USD.
Now it calls for a stronger CNY. We believe they will get
their wish.

See Included Chart.

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