Article / 12 August 2015 at 3:19 GMT

AUD the biggest loser in China’s currency game

Managing Director / Technical Research Limited
New Zealand
  • PBoC lowered the reference rate again today
  • AUDUSD has slipped to a six-year low
  • Australia’s TWI will rise unless AUDUSD compensates for CNY weakness

By Max McKegg

In last week’s Monetary Policy Statement, the Reserve Bank of Australia seemed relaxed about the level of the exchange rate and removed previous observations that further declines were “both likely and necessary”. 

But that was before People's Bank of China put a cat amongst the pigeons and signalled it was going to let market forces play a larger role in currency settings. The rate against the US dollar will still be controlled within a 2% trading band around the daily reference rate but the starting point for each day's trading is now going to be the previous day's close. 

So as long as the currency doesn't move more than 2% per day, it's effectively free to float up or down, theoretically to wherever the market wants to take it.
 
The PBoC proved it means business by setting the reference rate lower again today. AUDUSD fell to a six-year low of 72.15 in a knee-jerk reaction but gained some support from employment data, which matched market forecasts.

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 The PBoC's signal that it is going to let market forces play a larger role in currency settings
has put the cat among the pigeons. Photo: iStock
 
Australia’s exchange rate – as measured by the Trade Weighted Index – has been coming off steadily in line with commodity prices, but a lot of that decline was due to the fact that the yuan was tied to the US dollar so that as AUDUSD fell so did AUDCNY. The Chinese renminbi makes up almost a third of Australia’s TWI so if commodity prices remain under pressure and AUDCNY holds up because of renminbi weakness, then AUDUSD will need to fall to compensate. The Aussie dollar is now in a new ball game.

The people’s currency
 
The official name for China’s currency is the renminbi. It was introduced when the Communists came to power in 1949 and translates as “the people’s currency”. A yuan is a unit of the renminbi, in a similar way that a pound is a unit of sterling. 

Onshore yuan (CNY) is traded on the mainland and its value, or “reference rate”, is set daily by the central bank. Offshore yuan (CNH) is quoted in Hong Kong and is free-floating. Yesterday’s devaluation saw the biggest gap between the two rates since 2011 as traders tried to get their heads around the longer-term implications of the move. However, with the market now likely to have a bigger say in where the reference rate is set, CNY and CNH should converge.
 
China had to let go of the peg
 
The chart below shows why China devalued. USDCNY has been steady for some time, but as the yen and euro have declined against the US dollar, so have they also declined against the yuan. 

That means China’s Trade Weighted Index has been rising strongly. Furthermore, China’s inflation rate – a proxy for its costs of production – has been higher than that of its trading partners, so the real TWI, a measure of competitiveness that combines exchange rate and cost-of-production changes, has been rising even faster. Now it seems China has concluded it is no longer in a position to be the fall guy in the global currency wars and will stand aside and let the US dollar have the stage to itself.

Chinese exchange rates
 
















Source: Reserve Bank of Australia
 
That’s not good news for the Reserve Bank of Australia (and many other central banks in the Asian region). The bank wants Australia’s exchange rate (TWI) to fully adjust to the decline in the terms of trade caused by falls in base commodity prices. But the TWI is dominated by the Chinese renminbi, as per this list of the current index weightings:
 
  • China 28%
  • Japan 12%
  • US 10%
  • Eurozone 9%
  • Korea 6%
  • Singapore 5%
  • New Zealand 4%
  • UK 3%

China’s importance as an export destination has been growing steadily as this chart shows, albeit with a slight decline recently as the proceeds from iron-ore sales have come under pressure. 

Exports by destination
 
 
 

















Source: Reserve Bank of Australia
 
As long as the Chinese currency was tied to the US dollar their combined weightings in the TWI meant AUDUSD was effectively a proxy for “the exchange rate”. But with China now indicating it may go it alone, this tidy arrangement will come undone and the Reserve Bank – and the markets – will have to give as much attention to AUDCNY as to AUDUSD in determining exchange rate and monetary policy. 

This is why AUDUSD was hit hard after yesterday's devaluation. To prevent the TWI from rising, AUDUSD needed to fall to offset the rise in AUDCNY. In fact, with AUDCNY making up 28% of the TWI and AUDUSD only 10%, we could see some sharp moves in the latter in response to the daily reference rate fixings in China. Today’s action could be just the start.

My technical analysis (Elliott Wave) of AUDUSD is presented below. If you would like more
detailed trading advice then let me know.

AUDUSD weekly chart (click to expand)
AUDUSD weekly chart
 Source: ThomsonReuters


AUDUSD daily chart (click to expand)
 Source: ThomsonReuters. Create your own charts with SaxoTrader; click here to learn more 

– Edited by Gayle Bryant

Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.

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