China Continues To Cut Out The Middle Man - The Dollar

Includes: CYB, FXA, FXY, UDN, UUP
by: AlphaVN Research

China is aiming to increase foreign trade by 8% in 2013 amid a slow recovery in the world economy and rising trade protectionism. The Yuan (NYSEARCA:CYB) has been steadily appreciating versus the dollar since last September and accounted for an all-time high of 0.63% of global payments, making it the thirteenth most-used currency in the world.

China and Japan began direct trading between the yuan and the yen (NYSEARCA:FXY) last June as a move to boost trade and investment between them. This was also viewed as a further step to enable the yuan to become a true global currency. Japan is China's fourth largest trading partner after the EU, the US and ASEAN. Bilateral trade volume settled directly reached ¥10 billion ($1.63 billion US) in 2012. The huge trade volume between Asia's two biggest economies is much more significant than any other agreements China has signed with other countries. However, their deteriorating relationship over the Japanese position on the Senkaku/Diaoyu islands and subsequent massive devaluation of the yen by the new Abe government has slowed down the integration of these two Asian powerhouses.

The Japanese, making both of these policy decisions, have obviously sided with the U.S. in the growing trade and currency war that is upon us. This path that the Japanese have embarked on, however, is suicidal in the long run, in our opinion.

Australia has also cut out the US dollar (NYSEARCA:UUP) in trade with China when the two countries announced a $31 billion currency swap agreement in March and formalized it in early April. China is Australia's largest trading partner. Since the announcement and the rate cut by the Royal Bank of Australia, the Australian Dollar (NYSEARCA:FXA) is down nearly 10% versus the dollar and the Yuan. Much of this is a result of the Yen's devaluation, creating havoc in the foreign exchange markets by creating undue demand for the U.S. Dollar by Japanese investors fleeing the country. This effect cannot last indefinitely without engendering hyperinflation in Japan.

What should be obvious here is that the U.S. is putting heavy pressure on the Chinese economy by forcing a strong appreciation of the Yuan and threatening Chinese export competitiveness. These types of strong currency moves are the stuff wars are generally fought over.

One-third of China's imports come from Australia and bilateral trade between China and Australia has been rising every year, mostly in the form of base metal ores and coal. More than 40% of Australian SME exporting to or importing from China plan to settle transactions in yuan which will reduce their foreign exchange risk.

Direct yuan settlement is encouraged to reduce currency risk and trading costs. The direct exchange rate is based on a weighted average of prices given by market makers, excluding the gap of the highest and lowest offers. Bank of China (OTCPK:BACHY), China's third-largest lender, announced that it became one of the country's first market makers in yuan-yen direct trading recently. HSBC (HBC) was also approved as a market maker for direct trading on China's interbank market, followed by Mizuho Corporate Bank. This direct settlement is estimated to save Japan and China some $3 billion in transaction fees annually.

Similarly, major Australian banks found there is a 3-5% price advantage in selling to Chinese buyers when Australian companies price in yuan. The People's Bank of China has already approved licenses for Westpac Bank Corp (NYSE:WBK) and Australia & New Zealand Bank to act as market makers for direct currency trading. Direct conversion between the Aussie and the yuan could lead to the doubling in monthly volumes to US $600 million in the next six months, as trade between the two countries continues to grow.

In 2013, JETRO expected single digit Japanese export growth to China, and nearly 10% growth in imports from China, recovering from the 10% drop in 2012 to $144.7 billion. Direct trading among the two countries will help Japan maintain its competitive advantages in intellectual property, brands and capital while China can take advantage of its natural resources and labor force. With the cooling off of the Senkaku islands dispute which led to plummeting trade over the previous 6 months between two countries, there is a sign of improved sentiment. January sales in China for the top three Japanese auto makers, Toyota Motor Corp (NYSE:TM), Honda Motor Co (NYSE:HMC) and Nissan Motor Co (OTCPK:NSANY), were up from a year earlier by double digits. Demand is coming mostly from the private markets but hasn't recovered from the government and state-owned enterprises. But their share in overall Japanese exports isn't large enough to greatly influence the overall trend.

Japan obtained approval to buy about U.S $10 billion of Chinese bonds in March, allowing the investment of renminbi that leaves China during the transactions. Japanese foreign direct investment into China rose 16% to $2.7 billion so far this year over a year earlier. Australia is also the largest destination for China's surging overseas investment, reaching $55.9 billion by the end of 2012, according to statistics from the China Global Investment Tracker. Chinese investment is starting to diversify away from mining into energy and other sectors which will drive trade in direct currency conversion. Investment by private Chinese companies (versus state-owned enterprises) is on the rise. Meanwhile, the RBA will invest about $1.9 billion, or 5%, of the country's foreign currency reserves in China's bond market.

Direct convertibility is an important step in China's drive for the Yuan to become a reserve currency. France announced it will set up a currency swap line with China to allow French companies to bypass the U.S dollar for trade on April 12th. And with each of these deals the U.S. Dollar gets fundamentally weaker, regardless of what the short-term trend looks like. This is simply another counter-cyclical bull move in an overall bear market for the dollar. However, it is crucial that China continues to liberalize all facets of its currency markets. With the loss of central control will come more power through indirect methods and inherent demand.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.