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As the initial market optimism surrounding China’s announcement of allowing the yuan to float more freely begins to wane, attention across asset classes is beginning to turn to the potential longer term impacts of appreciation in the renminbi. Never is this more the case than in the commodity markets, where China’s role as a major powerhouse across the energy, precious and base metals complex, leaves these global markets open to a broad and deep move on the back this currency liberalisation.

Although the nature of a floating exchange rate allows price moves in both directions, it is general consensus that the renminbi will strengthen against the US dollar going forward. This is mainly due to trade imbalances between the two countries, and also more recently on the back of an influx of dollars into the country amid both foreign investment, and as the Chinese government continues to maintain strong dollar reserves.

In mid 2008, due mainly to the turmoil of the global economic crisis, China unofficially reinstated the historical currency peg (although at an updated rate) of the yuan against the US dollar. This was a managed floating exchange rate, where the Peoples Bank of China (PBC) would actively intervene to keep the yuan within 0.5% of the daily peg to the US dollar (originally within 0.3%).

Much speculation has been going on during the past few months, that as the global economy shows signs of recovery, China was likely to make moves back towards a more flexible currency policy. This was confirmed last week, when the Peoples Bank of China announced that it was going to allow the renminbi to trade more freely within the 0.5% band. Although this is still far from a free floating exchange rate, it is a move towards forex liberalization for the Asian giant, and indicates further the country’s intention to eventually allow the yuan to trade freely on the open market.

The impact on the commodity markets will depend largely on the extent and speed to which this happens. The effects of the move on the commodity markets can be expected to come from three main angles; Firstly, the impact of the move itself on consensus surrounding the prospects of global recovery and economic strength.

Secondly, the direct impact on imports and exports (or seen another way, demand and supply) of commodities to and from China. Finally, the broader knock on effect on the demand for commodities coming from changes in the Chinese balance of trade, and the impact this will have globally on manufacturing competitiveness.

It should also be noted that although these will be the two primary fundamental factors driving commodity price action on the move, in the shorter term, it will in fact be speculation by paper accounts, which will be directing prices on the perceived impact of the PBC announcement. This can not be ignored, as in a large way the move in commodity prices is likely to come much sooner than the physical market would derive, as is often the case when speculation impacts prices far ahead of the underlying fundamentals.

One final caveat should also be put in place. Although expectations are for the PBC to eventually allow the currency to float freely, they have stated very clearly their intention to have any price appreciation be “basically stable”, and it is likely that moves over the coming year will be relatively subdued compared with fluctuations often seen in the FX markets.

As discussed, China reinstated the currency peg in 2008 due to the economic turmoil surrounding the global economy during the credit crunch. It was a move designed to help, or at least limit problems with, the Chinese balance of payments, as well as provide a stable macroeconomic and financial backdrop for China during highly turmoil times. This latest announcement by China, and the assumption that they will eventually move to a free floating rate, has effectively indicated to the market that one of the worlds largest economies, and commodity consumers, believes we are at least on the road to recovery.

Naturally this brings about the likelihood that manufacturing will increase globally, consumer demand will rise as GDP growth recovers, and in turn, demand across commodities will increase. It could be argued that this has had the most immediate impact on commodity prices since the Chinese announcing, but again, this is predominantly on the back of moves by speculators and paper accounts, who are assessing the impact of a global recovery which will be months, and possibly years, in coming.

At its most basic level, allowing the yuan to strengthen against the US dollar will make all USD denominated securities relatively less expensive, cetris paribus, for Chinese consumers (or those who deal in commodities via the yuan-dollar). This brings into play the natural inverse relationship commodities have with the dollar; the greenback will effectively be weakening against the renminbi allowing commodity prices to climb. As the yuan strengthens, and the effective price of USD denominated commodities becomes cheaper in China, we would expect broader demand for those commodities to increase as Chinese imports of the commodities climb higher.

In turn, this of course will mean commodity prices climb (again assuming all other things being equal) as Chinese consumers are able to import more raw materials, until eventually, economic theory suggests, equilibrium will be found. One could also argue that cheaper raw materials prices for Chinese producers will mean cheaper end product prices and increasing demand for those consumer goods, such as cars, which directly benefit. In turn, this would increase demand for the commodities used in producing them and so squeeze the prices higher. This would particularly be the case for those commodities heavily used in industry and manufacturing, such as base metals, crude oil and even some of the precious complex, with the platinum group metals (PGM’s) used extensively in car production.

The impact of the price shift in the yuan will not just have the direct impact on the balance of trade in China as far as commodities are concerned, but will impact the wider national trade balance in much the same way. A stronger yuan compared to global currencies will, broadly speaking, make imports comparatively cheaper for Chinese consumers, while at the same time reducing exports from the country as other nations feel the relatively higher prices. Naturally this should begin to at least curb the massive double digit growth seen from China.

Although simply speaking this would be expected to reduce both demand and production of manufactured goods in China, it is to the rest of the world we can look for an upside. As once cheap Chinese imports (from the perspective of other countries) become comparatively more expensive, demand will begin to fall back to the now more competitive domestic products (or imports from countries apart from China). Although effectively this rebalancing would likely reduce Chinese demand for commodities, in essence it means all other commodities will demand more. General consensus is that eventually, this should more than offset the negative pressure brought about by China, particularly given the other factors, as previously discussed, that would be expected to keep Chinese demand firm.

The truth is of course, that at this stage the extent to which any or all of these factors will impact the commodity markets is hard to predict. A myriad of other factors are likely to come into play over the coming years, not least moves by the Federal Reserve and other central banks with regards to their own currencies. There is no doubt that the potential is there to support commodity demand, both in China and globally, on the back of any currency liberalisation.

But that said, China’s intention to keep the moves relatively tight, and the yet uncertain timescale which they would extend the moves to full free floatation, is likely to curb the extent of any moves going forward, even if speculators are directing price action on the back of their expectations.

Disclosure: No positions

Source: Specter of a Free-Floating Yuan Excites Commodity Bulls