The U.S. And China: The Dollar/Renminbi Dance

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Summary

China is becoming a significant enough force in the world that officials at the Federal Reserve are going to have to pay more attention to world currency markets.

The US/China economic and financial relationship is so important to China that the People's Bank of China has reduced its currency reserves by $470 billion since last August.

Importance? Since the Federal Reserve announced it was stopping its quantitative easing in the summer of 2014, the PBoC has seen its currency reserve drop by around $800 billion.

One of the issues hanging over the meeting of the Federal Open Market Committee meeting at the Federal Reserve this week is the value of the Chinese currency, the renminbi, in terms of the US dollar.

Although Federal Reserve officials do not let foreign economic factors play a big role in their decision-making efforts, remember Congress has given the Fed only two objectives to base its policy decision upon - employment and inflation. In recent months it appears as if these officials are looking more and more into what China is doing and how it impacts the United States.

The People's Bank of China (PBoC) has had a lot to deal with over the past two years.

Not only is China the second largest economy in the world, reports now show that China has the third largest bond market in the world, even though foreigners only own a small amount of the securities that are traded in it.

Chinese foreign trade is growing and the use of the Chinese currency in transactions has grown substantially.

China continues to move to make its currency acceptable to the International Monetary Fund, gaining the designation of an official world reserve currency, and to trading partners around the world.

In attempting to stabilize the value of the currency and sustain its relationship with the US dollar, the PBoC has used $470 billion of its currency reserves since August 2015.

Several things, including a currency devaluation, were happening last August and it is not entirely clear what exactly was the reason for the move on the part of the PBoC to begin using reserves in such large amounts to provide support for the renminbi.

One thing certainly was the desire to keep IMF officials moving in the direction of making the renminbi an official world reserve currency.

Another reason given for the August move was to reassure world markets that the Chinese economy and Chinese financial markets were doing well and that Chinese officials were in control of the situation.

At the time, there was growing concern about the strength of Chinese economic growth and concern that there might be some disorderly depreciation in the value of the renminbi.

Connected with this is the fact that many market participants believed that the Federal Reserve was going to raise interest rates in September and that this move would have a bad impact upon the renminbi/dollar exchange rate.

This latter reasoning makes a lot of sense to me because of the behavior of the PBoC just before the Federal Reserve actually ended its third round of quantitative easing and began to "guide" financial markets with its thoughts on when the Fed would begin to raise interest rates.

The interesting thing about the decline in currency reserves at the PBoC is that since June of 2014, the decline has actually totaled close to $800 billion. As is reported in the Financial Times article, "Reserves fell to $3.19 trillion last month, down from a peak of $3.99 trillion in June 2014."

In looking at the PBoC statistics one can see that the uses of the bank's currency reserves started picking up in the early fall of 2014, just a month or two before the Fed ended its third round of quantitative easing.

After quantitative easing ended, Federal Reserve officials began to give financial markets some "forward guidance" as to the direction its policy interest rate might take in 2015. The "guidance' was that the Federal Reserve was likely to raise its policy rate by 0.25 percent, four times in 2015. The feeling was that there would be a 25 basis point rise once every quarter.

The use of currency reserves at the PBoC rose.

The economic data for the United States did not come in very strong in the first half of 2015 and the Fed constantly postponed raising its policy rate of interest.

In the summer, the pressure seemed to be building on the Fed and it really looked as if the Fed was going to raise its policy rate in September.

This belief seemed to put substantial pressure on the value of the renminbi and with the decision of the IMF looming in the near future and with the possibility of the Fed raising its policy rate in September, the PBoC decided to move. Devaluation was followed by the commitment to let the value of the renminbi float.

Financial market volatility followed.

The Federal Reserve decided, once again in September, to postpone changing its policy rate.

Still, the Federal Reserve wanted to change its policy rate in 2015, if for no other reason than to gain back some of the credibility it had lost throughout the year by continuing to waffle on any rate increase.

As the Fed built up its position in October and November of 2015, more pressure was put upon the value of the renminbi. The PBoC used up more of its currency reserves.

The Fed moved on its interest rate in December… and promised more rate increases… two more… in 2016.

Chinese monthly use of its currency reserves hit new highs in January and February as financial market volatility rose, once again.

The Fed backed off raising its policy rate… again… in the first few months of 2016. Still the expectations were that the Fed would move… in June.

Well, as we know, those expectations have dropped off.

And, this seems to be a real positive for the Chinese and the renminbi.

And, it seems to indicate that the Federal Reserve cannot make decisions on interest rates without considering the state of world economies and the value of the dollar relative to other currencies.

How important is China in this equation? Well, Henny Sender of the Financial Times believes that the position of China is very important: "China's influence over the fate of other markets grows ever larger, from Australia to Brazil and Chile to Korea. This means an unstable, weak renminbi can destabilize the globe. Getting the balance just right is in everyone's interest."

Federal Reserve officials, take notice of this.

Disclosure: I/we 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.