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YUAN Dollar Peg Decision

06/20/2010
On Saturday, June 26, G20 leaders will begin a two day summit in Toronto. Continued global pressure on the Chinese to revalue their currency, the yuan, otherwise known as the renminbi, is expected to be on the agenda.  There will also be pressure, in particular from German Chancellor Angela Merkel, for governments to enact strict measures to reduce deficits and remove the credit crisis stimulus. On that front, the United States will push back, highlighting deflationary pressures and the need to keep stimulus in place. In fact, this week's upcoming FOMC decision will probably confirm keeping the quantitative easing measures in place.

Over the weekend of June 18, the market received news that the Chinese will end their currency's two year old peg to the U.S. dollar. The People's Bank of China (PBOC) said it will focus on "market supply and demand with reference to a basket of currencies."  The PBOC ruled-out a one time revaluation and kept the yuan's 0.5 percent daily trading band unchanged. From 2005 to 2008, a crawling peg was utilized; during that period, using a basket of currencies, including the yen and euro, the yuan appreciated 21 percent.  This announcement appears to be a return to that flexible currency valuation policy.

I believe that global, and in particular Chinese markets, will react very positively to the news, with the expectation of appreciation in the yuan making Chinese assets worth more.

The euro crisis and subsequent freefall in the eurocurrency has appreciated the yuan relative to the euro - an unfavorable capital markets condition - over the past few weeks. Stabilization in the euro, which has occurred over the past ten days, is a positive development. A resumption of the euro downtrend will depreciate the yuan relative to the dollar, an undesirable scenario for the capital markets.  This would be the "fly in the ointment scenario."
Realistically, a gradual appreciation of the yuan relative to the dollar - in the order of 3 to 5 percent over the next year - seems probable.

Overall, China and the world need to export Chinese growth beyond Asia. This move suggests comfort on the part of the Chinese that their economy is on solid footing. It also suggests confidence in the growth of the Chinese consumer and their contribution to China's economic expansion.  Expect Chinese demand for the "bare necessities" to increase even more.

Clearly, the Chinese at the G20 have a prominent seat at the table. It may just be that seat is up on the dais all alone looking down at the rest of the world leaders that struggle with tepid growth.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.