How Chinese Tightening Could Affect Currencies

It is the Year of the Tiger and to celebrate, Chinese markets are closed for the entire week. Here in the U.S., markets are also closed in observation of Presidents Day. As a result, it is expected to be an exceedingly quite trading day, which gives us the opportunity to contemplate the recent actions by the Chinese government. Unlike the U.S. and other economies in Europe for example, growth in China has been piping hot. So hot that the Chinese government has felt compelled to step in and start tightening their economy in fear of developing an asset bubble. China's economy is expected to grow by as much as 10 percent this year. On Friday, China's central bank increased the reserve requirement ratio (RRR) of large commercial banks, which basically restricts the amount of money that these banks have available to lend to companies and individuals. This is the third action in 5 weeks and the second time that the PBOC has increased the RRR, which indicates how serious they are about cooling lending growth. Most articles written about these actions center on the consequences that it may have on the global economy. We all know that China is the dominant engine of growth for the world right now and a dramatic slowdown could cause economic unrest in many parts of the world. On Friday, we mentioned how this decision may be related to seasonal flows because the PBOC tends to increase liquidity ahead of the Chinese New Year and extract it shortly after. However given that loan growth failed to slow significantly after the first reserve requirement hike last month, they have felt the need to apply the brakes again sooner rather than later. Lending surged to 1.3 trillion Yuan in January while property prices rose to the highest level in 21 months.

 

It is no secret that China's actions move markets and for the purposes of this article, we want to examine how the major currency pairs have traded after China's prior announcements. This is an isolated sample set since we only have 2 prior and recent developments in China and there y have been other factors impacting the trend in the forex market. Nonetheless, it is still an interesting exercise to see how the dollar has traded since then against the major currencies so we can extrapolate how it could possibly trade following Friday's announcement.

 

Based upon the following charts of the EUR/USD, USD/JPY and the AUD/USD, we can see that in all 3 cases, China's announcement to increase their reserve requirement ratio on January 12th and reports that they have pressed some banks to restrict lending around January 20th have been followed by a wave of risk aversion that has taken all 3 currency pairs lower. This price action is not surprising considering that China's decision to tighten their economy has negative implications for the global economy. Therefore barring any external factors, the latest announcement from China should have negative implications for the forex markets and keep pressure on the EUR/USD.

 

EUR/USD Daily Chart

USDJPY Daily Chart

 

AUDUSD Daily Chart