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Merril Lynch

Global: CHINA REVALUES FX 2.0% and raises interest rates 50bp to 6.08% in an effort to take some steam out of their economy. IMPACT:
A small move and largely symbolic but it preludes a bigger move to come.
For China importing Oil, metals and other commodities will get cheaper so it is positive for the commodities but effect may be countered as China economy should SLOW.
For Asian Equities this is a positive as hot money will flow into stocks to get ahead of the next currency revaluation which will benefit them when it comes. Bad for Asian exporters good for Asian domestic plays. Buy HK-Malaysia, sell the smaller less competitive exporters-in Korea and HK.
Overall likely positive for US equities for sentiment reasons as it is a move towards giving Bush what he wants, a more competitive relative currency regime vs China.
Makes MEXICO MORE competitive in exporting to USA
Makes TURKISH textiles MORE in exporting to USA and Europe


ML believes revaluation would have a significant market impact. Massive intervention by Asian central banks has distorted world financial markets and the global price of risk. Lower Asian reserve accumulation would imply a weaker USD, modestly higher US interest rates, and wider credit spreads.

Based on our macro views, our top revaluation trades are:

long equities in Hong Kong and Malaysia;
long Asian currencies against the USD (alternatively, hold low-beta, domestically focused stocks);
after the revaluation, short HKD interest rates against USD rates.

Morgan Stanley:

Stephen Roach

1. It diffuses US-led political tensions. Admittedly, a 2.5% move stops well short of the Schumer bill's demand for a 27.5% adjustment. But it is a start -- a small step in the right direction -- and it suggests that more such moves will now be in the offing on a timetable that is in keeping with Chinese stability objectives. With China now in play, there will be less sympathy in the US for the extreme positions of the anti-China bashers in the US Congress. China is making an effort to respond to international pressures. US Treasury is likely to offer a guarded endorsement of this move.



2. A small move does little damage to China export competitiveness, but it does hold out the possibility that export growth will now begin to ease off from its current torrid pace of 30%. This, together with a reduction of speculative construction activity in China’s overheated residential property market, is consistent with the China slowdown call within the next 6-12 months.



3. A basket is a much more stable arrangement for the Chinese financial system. It helps them address their "incomplete sterilization" problems, which have been destabilizing their money and credit cycles.



There is a downside for financial markets that must also be considered: A basket now allows China to begin diversifying its FX reserves out of their extreme overweight positions in dollar-denominated assets. This may be a diversification signal for other Asian central banks (especially Korea), who have been chomping at the bit to do the same. Malaysia’s just-announced move to go from a peg to managed float against a basket for the Ringgit is a clear example of this trend.



Financial market implications: At the margin, the FX reserve diversification play is likely to predominate. That is likely to be negative for the dollar and bearish for US rates. It would tend to limit the “natural” Asian bid for dollar-denominated assets that many have been taking for granted. That raises the likelihood of a long-overdue US current account adjustment.


Stephen Jen

Bottom line: This is not like the THB float of 1997: this is the first of several steps that Beijing will take. This step is politically meaningful, but economically meaningless. In fact, it's really the least China could do, among a spectrum of possible policy changes. Shifting to a basket deflects some attention from China. Importantly, USD/RMB could still rise above 8.28 if the USD strengthens.

1. Timing. The timing of the change is not a total surprise. With Q3 devoid of political pressure points from the US, and with the US officials hinting that China would move in August, Beijing's decision to move now is sensible from that perspective. More importantly however, is the fact that the USD has been on the strong side. When the USD was under pressure in late-2004, Beijing did not have the option of floating/revaluing, because of the fear that any flexibility would draw in more speculative capital and would force the PBoC to intensify its intervention. Now that the dollar is trading strongly, it is 'safer' to move, without severe repercussions for China and the rest of the region. All in all, making the move now would help deflect some political pressures from the US, with minimal costs to China.

2. Revaluation versus float. To me, the decision to revalue, albeit by a small margin, rather than to float, did come as a surprise to me. China's ultimate objective is to gain greater monetary independence, but that would necessarily imply that the link with the USD will need to be severed. This small revaluation is virtually meaningless, as far as the 'grand plan' is concerned. I would interpret this as a 'down-payment' rather. More changes will be announced in the period ahead. In this sense, today's move is very different from the float of the THB in 1997, which was one-off.

3. The size of the revaluation. This is politically and strategically meaningful, but economically and financially meaningless. We saw a bigger move from cable last night.

4. Basket. Of the three features I believe China will ultimately introduce in its exchange rate regime -- basket, band, and crawl, China effectively introduced only the first of the three. The currency basket is now announced, but my guess is that it will have 5 or so currencies (USD, JPY, HKD, EUR, GBP). Over time, this list could be extended. It is likely that China follows Singapore's strategy of not announcing which currencies are included or the weights of these currencies. However, looking at the trade weights, this basket index should be heavily USD-centric (USD = 27%, HKD = 24%, JPY = 31%, EUR = 15%, GBP = 4%). Since JPY is still 'sticky' with the USD, the RMB index will have close to 80% of its weight on the USD. Since the RMB is pegged to a basket now, if EUR/USD or GBP/USD falls, USD/RMB could actually head higher. Similarly, if USD/JPY rises, USD/RMB could be pushed higher. The important feature here is that, by adopting a basket band, no longer is the RMB a source of volatility, it moves with the other currencies. In other words, moving to a basket deflects the market's attention on China, at least until the next change, and puts the burden on the currencies in the basket.

5. Band. This +/-0.3% band is not meaningful; it's exactly the same band width as before. I expect this band width to be gradually widened over time, up to 15% eventually. Meaningful currency flexibility requires a wide band.

More later.

Daniel Minerbo
Morgan Stanley | International IIG