The yuan can drop

The Chinese currency cannot fluctuate against the U.S. dollar unless the U.S. dollar is reduced as a share of the country's foreign reserves.

China Favors Euro Over Dollar as Bernanke Alters Path

China, whose $2.45 trillion in foreign-exchange reserves are the world’s largest, is turning bullish on Europe and Japan at the expense of the U.S.

The nation has been buying “quite a lot” of European bonds, said Yu Yongding, a former adviser to the People’s Bank of China who was part of a foreign-policy advisory committee that visited France, Spain and Germany from June 20 to July 2. Japan’s Ministry of Finance said Aug. 9 that China bought 1.73 trillion yen ($20.1 billion) more Japanese debt than it sold in the first half of 2010, the fastest pace of purchases in at least five years.

“Diversification should be a basic principle,” Yu said in an interview, adding a “top-level Chinese central banker” told him to convey to European policy makers China’s confidence in the region’s economy and currency. “We didn’t sell any European bonds or assets, instead we bought quite a lot.”

What else are they going to buy? The Chinese have said they cannot buy gold without greatly affecting the market. They've been buying euros and yen because these currencies have the most liquidity, after the U.S. dollar. Therefore, China is not bullish on the yen and euro, they are diversifying their reserves so that their currency will move away from the U.S. dollar, as Congress asked. But which way will it move?

US and China to clash over yuan fall

The yuan dropped at the fastest pace in almost two years last week and is now 1.8pc lower against a basket of currencies than in June, when Beijing announced the end to its fixed peg against the dollar.

Western economists had seen yuan liberalisation as a sign that China is abandoning its mercantilist policy in a step-by-step move towards a floating currency, which was expected to rise. They misjudged China's motives badly.

The U.S. dollar is still the engine pulling the currency caboose. Instead of looking at Chinese currency appreciation as inevitable, it's better to consider what direction the U.S. dollar will take against major currencies and whether the Chinese are increasing or decreasing U.S. dollar exposure. Since it is the latter, the yuan will weaken versus the U.S. dollar during a U.S. dollar rally against major currencies.