China Continues Currency Manipulation Scheme?

On Tuesday, rumors persisted that China would enter the market for Italian debt, either directly or in the form of acquiring Italian industrial holdings.

The move initially provided support for the EUR/USD pair, before the trade reversed when it was reported that the rumors had little merit.

News that China had been purchasing European debt has stretched back for months.

As is widely known, China has a significant quantity of foreign reserves. These reserves are primarily denominated in U.S. dollars.

In purchasing European debt, the Chinese may be able to diversify their reserve holdings out of U.S. dollars and into euro-backed assets.

As the debate over the debt ceiling's extension may have demonstrated in July, the safety of dollar-backed assets may be more questionable than was previously thought.

Yet, perhaps China has other motives in a possible purchase of European debt.

Many market commentators have accused China of being a currency manipulator. The People's Bank of China maintains a peg of its yuan to the U.S. dollar.

This peg may be giving China an unfair advantage in international trade. As China's goods appear relatively cheaper (priced in the cheaper yuan) foreign consumers may prefer to purchase goods manufactured in China.

In order to maintain that peg, the Chinese have had to purchase U.S. dollars and government bonds.

Now, the Chinese may be enforcing that peg with a purchase of euro-denominated assets.

Then, as the euro weakens, the yuan may weaken further. This could continue to benefit Chinese manufacturers, but may increase the rate of inflation within China.

As China has been struggling with inflation in recent months, the PBoC may find that the maintenance of the peg is exceedingly difficult.

If China does become an aggressive purchaser of European debt, it be will interesting to see how it affects China's currency going forward.