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What the Chinese Could Do to the Euro

Steven Puetzer | Getty Images

China's foreign-exchange reserves are growing, no doubt. They just aren't growing as fast as they used to - and that could spell trouble for the euro.

That's the view of Simon Derrick, chief currency strategist at Bank of New York Mellon. Derrick has reviewed the evolution of China's reserve policy, and found a series of statements by policymakers indicating that the slowing reserve growth "has, at least in part, been driven by a genuine shift in behavior by China."

Chinese officials were alarmed by the 2011 U.S. debt ceiling debate, Derrick says, citing a Financial Times commentary by Yu Yongding, who was an academic member of the People's Bank of China's monetary policy committee. The commentary stated that "If there is any lesson China can draw from the US debt ceiling crisis, it is that it must stop policies that result in further accumulation of foreign exchange reserves," even if that means allowing the yuan to float more freely.

Sure enough, China has since loosened the trading band on the yuan and is showing some guarded tolerance for a stronger currency.

(Read more: China's Floating Exchange Rate: CNBC Explains)

At the same time, Derrick says, "we certainly would not dispute the idea that China has more than sufficient reserves (USD 3.31 Trn) to deal with all but the most extreme of circumstances."

So it's probably not surprising that the growth of China's FX reserves is slowing. What's more complicated is what it means for currencies, and here Derrick has a clear view.

"We believe there has been a reasonable link over time between the pace of reserve growth in China and the performance of the Euro (EUR) against USD," he wrote in a note to clients. "The faster the pace of reserve growth then the greater the amount that China needs to diversify into the EUR (and other currencies) in order to keep its portfolio balanced."

On the flip side, though, slowing reserve growth means the Chinese have less need to buy euros, as Derrick concludes. Other factors, like a weaker yen, will of course also influence the level of the common currency in the next few months, he told me. However, "given the increasingly established trend of declining reserve growth in China, it therefore also seems reasonable to argue that the EUR should continue to see reducing levels of support over time."

There could be clues to China's reserve plans in the coming weeks, but Derrick thinks the clearest signs will come after the National People's Congress in March. Stay tuned.

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