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Watch This Currency If You Want to Trade China

China Photos | Getty Images

China is the big story - the second biggest economy in the world and on its way to become the biggest (according to one way of measuring it, at least). So it's only natural that foreign exchange traders should want to get in on this Next Big Thing and trade the up-and-coming country's up-and-coming currency as well so that they too can ride the wave.

China's currency, the yuan (CNY), only partially reflects what goes on in China's economy. It doesn't trade freely; the Chinese government sets an official rate for it every day and only allows it to fluctuate 1 percent around that level every day. In fact, it doesn't even vary that much; the average difference between the high and the low price last year was a mere 0.15 percent.

(Read More: China Central Bank Takes Lead in Economic Reform Push)

However, there is a version of the yuan (CNH) that trades freely overseas. The government doesn't fix a value for that, but as its value never strays that far from the value of the yuan, it too is relatively stable. The result is that the currency, whether traded on the mainland or overseas, only reacts modestly to Chinese economic indicators and other news that would be market-moving in other, freely traded currencies.

That's why the market has turned to the Australian dollar as a proxy for China. The Australian economy is almost tied to the hip to China – about one-third of its exports go to Greater China and, perhaps more importantly, two-thirds of its exports are products where China sets the price: coal, iron ore, wool, metals, etc. The mining and mining-related sector alone accounts for 19 percent of gross domestic product, while most of the growth of the country comes from the mining and agricultural sectors, which are now aimed squarely at the China market. With the fate of the Australian economy tied so closely to China, it should be no surprise that people who trade the Aussie dollar do so with one eye on China.

(Read More: Is This the Start of China's Tightening Cycle?)

The following graphs tell the story. They compare the level of the Aussie dollar versus the U.S. dollar against an "economic surprise index," that measures the difference between the market's forecasts of economic indicators and the actual number. A rising index shows that the country's data are turning out better than the market had expected.

Naturally, that would be seen as good for the currency and in this scenario the Aussie dollar/U.S. dollar could be expected to rise. The first graph shows how this comparison works for the Aussie dollar/ U.S. dollar pair and Australian economic surprises. Answer? Not very well. The second graph shows how the pair compared with the economic surprise index for China. It's a better fit. And how does the yuan that is traded overseas do? As you can see, there is relatively little impact of the economic indicators on the currency, which tends to move in a much smoother trend.

For the retail client, there's an additional problem in playing the yuan: it's hard to get a good liquid market. Not many of the on-line brokers make a market in U.S. dollar /CNH and prices are updated infrequently outside of Hong Kong trading hours. The Chicago Mercantile Exchange offers contracts in U.S. dollar/CNH as well as futures and options, but here too you have the basic problem in trading a pegged currency: will the government allow the currency to reflect fully the market's view? You may think U.S. dollar/CNH should move, the whole market may think U.S. dollar/CNH should move, but if the Chinese government doesn't want it to, it won't, at least not very much.

If you want to express a view on China, look to the Aussie dollar/ U.S. dollar pair. It is not perfect – obviously it is also affected by what goes on in Australia – but it is better than the home product.

The author is the Head of Global FX Strategy at IronFX, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.