A loosening in China's yuan policy that lets the currency rise while keeping it pegged to the dollar may deal another blow to the battered euro as such a move is seen slowing China's accumulation of foreign reserves.
The euro has weakened about 7 percent versus the dollar and the yen this year on concerns Greece may face problems servicing its debts, and demand for euro assets will shrink further if a possible yuan move results in less euro buying by China.
Market speculation is growing that China may soon allow the yuan to strengthen against the dollar from the level at which it has been effectively pegged since mid-2008, and allow it to appreciate by around 5 percent by year-end to slow inflation.
Beijing has tethered the yuan to the dollar's exchange rate, keeping it weak to boost its exports. This has drawn complaints from Washington that the yuan is seriously undervalued and offers Chinese firms an unfair trade advantage.
A yuan appreciation could slow the pace of China's foreign reserve accumulation as there would be less need to buy overseas assets to keep the domestic currency weak. Chinese reserves, the world's largest, stand at $2.4 trillion and grew at the rate of more than $50 million an hour last year.
With reserves believed to be held primarily in dollars, analysts say Beijing has sought to diversify its holdings by increasing assets in euros and other currencies.
"The euro will be more vulnerable from the perspective that the People's Bank of China in the past diversified away from Treasuries to buy euro zone bonds," said Monica Fan, senior currency product engineer at State Street Global Advisors.
"Given the depreciation of euro zone bonds and a more modest pace of accumulation in currency reserves, euro zone securities are not going to be as attractive as before."
Fan added that given broad euro weakness at the moment, a slide in the euro to a one-year low of $1.30 by mid-year was a possibility. On Thursday it traded at $1.3290.
The euro has tended to benefit from talk of diversification as its liquidity and the depth of euro financial markets has made it the only serious competitor to the U.S. currency.
The euro's share of global reserves was 27.4 percent by the end of 2009, up from 26.4 percent in 2008, International Monetary Fund data showed. Dollars accounted for 62.1 percent last year and have been declining.
However, the euro might be less attractive as a reserve currency as concerns about sovereign debt uncover weakness in the euro zone framework.
Moreover, a looser yuan policy could give euro bears a chance to pile more selling pressure on to the euro.
"I would imagine that some fund managers would consider a yuan revaluation as a good opportunity to reduce euro exposure," said Kenneth Broux, market economist at Lloyd's TSB.
Many analysts believe China may soon loosen its grip on the yuan as tensions between Washington and Beijing over the matter seem to have subsided and some Chinese policymakers hint at their readiness to let the currency rise.
Some Chinese officials have said Beijing could give a basket of currencies a greater role in yuan policy in the future.
U.S. Treasury Secretary Timothy Geithner will meet Chinese Vice Premier Wang Qishan on Thursday, while Washington has delayed the release of report that could have branded China a currency manipulator, before a Group of 20 summit this month.
Analysts say a yuan move could spark initial dollar selling and a rise in Asian currencies, while benefiting the currencies of big exporters to China, including Japan and Switzerland.
In the longer run, some analysts say any impact on the euro from a stronger yuan would depend on whether China's currency reserves do indeed fall after Beijing lets the yuan appreciate.
John Normand, head of global currency strategy at JP Morgan, reckons China's reserves could rise even after a policy change if its balance of payments surplus rises due to global expansion or structural capital inflows.
China's reserves have more than tripled since the last revaluation in July 2005, when a growing trade surplus prompted the PBoC to reset the yuan rate to 8.11 per dollar from 8.28.
"Reserve diversification renders the euro most vulnerable to a revaluation, but only if a stronger yuan reduced China's reserve build-up," Normand said in a note to clients.
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