There is a huge developing story in China’s currency, the renminbi. After years of structural under-valuation, things are changing. China faces what we have described before as a “dollar shortage” problem, a situation it last faced on a major level in 2008.  This might seem counterintutive given China’s large stock of US Treasuries, but we promise, this is a real and growing problem. As it stands, China sits on a huge pile of Treasuries it can’t openly liquidate for fear of sending the wrong signal to the Treasury market, as well as fear of moving the underlying.

But at the same time it is finding it ever harder to absorb dollars from the system, because fewer surplus greenbacks are making their way into China via trade. Ordinarily, China offers traders the chance to exchange dollars — received through their business practices — for renminbi at the standing PBoC renminbi rate. This bid is always attractive for traders because on a structural level it is undervalued versus the dollar. (Traders get more renminbi than they probably should.)

Since this creates an excess renminbi liquidity issue, the government simultaneously offers yuan-denominated bills to the market so as to absorb the huge amounts of yuan-denominated cash that it creates. But, whilst this creates big yuan-denominated liabilities for the government, the process also creates large dollar-denominated assets, which are usually reinvested into dollar-denominated “safe” securities like Treasuries (or GSE paper before 2008).

via FT Alphaville » Why China’s RMB exodus IS the story.