Yuan For The Money

A pattern of thinking that plans the steps at the beginning of major undertakings lends itself well to manipulating the eventual outcome of a quest, to the traveler's ultimate advantage. It is in this light that investors looking for greater than average returns on their capital might give a look at converting some of their US dollars into what the People's Republic of China calls the renminbi, better known as the yuan.

While the US of A demands, almost exclusively, instant gratification in its undertakings, the people of China, especially the leaders, are willing to take a longer-term look at any given situation. First they ascertain where they are, and then they look at their desired destination. Keeping in mind a favorable journey's end, they plan the initial steps of their journey in such a manner so as to wind up, eventually, where they want to be. What may seem to be a wrong-footed start in the early going often turns out to have been an advantageous positioning when viewed from the finish line. Further, what appears to be the finish line to some observers could well be just the start a new leg of an even longer journey for the yuan and for all.

The true destination of the Chinese government appears to be for the yuan to become the established regional currency for Asia and the Far East. The short story is this: The renminbi is, and has been since early 1994, officially pegged between 8.2 and 8.3 to one US dollar. It is now worth considerably more, but the Chinese government continues to keep the peg firmly in place because, in this phase of their journey, this ratio gives them the most political and financial leverage.

YUAN FOR THE ROAD

When the yuan's journey of a thousand miles to becoming a regional currency began is open to speculation. However, there can be no doubt that one of the first notable steps toward that end came in early 1994 when China devalued the yuan from 5 to 1 versus the US dollar to an 8.2 to 1 ratio.

One of the things that becomes evident when researching this subject is that — depending on what article you read — 1) there are some real problems in the Chinese banking system, or 2) their banking system is corrupt. Without getting into the banking system discussion, the government's 1994 devaluation started a major flow of foreign money into China.

Many feel that when China pegged the yuan at 8.2 to 1, it precipitated the financial crisis that hit Asian country after country in the years immediately following the yuan's devaluation. The rationale is that the Chinese currency's devaluation and repegging sucked huge amounts of foreign money into China's coffers and out of the coffers of countries that floated their currencies on the world's foreign exchange markets. With the yuan's devaluation, computer parts, plastic toys, and all other sorts of widgets became a good deal less expensive when purchased from China. A more in-depth look at the situation from a 1998 perspective can be found at: http://mondediplo.com/1998/01/04china

Regardless of what the devaluation did to other countries, the ploy worked so well for China that its surplus of payments has grown to one of the two largest in the world, with Japan being the other. At the end of 2002 China's surplus balance of payments was something over US$286 billion. (http://ce.cei.gov.cn/enew/new_h1/f400hee8.htm)

Keep in mind that this is in contrast to the negative balance of payments for the United States that is running about $500 billion per year. In addition to a growing surplus of foreign money, China is accumulating a fairly healthy amount of gold. A recent report puts the official amount at more than 600 metric tons. That puts China in the top dozen of gold holding countries. (http://www.atimes.com/china/DF01Ad05.html)

According to BusinessWeek Online's article by Hong Kong reporter Mark Clifford in the July 10, 2000, issue, Chinese Prime Minister Zhu Rongji told a group of Hong Kong businessmen that he might let the yuan float by the end of the year. Zhu convinced the group that he was serious and left them with the expectation that a floating yuan was in the cards. (http://www.businessweek.com/2000/00_28/b3689155.htm)

Nine months later came a complete reversal of the official position on floating the yuan. In a Beijing interview with the editors of BusinessWeek Online, the head of China's central bank, Dai Xianglong, stated in March 2001 that he would not let the yuan depreciate against the US dollar. (http://www.businessweek.com/bwdaily/dnflash/apr2001/nf2001044_717.htm)

Most certainly that was a promise kept. In the same interview, Xianglong mentioned that one of the things that would bring pressure on the yuan to float against other world currencies would be China's entrance into the World Trade Organization (WTO). So far they have managed to become a part of the WTO but still hang on to the peg. How much longer they can keep the artificially low ratio in effect is a fair question.

THE PEG HELPS BOTH WAYS

In May 2003 for the Business & Finance Review, Shan Saeed wrote that:

Washington had put forth the notion that the Asian financial crisis of 1997 was precipitated by Chinese devaluation two years earlier of the RMB yuan from 5 to 8.2. Beijing has since received praise from Washington for resisting devaluing the yuan all through the Asian financial crisis that began on July 2, 1997. Market forces since 1999 have been putting pressure on the yuan to appreciate against other currencies, reflecting China's robust economy. (http://www.jang-group.com/thenews/may2003-weekly/busrev-26-05-2003/p7.htm)

The 8.2 peg has been an advantageous position for the yuan during the times that the US dollar gained strength versus the other world's currencies, in that the dollar imparted strength to the yuan as well. And the peg is now advantageous to the yuan in that Chinese-made goods remain the same relative bargain to the US consumers as they have been over the past decade. The downside is, of course, that US goods should be much cheaper than they now are to the citizens of China who would like to buy American-made products. With the two currencies linked, the "Made in the US" goods continue to be expensive. American computers, clothes, and so on still cost a good deal more than they would if the yuan floated freely.

As the US dollar falls against many of the world's currencies, the imports from those other countries become more expensive to the US, which in turn decreases the US purchases of their ever more expensive goods. However, with the yuan pegged to the US dollar, Chinese goods are no more expensive today than they have been since the mid-1990s. That is good for the American consumer. That is good for the Chinese exporters. But that is bad for countries that manufacture comparable goods and cannot compete with the Chinese products due to the relatively higher cost of their goods in US dollars.

In the US House Committee on Small Business on June 25, 2003, on "Foreign Currency Manipulation and its Effects on Small Manufacturers and Exporters," Edward M. Tashjian testified:

China's currency has remained fixed at about 8.3 yuan to the dollar since 1994. The stability of this currency over that period is completely at odds with economic fundamentals. China's emergence as both an export powerhouse, and a destination for foreign direct investment, should tend to exert upward pressure on the yuan. This has been the pattern for emerging economies across the globe, and one of the factors that over time equalizes the competitive balance between trading partners.

The failure of this process to occur in China is in all likelihood due to intervention by its central banks. Essentially, the profits from China's booming manufacturing sector are used to buy and hold dollars and euros, rather than to purchase foreign goods and services. In the last few years, China has accumulated $300 billion in foreign exchange reserves — $100 billion last year alone.

Certainly, central banks enter the currency market for many legitimate reasons. However, the consistent, long-term purchase of dollars and euros can only be understood as a means of artificially depressing the yuan. According to the International Monetary Fund (IMF), such a pattern of 'protracted large-scale intervention in one direction in the exchange market' is a principal indicator of prohibited currency manipulation.

Adherence to global trading norms was the quid pro quo for China's accession into the World Trade Organization (WTO), and ultimately, access to the lucrative consumer markets of the US and Western Europe. Both IMF and WTO rules proscribe currency manipulation for the purpose of obtaining a competitive advantage or to interfere with the working of trade liberalization. Article IV of the IMF Agreement, for example, requires member nations to "avoid manipulating exchange rates to gain an unfair competitive advantage."

US trade authorities must monitor and enforce China's obligations in this area, and ensure that the timetables for action embodied in the WTO agreement are met. We were very encouraged to hear [US Treasury] Secretary [John] Snow voice his support for more market-based exchange rates, and his belief that China was agreeable to moving in that direction. Early indications are that the announcement itself moved the value of the yuan upward on the currency exchanges. Therefore, it is vital that US policymakers stand firm in pursuit of fair valuation.

(http://www.house.gov/smbiz/hearings/108th/2003/030625/tashjian.html)

Suppose for a moment that every widget we import from China was priced 50% higher than it now is. With that in mind, it is possible that we would be able to actually produce that widget here in the US at the same price, or even less. Now suppose that American-made cars, computer parts, and assorted widgets would have a market in China if they could be purchased at 50% less than what is possible now. The US consumer could be paying a lot more, in the form of jobs lost, by having Chinese imports available at lower cost due to the artificial relationship between the yuan and the US dollar.

On June 26, 2003, Bloomberg News asked Treasury Secretary Snow about the talk of China floating the renminbi. Though Snow agreed that there have been talks about China widening the trading band prior to letting yuan float, he had a flat "no comment" about how high in the government these talks were occurring. Snow did say that the Chinese economy continued to grow at an 8% pace and that a floating currency was necessary for a free trade policy. Even if Snow and his European equals are putting pressure on China to float the yuan, we must remember that China does not generally react to pressure in a manner consistent with the desires of those who are applying said pressure.

Be that as it may, sooner, rather than later, China is going to have to let the yuan float, as most of its competition — Japanese yen, Australian dollar, New Zealand dollar — does now. When the official peg comes loose, it will appreciate a lot.

HOW DO YOU DEFINE "A LOT"?

In an April 24, 2003, article titled "McCurrencies," The Economist rated the world's currencies based on the comparative price of a Big Mac. (http://www.economist.com/markets/bigmac/displayStory.cfm?story_id=1730909)

First, the average cost of a Big Mac is given in the currency of the country, and then that price is converted into US dollars. Based on this "Big Mac index," the yuan is the most undervalued currency in the world, to the tune of 56%. An investment of $10,000 could give a instant $5,600 return if the yuan were to become unpegged. Granted, there are no guarantees, but even if it was only a $4,000 or a $2,000 return, and even if it took two years, that kind of return wouldn't be all bad in today's investment climate.

Bruce Faber may be reached at BFaber@Traders.com.

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.