Over the past decade, the Chinese renminbi has been one of the world's best performing currencies. While the People's Bank of China has generally controlled the exchange rate between the U.S. dollar and the renminbi, the latter has been allowed to appreciate against the former. That's happened sometimes in large, sudden revaluations (such as in 2005, see chart below), and other times in more gradual movements over time where the daily fluctuations are limited -- as has been the case from 2010 to the present day. While the USD/CNY cross has been controlled to ensure stability in United States/China trade, over the past decade the U.S. dollar has gone from being able to purchase more than eight renminbi to being able to purchase 6.14.
Click to enlarge images.
I think there is a strong possibility that this trend will continue, and in this article I give the following reasons for this:
- Demand for the renminbi is growing outside of China as a means for nations around the world to trade directly with the Chinese.
- The monetary base in China is growing at a slower rate than in the United States.
- There is evidence of a credit bubble in China. Assuming that this bubble pops and that credit begins to contract, demand for the renminbi will spike in China.
I will conclude by discussing how investors can participate in the anticipated appreciation of the renminbi with respect to the U.S. dollar.
1. Demand for the Renminbi Is Growing Outside of China
Chinese exports to the rest of the world have been soaring since the beginning of the 21st century.
In April, 2000 Chinese exports were $20.5 billion, whereas in April, 2013 Chinese exports were $182 billion, which equates to a compounded annual growth rate of over 18%. However, demand for the renminbi outside of China has grown at a faster rate than this. This is the case because, over the same time period, usage of the renminbi in the rest of the world's transactions with China has increased as well. For the most part, especially toward the beginning of the 21st century, nations that traded with China would use U.S. dollars because of the restrictions that the Chinese government placed on renminbi trading outside of China. More recently, especially since the 2008-09 financial crisis, the Chinese have opened up to trading with other nations directly in renminbi. This has placed pressure on demand for the U.S. dollar, which is no longer used in many transactions, while bolstering demand for the renminbi.
Some of the more significant trade agreements made between China and other nations are as follows:
- Australia: In April 2013, China and Australia announce direct trade between the Australian dollar and the Chinese renminbi, eliminating the use of U.S. dollars as an intermediary in transactions between the two countries.
- Brazil: In June 2012, Forbes reports that China and Brazil agree to allow the exchange of up to $30 billion worth of real or renminbi in order to facilitate trade between the two countries.
- Japan: In December 2011, China and Japan sign an agreement whereby the two countries trade using yen and renminbi, eschewing the U.S. dollar as an intermediary in transactions between the two countries.
These deals are but preliminary steps toward what will likely be a scenario in which the renminbi is the predominant currency used by the rest of the world to trade with China. But presently, the renminbi is still used sparingly in world trade. To illustrate this, renminbi comprise only a tiny fraction of global currency reserves (of course China itself is the largest holder of global currency reserves, and it does not hold any renminbi). Consider the data of currency reserves from the IMF. As of the end of 2012, the renminbi still goes in the "other" category, which as an aggregate comprises just 6% of global allocated currency reserves.
Nevertheless, this trend is only going in one direction; that is to say, there aren't any countries that, having used the renminbi in trade with China, have decided to drop it in lieu of another currency (although precarious Sino-Japanese relations may change this). Furthermore, given the size of China's economy (it is the world's third largest behind the United States and the eurozone) and the rapidity with which China's export market is growing, there is no reason that this trend will not continue. Ultimately, this means that global demand for renminbi will rise, and this will occur primarily at the expense of demand for the U.S. Dollar.
2. China's Base Money Supply Vs. The United States' Base Money Supply
Base money supply in China is growing more slowly than the base money supply in the United States. I am putting forth more than one argument based on base money supply in this article because there are numerous ways of calculating "money supply," and they all have different implications as well as accuracies in their respective measurements. Base money is arguably the most easily measured, and the most "objective" because there is only one way of calculating it. That is, there is no debate as to what is included or excluded -- it is simply the size of the central bank's balance sheet.
The following is a chart of China's base money supply going back to 2004:
Since the beginning of 2004, Chinese base money supply has grown at a CAGR of roughly 10.3%. While this seems high, it's not nearly as high as the base money supply growth in the United States, which during the same time period has grown at a rate of nearly 16% per year.
The following is a chart of Chinese base money supply in terms of U.S. base money supply:
How this trend will continue is difficult to predict. The U.S. monetary base is growing at an anticipated rate of $85 billion per month, while the Bank of China has historically increased (or decreased) China's monetary base in order to manage the exchange rate between the U.S. dollar and the renminbi. Whether or not this continues remains to be seen. As I suggest in the next section, there appears to be a credit bubble forming in China, and should it pop the People's Bank of China may be forced to rapidly increase the monetary base in the same way that the Federal Reserve was forced to do in 2008.
Yet while the monetary base in the United States soared, nearly doubling during the financial crisis, the M2 money supply (a measure of money supply which includes bank deposits) continued its ascent at a CAGR in the low double digits, and the purchasing power of the dollar relative to real assets (stocks, commodities, and real estate) soared. Thus, monetary base is not necessarily an ideal indicator to use in order to predict the value of a currency. However, longer term the exchange rate between the renminbi and the U.S. dollar has generally reflected the relative change in the two currencies' respective monetary bases over a long period of time. Still, it is necessary to consider other measures, as I do presently
3. There Is a Credit Bubble in China
While the renminbi has been increasing in value relative to the U.S. dollar, if one looks at a broader measure of money -- M2 -- the supply picture looks completely different than that painted by measuring the monetary base. China's M2 money supply has been soaring rapidly since the beginning of 2004, as the following chart illustrates:
During this time period, the M2 money supply in China has grown at an astonishing rate of nearly 18% annually. Furthermore, while China's monetary base is growing far more slowly than that in the United States, if we look at the relative change in these countries' respective M2 money supplies, China's has been growing far more rapidly -- as the following chart illustrates:
Since M2 money supply is a more overarching measure of the money supply as it includes bank deposits, the fact that the renminbi has markedly appreciated against the U.S. dollar speaks to the enormous demand for the renminbi outside of China. That said, the rapid rise in China's M2 money supply at first glance would appear to be a reason to favor the U.S. dollar over the renminbi when looking at the supply side of the supply/demand equation. However, the fact that the M2 money supply has grown much faster than the monetary base speaks to the rapid growth of credit in China, and all of this accumulated credit must ultimately be paid back. That is to say, it is indicative of pent up demand for renminbi that will be used to pay back this debt some time in the future.
To illustrate what impact this might have on the renminbi and on measures of its supply, it is useful to look at the U.S. dollar and what transpired during the deflationary spiral in the United States in 2008-09. As I mentioned above, when the deflationary spiral took place in the United States the Federal Reserve rapidly increased the monetary base while the M2 money supply continued its gradual ascent. All the while the purchasing power of the U.S. dollar increased markedly. Ultimately there was a rapid decline in the ratio of the M2 money supply relative to the monetary base, or the money multiplier, which is a rough yet useful estimate of how much credit there is in the financial system (there are other ways of defining the money multiplier). The following is a chart of the money multiplier in the United States from 2004 to the present:
We see that the money multiplier peaked at around nine, and it has languished after its initial crash during the financial crisis. There is no denying that when the money multiplier was at nine there was a massive credit bubble in the United States. Furthermore, the collapse in the United States' money multiplier from nine to four during the financial crisis in 2008 accompanied a catastrophic deflationary spiral, during which the U.S. dollar's purchasing power increased dramatically with respect to virtually every global asset.
If we look at similar data from China we see a frightening picture. What follows is a chart of China's money multiplier during the same time period.
Currently the money multiplier in China sits at around 18, which is twice what it was in the United States before the biggest credit crunch in generations. While these are only rough measurements that are subject to debate, it is evident that even if this image reflects a large error, one can still conclude that there is still an enormous credit bubble in China. While it is impossible to know when this bubble will pop, no bubble lasts forever, and eventually there will come a time when it does pop, which will lead to a substantial rise in the demand for renminbi within China.
There are two significant risks to my thesis that the renminbi will continue to appreciate against the U.S. dollar. First, a major reason that demand for the renminbi has been increasing is that the Chinese government has encouraged the rest of the world to use it in global trade. Thus global demand for the renminbi is largely based on political decisions, and not economic reality. Thus there is a very real possibility that the Chinese government will cease encouraging renminbi-based global trade. While I cannot imagine this happening given China's growing role in the global economy, historically China's culture has been isolationist, and the right political circumstances can lead to the Chinese government building trade barriers, which will dampen global demand for the renminbi.
Second, the supply of the renminbi (or any currency for that matter) depends largely on the actions of central banker decisions. The People's Bank of China might decide to radically increase the monetary base, especially in response to the credit bubble bursting. This would not be the first case of a central bank interfering in the market in order to stop its currency from appreciating. Just within the last two years we have seen radical central bank intervention in Switzerland and Japan, and both interventions successfully reduced the values of two of the world's strongest currencies: the franc (FXF) and the yen (FXY). While it is debatable whether such an intervention would be in China's best interest, the fact remains that the People's Bank of China can greatly reduce the value of the renminbi simply by making the decision to do so.
Gaining Renminbi Exposure
Investors who are interested in gaining exposure to the renminbi have various options, two of which are fairly straightforward for retail investors. Given the restrictions placed on renminbi trading by the Chinese government, each of these options is subject to various limitations and risks.
- Open Up a Renminbi-Denominated Bank Account
The simplest way for investors to get exposure to the renminbi is to open up a renminbi-denominated bank account. Generally, one cannot simply walk into his or her local bank and request that his or her account be denominated in renminbi, although HSBC offers a service to this effect. However, beginning in 2011 American citizens can access renminbi-denominated checking accounts, savings accounts, money markets, and certificates of deposit through the Bank of China.
According to a Wall St. Journal article from 2011 American citizens who wish to deal with the Bank of China were limited to deposits of $4,000 per day and $20,000 per year. However according to this article from May, 2012 the bank was offering CDs with a $10,000 minimum that are FDIC insured up to $250,000, implying that these restrictions no longer apply. Furthermore, there are no such restrictions listed on the Bank of China's personal banking website. In fact now, according to the Bank of China's website the CD minimum is $1,000, or $5,000 for a "Super CD." Potential investors will be pleased to learn that renminbi-denominated CDs offer a "whopping" 2.25% APY on a one year CD, while the highest rates available on one year U.S. dollar-denominated CDs is roughly 1.05% with a $25,000 minimum, or 0.95% with a no minimum.
- Purchase a Renminbi ETF
There are three ETFs on the market that supposedly offer investors exposure to the renminbi:
- CurrencyShares Chinese renminbi Trust Fund (FXCH): This is a new fund that launched in September 2011. It has an expense ration of 0.4%. Investors should be wary that there are currently only 100,000 shares outstanding and trading volume is extremely light. However, the fund has performed closely in line with the CNY/USD cross, making it the only renminbi ETP that can justifiably be held.
- WisdomTree Dreyfus Chinese Yuan Fund (CYB): This fund has been around since May 2008. It has an expense ratio of 0.45%. Investors should be aware that while the CNY/USD cross has appreciated by 12.6% since the fund's inception, the fund itself is up by only 3.4%. This is due to the fact that the fund holds currency contracts instead of renminbi. While the structure of the fund has led to its paying dividends, it has still underperformed the CNY/USD cross, and for this reason I would avoid it.
- Market Vectors Chinese renminbi/USD ETN (CNY): This is the first renminbi fund to begin trading in the United States, having begun trading in March 2008. It is also the most expensive with an expense ratio of 0.55%. Furthermore it is by far the worst performer, having appreciated by just 3.7% while paying no dividends, while the CNY/USD cross appreciated by 13.7%.
The following points summarize this article:
- The renminbi has appreciated meaningfully against the U.S. dollar over the long term, despite the fact that it is a managed currency.
- Nations around the world who trade with China do so primarily using U.S. dollars. However, this is changing so that the renminbi is used more frequently. This is a positive development for the value of the renminbi vs. the U.S. dollar.
- The Chinese monetary base has been increasing, albeit at a slower rate than that of the U.S. dollar. Should this trend continue it is beneficial to the value of the renminbi relative to that of the U.S. dollar.
- The M2 money supply in China has grown more rapidly than it has in the U.S. While this might seem to favor the U.S. dollar, it is indicative of a credit bubble in China. Because the debt in China has to be paid off, there is pent up demand for the renminbi in China, which will be positive for the value of the renminbi.
- The activities of politicians and central bankers in China can potentially negate the prior three points, and this means that there is downside risk to owning the renminbi.
- Investors who are interested in owning the renminbi can open up an account with the Bank of China, or they can purchase an ETF.