The War of the Yuan: What Investors Should Expect

Includes: AAPL, ACH, BIDU, FXI
by: Jim Trippon

War of the Yuan: How It Will Affect Your Investments

The political temperature is rising sharply in Beijing and Washington in a war of words over the value of the yuan. This is a battle that has been brewing since 2003, with U.S. lawmakers arguing that China has gained an unfair trade advantage by artificially depressing the value of the yuan. The war of words escalated sharply over the weekend and it continues to grow hotter.

Nobel Laureate and New York Times columnist Paul Krugman took off the gloves on Sunday, writing: “we’ve been reasoning with China for years, as its surplus ballooned, and gotten nowhere: Wen Jiabao, the Chinese prime minister, declares — absurdly — that his nation’s currency is not undervalued. (The Peterson Institute for International Economics estimates that the renminbi is undervalued by between 20 and 40 percent.)”

Krugman’s cure? Slap a 25% tariff on imports from China. Harsh medicine indeed.

The rhetoric became even hotter on Monday as 130 members of the U.S. House of Representatives called on the Obama administration to impose harsh tariffs on Chinese imports if other measures fail. They suggest that Obama wage a “multi-front fight” against China's currency policy (effectively suggesting that European and some Asian allies be persuaded to join in a battle against Beijing’s currency value).

War of the Yuan: How It Will Affect Your Investments

The lawmakers pleaded in their letter, “The economic impact of undervaluation on American businesses and workers is too great for the administration not to pursue a comprehensive [multi-front] effort.”

Worried investors have contacted us wondering what would happen if Beijing suddenly devalued the yuan in response to American, or global pressure. As I replied, there is no likelihood that Beijing will sharply devalue the yuan, or allow it to float freely, because the result that would cause a huge jump in the price of Chinese exports and severely dislocate sectors of China’s economy.

Beijing does not respond obediently to threats and it will not dance to Washington’s tune. Beijing is more likely to respond to international pressure a year from now by adjusting the value of the yuan upward in very small amounts, gradually, as China monitors the economic repercussions. Beijing is in no hurry to do this and it likely won’t happen this year.

War of the Yuan: How It Will Affect Your Investments

The effects of any upward valuation of the yuan will depend on individual Chinese companies and the industry in question. An international resource-buying company like Aluminum Corporation of China (NYSE:ACH) will have more purchasing power and should have lower import costs due to the higher purchasing power of the yuan, for example.

Exporting companies, which we have never recommended at the China Stock Digest, will suffer as their prices on world markets rise in concert with their currency. Many operate on very low margins and survivors of the global financial crisis are just now recovering. A sharp upward valuation could be a death blow, something that Beijing is very unlikely to contemplate.

Companies which do business strictly internally, like Baidu (NASDAQ:BIDU), will be unaffected in the short term by a rise in the value of the yuan. But the uncertainty generated by political and economic turmoil is likely to cause ongoing volatility in Chinese equities.

There is no likelihood that Beijing will allow even a token revaluation of the yuan in the near future, considering the concerted pushback in the Chinese media. China’s news media, all of them effectively operating under official approval, point out that a vast number of Chinese exporters are American companies or contractors who use mainland firms to generate products more cheaply than they could be made in the United States.

An article from Xinhua effectively argues:

The University of California conducted a study of Apple's (NASDAQ:AAPL) iPod to examine which countries captured the most economic value from iPod production. The conclusion showed that only four dollars was retained in China, with the bulk going to the designers, retailers and component suppliers. It seems unfair therefore that the full price of an iPod, roughly $300, instead of four dollars, was counted as part of China's exports to US.

War of the Yuan: How It Will Affect Your Investments

The rhetoric is getting hotter. I assure readers China will not bow to bullying, whatever the merits of the underlying arguments. But Beijing is very pragmatic and will consider careful steps that do not involve a loss of face internationally.

Read carefully this excerpt from the Reuters report about Premier Wen Jiabao’s controversial weekend speech.

Mr. Wen recommitted to pushing ahead with reform of the yuan's exchange rate mechanism, leaving the door open to reintroducing exchange rate flexibility if it suits Beijing. Wen said, “We will keep our economic and trade policies, including exchange rate policies and export tax rebates, stable this year.

In other words, we should expect gradual adjustment, not sharp dislocations. We probably will continue to hear hot rhetoric, signifying very little, until next year. That means market uncertainty and volatility, most of it caused by gusts of hot air.

Author's Disclosure: no Positions