The Hottest New Currency In Town May Not Give You The Returns You Expect

Includes: CNY, FXCH
by: Joshua Brown

A Chinese Currency Outlook for 2014

The RNB, CNH and CNY

Many traders are still unsure about the difference between the Chinese currencies. The renminbi, which literally means "the people's currency," is represented by RNB, and the yuan, which is represented by codes CNH and CNY. To make life confusing, the CNY or the yuan is the basic unit of the renminbi but it's also a synonym of the currency, and therefore, the codes RNB and CNY are interchangeable when talking about the currency in a literal sense. The CNH is the code of the Chinese currency when it is traded offshore, while the CNY is the code used when it is traded onshore. Due to the restrictions on monetary outflows, the CNH and the CNY can have short-term variation in the price, however generally in the long-term, they do correlate almost perfectly.

The yuan has recently overtaken the EUR to become the second-most traded currency in international finance, and it is fast becoming an alternative reserve currency to the USD. Until 2005, the Chinese currency was pegged to the USD, however, as the Chinese transitioned to a market economy, the monetary authority of China found it necessary to participate more actively in foreign exchange due to its increasing foreign trade. The Chinese have demonstrated that they will use new monetary powers to manipulate the currency in order to maintain its high rate of growth into the future. It has on several occasions devalued the currency to increase competitiveness, yet in January, it was allowed to rise higher in order to tame inflation. In any case, People's Bank of China has stated that it will gradually increase the flexibility of the exchange rate, as it now floats within a narrow margin (1%) around a fixed base rate set in orientation to a basket of major global currencies (mostly USD, JPY, EUR and KRW).

The Chinese Slowdown and what this means for the renminbi

Asian currencies (and emerging market currencies in general) have declined recently amid concerns of a slowdown in China's growth and U.S stimulus cuts, with the USD/CNH bouncing off a low of 6.0136 to 6.0429. Many analysts are concerned that the maxim "the higher they climb, the harder they fall" may yet ring true for China and a sincere downturn may have huge push-pull consequences for the national currency. Inflation, a potential housing bubble, rising debt and decreasing manufacturing are all adding uncertainty to China's story. The high that we saw earlier this year of the CNH against the USD could certainly be repeated, as the Bank of China continues efforts to restrain inflation and the Chinese and American economies continue to narrow the gap in terms of size, after all Chinese exports are still relatively very strong. However, the big question facing analysts is how long the Chinese can keep up the pace of growth - a slowdown would severely offset the appreciation of the currency, but not enough to halt it completely (Lombard Research says growth will drop to 4%!). Chinese authorities claim their currency is close to fair value, and indeed the currency may trade sideways for a while yet, but it remains to be seen just how resilient the yuan really is. The market consensus is that the USD/CNH will drop below 6.0, and according to the median estimate of nine economists recently polled by the South China Morning Post, the yuan will rise 2 per cent to 5.93 per US dollar by the end of this year. Nevertheless, it's hard to see the monetary authorities of China allowing the currency to appreciate much above that, especially if growth continues to fall and capital inflows diminish. All in all, I would say 6.0 is the right price target, but we will see major fluctuation around that level in the months ahead. According to Euromoney magazine, "the Chinese authorities are stuck between a rock and a hard place. A weaker currency would help boost export competitiveness and even help inflate away rising debt burdens, but at the cost of delaying the much-needed rebalancing of the Chinese economy while triggering a domestic and global political backlash."

Chart: Bloomberg

Please see this link for an excellent infographic on the Chinese situation:

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.