Why China Might Not Revalue the Yuan

Includes: CNY, CYB, FXE, TAO
by: Ethan Backus

It seems clear that by almost every standard imaginable that the Chinese Yuan (NYSEARCA:CYB) is undervalued against the dollar and other currencies. Academics have long had a good time proving this over and over again. What seems equally clear to most people is that China will strengthen the currency in the short and medium term. This inevitability is set in stone and countless investment strategies are built around this iron-clad assumption.

Here are some interesting reasons why it might not be so easy for the Chinese government to strengthen their currency any time soon:

1) The Chinese real estate market is overheating. At this point construction, banking and real estate related activities make up a huge part of the Chinese economy. What is the other large part? The export sector. Strengthening the RMB would hurt the export sector substantially. It would be terrible timing to hurt one part of the economy just when the other largest part is losing steam. Out of work people all over China would threaten the Communist party. Remember, it was partly the rapid inflation of the 1980s that culminated in the Tiananmen Square demonstrations in 1989. The Communist Party of China is well aware that their legitimacy rests on the promise of economic growth. Check the progress of housing prices, if things start getting bad, don’t count on a large revaluation of the Yuan.

2) The recent decline in the Euro makes it harder to justify strengthening the Yuan. As the Euro falls against the dollar (and therefore the RMB) it makes Chinese exports less competitive; is now a good time to make them even less so?

3) Instability in Europe has made the Chinese much less enthusiastic about rocking the boat. Premier Wen Jiabao has said that he sees further instability in the world economy. China stopped the appreciation of the Yuan in 2008 exactly because of world-wide instability. Any signs of a double dip anywhere in the world could easily spook the Chinese Politburo.

4) Finally, China is addicted to the currency peg. The Central Bank of China basically buys their peoples' dollars at a fixed price (set by them) for Yuan and stashes the money in treasuries. It might well be the biggest scam of all time. All of this capital is being taken from people and put into unproductive US bonds. This is a powerful and entrenched system, it will not be easy to change it. The entire Chinese economy has now been geared towards exports and forced not to consume. A major shift in the value of the Yuan would require a re-structuring of the Chinese economy which cannot happen overnight. Economies are dynamic and adaptable creatures, but when you have 1.3 billion people ready to revolt against an un-democratic government, why take a chance? Better to battle Washington than your own people.

It is entirely possibly that China might comply with Timothy Geithner and let the RMB peg go a bit. They could let it appreciate 1% a year for the next five years if they wanted to get Congress off their back, or let it appreciate 5% this year, then pull back 5% the next year. Jim Chanos, Short Lord, even thinks that it’s possible that the Chinese might have to depreciate the Yuan against the dollar as they use dollars to sterilize the bad loans in their banking system after the real estate market goes south.

Remember: nothing is ever a sure thing. Especially in finance.

Disclosure: I am not long or short CYB.