Why a Floating Chinese RMB Might Sink

| About: Market Vectors (CNY)

With Chinese President Hu Jintao coming to the United States for a state visit, the RMB (renminbi) is sure to once again occupy a space in the spotlight. So far trade and financial issues are at the center of the debate about its value but monetary concerns may trump these in importance. Unbeknownst to many the Chinese embarked on a liquidity of their own.

It has become common wisdom to speak of the Chinese Yuan as a deliberately undervalued currency. And there are many facts pointing into this direction, ranging from the trade surplus to more sophisticated analysis such as purchasing-power comparisons.

If the RMB were to be floated soon one could expect that many investors would try and get on that trade in anticipation of a substantial appreciation in value. But, alas, there is more to this story. Faced with a negative external-shock after the Lehman crisis the Chinese leadership decided to counter it with a surge in investment expenditure. That spending was heavily financed via bank loans which are inherently inflationary. It takes time for inflation to work its way throughout the system, its beneficiaries are those with first access to the newly created money. As the rentability of factories has come down due to increased wage pressure and lower world-market demand people use another outlet for their investment: Real-estate.

Basic economics suggests that inflation causes the value of a currency to decline. Unseen to many, China has become the country that prints money the fastest in recent years. In 2009 alone new loans at 9.6 trillion yuan amounted to a stunning 30% of the previous year's GDP. New loans fell to 7.95 trillion yuan in 2010 but still exceeded the government quota by almost 7%. With the leadership transition in full swing it is unlikely that officials want to rock the boat, hence they will do what is necessary to keep growth going. That means bank lending in 2011 will be at a level deemed appropriate by the authorities, in other words elevated, even though investment makes up a dangerous high amount of GDP in China, higher than in Japan or South Korea at any time in their development.

With global imbalances still unresolved and hot money making its way into China this leads to an absurd situation where economic fundamentals meet monetary dynamics.

Investors speculating on a rising RMB force the People's Bank of China to print RMB to offset potential gains in value. This process is well known and in the past those newly-printed RMB were sterilized in order to keep inflation in check. However, sterilization and other administrative measures are no longer enforced to a large degree. The fundamental case for a rising RMB hence weakens as money supply grows at rates of more than 20% a year.

In conclusion, whilst I believe that the fundamental case for a rising RMB justifiably points out to a double-digit appreciation, the possibility of the central bank losing control over inflation is not remote and weakens the scope of appreciation.

Interested observers will further note that on January 20th the Chinese National Bureau of Statistics releases key economic data such as CPI and GDP.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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