Yuan Appreciation vs. Chinese Inflation

by: Clayton Reeves

One of the fundamental debates in Chinese investing and world politics in general centers itself around the appropriate valuation (or lack thereof) for the yuan. Right now, it is generally accepted that the currency would trade at a higher valuation were it allowed to float freely. After that consensus, opinions deviate about the level and depth of global impact should any revaluation be pursued. Geithner is never short of opinions on the need for rapid and aggressive revaluation. Conversely, China is not about to let the yuan float unrestricted anytime soon, but recent news suggests that they are open to the idea of letting the currency gradually appreciate. One of the interesting things to watch over the next few years will be the boxing match between yuan appreciation and Chinese inflation.

If the yuan appreciates quickly: In this situation, we are assuming that the yuan appreciates 20-30% in the medium term. With it, Chinese residents will see an increase in purchasing power that could change the world in terms of investments. Yuan appreciation will decrease the cost of domestic consumption, increase international travel and decrease China’s competitive advantage in terms of trade.

Yuan appreciation would provide benefits in the form of cheaper consumption to the people in China. There would be a cost associated with this transition, as factories are moved to countries with cheaper labor and China shifts the focus of their economy away from cheap exports. However, the overall impact would be evident in lowered prices. Normally this deflationary pressure could prove disastrous (ask Japan), but in this case, China needs to throw some water on the fire. Their economy is overheating and without some sort of restrictive measures inflation will be difficult to keep masking in politically massaged numbers. A move like this still might stifle a company like Feihe International Inc (NYSE:ADY), who depends on the increasing price of milk to increase margins. I personally believe that they will be fine, as a demand for their product will offset any downward pricing pressure from deflation.

With the renminbi kept artificially low, it is expensive for the billion plus people of mainland China to venture outside their borders. However, if the currency appreciates we will start to see a different story play out. International travel by the Chinese will undoubtedly increase, though the rate at which this occurs is debatable. This means a boon in tourism as the Chinese find more affordable ways to explore the world. This would be great news for Chinese travel companies like Ctrip.com International, Ltd. (NASDAQ:CTRP) and Universal Travel Group (UTA), who depend on this industry for their livelihood.

Finally, the appreciation would decrease competitiveness of Chinese exporters in some industries. As the yuan appreciates, low cost production will shift to countries like Vietnam, Cambodia and even Mexico in some cases. This could provide opportunities in export heavy emerging markets but would hamstring companies in China that are dependent on the advantages provided to them by a cheap renminbi.

If the yuan doesn’t appreciate: Robert Mundell, Nobel Peace Prize winning economist from Columbia University thinks that appreciating the yuan would be a mistake. He said recently that:

It's a mistake to have China change the exchange rate. This is a bad way of changing something. A big appreciation in China would create deflation, aggravate poverty in the western part of the country, in the rural areas. It would be something that would in the long run come back to haunt China.

However, one of the main concerns in China is inflation, so it is interesting that Dr. Mundell neglects to comment on that. Mundell sees the need for change, but believes that China should let the currency rise by 2-3% a year and try to solve their issues by increasing domestic wages. This increase in wages would provide a boost in domestic consumption that he says would not prove to be inflationary. China seems to agree, with He Keng, deputy director of the financial and economic-affairs committee of the National People's Congress recently saying that:

China should keep the yuan stable, and the yuan shouldn't appreciate.

That statement is full of conviction. However, the inflation problem will have to be dealt with and the measures they are talking about now will most likely result in higher borrowing rates and a slow appreciation of the yuan. If this happens, expect some downward pressure on the price of commodities like oil while people try to determine what sort of impact slower Chinese growth would have on the tepid global recovery.

This would be good for Chinese companies dependent on exports. The effect of yuan valuation is fairly straightforward for Chinese companies dependent on the yuan. The cheaper the currency is, in relative terms, the bigger the advantage for Chinese exporters. If China continues to be so protective of their exporters, they will continue to reap the benefits of that protection.

What will happen? Unfortunately, the world consensus is not clear. The majority of economists seem to agree that appreciating the currency is in the best interests of the rest of the world and remains the fairest possible move by China. Large economies such as Brazil and Germany have made statements in the past year supporting this course as well. Furthermore, many economists (Dr. Mundell not included) agree that doing so will help reign in an overheating Chinese economy.

The problem is that in order for the currency to appreciate, China will suffer growing pains. Transitions will be made away from manufacturing into other industries, and there will be a certain friction associated with that. As of right now, China is averse to putting workers through that hardship despite any benefits it may have for consumption overall.

Regardless of the timing, the appreciation and elevation of the Chinese yuan will have huge impacts on currencies around the world. HSBC bank may have put it best when they said:

The internationalisation of the renminbi will have significant implications on China and the global economy over the long term. We may be on the verge of a financial revolution of truly epic proportion.

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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