New China Yuan Policy Holds Promise As the 'Trade of the Century'

Includes: CNY, CYB
by: Keith Fitz-Gerald

When the state-owned Bank of China Ltd. (BOC) recently announced that it would begin allowing U.S.-based customers to trade the Chinese yuan here, it represented the biggest step yet in China's ongoing campaign to build global acceptance for its currency.

That desire to boost interest in the yuan in the global currency and trade markets is bolstered by the fact that Beijing's foreign-exchange reserves have now reached a staggering $2.8 trillion.

For investors, this new China yuan policy marks the beginning of a new era in global investing -- in commodities, in import-export activities and in the trading of the currencies themselves.

In short, I believe this new currency policy is setting us up for some of the best profit plays that we'll see in our lifetimes. So it's not investment hype to refer to it as the "trade of the century."

The Foundation For Change

As we've been reporting for some time now, Beijing has been shrewdly building up to this for years -- using subtle policy shifts, underplayed public statements and the quiet establishment of currency swaps around the Pacific Rim to hint at what it was planning for the yuan.

Examples of the policy shifts include:

  • The signing of billions of dollars worth of currency-swap agreements with international trading partners authorizing the use of yuan to settle payments for commercial transactions. These pacts have prompted analysts to predict that, within five years, as much as 30% of China's $2.3 trillion in annual exports could be settled in yuan rather than dollars, up from just 1% today.
  • A December decision by Chinese regulators that opened the door for more than 7,000 additional exporters to use the yuan to settle global trade accounts.

Two of the most notable and recent public statements include:

  • A 2009 essay by Zhou Xiaochuan, governor of the People's Bank of China (PBOC), in which he called for "Reform of the International Monetary System," the major feature being dismissal of the U.S. dollar as the world's main currency reserve.
  • A statement by China President Hu Jintao last month, in a written response to U.S. media questions, in which the Chinese leader called the current global monetary exchange system "a product of the past," and suggested the yuan would make a sensible reserve-currency replacement for the dollar. China's leaders contend that if the U.S. Federal Reserve continues to maintain a loose monetary policy, the U.S. dollar is almost certain to undergo a steady decline in value. That's a view with which many experts agree -- myself included.

The new China yuan policy announced last month is both a policy shift and a public statement. The policy shift would let U.S. individuals trade up to $4,000 worth of yuan in a single daily transaction, with a $20,000 annual limit. The limits are designed to suppress currency speculation. What's much more significant is that those limits do not apply to businesses engaged in international trade -- meaning such U.S.-based companies will be able to acquire all the yuan they need to settle foreign transactions that are not denominated in dollars.

Until relatively recently , U.S. customers could convert only a limited amount of yuan (also called renminbi) through a few Western banks, or inside China. But that started to change in July 2010, when Beijing approved the trading of yuan by foreigners in Hong Kong. Once that occurred, activity soared from zero to more than $400 million per day in a mere six months.

The move to U.S.-based trading was the logical next step, according to Li Xiaojing, general manager of BOC's New York branch. As Li told The Wall Street Journal, "We're preparing for the day when renminbi becomes fully convertible." Li added that his bank wants to become "the renminbi clearing center in America."

That may or may not happen. What's important is that by stepping into the market now, the BOC is paving the way for China's three other big state-owned banks to step in as well. China Construction Bank Corp. (OTCPK:CICHF), Agricultural Bank of China Ltd. and Industrial & Commercial Bank of China (OTCPK:IDCBF) are all expected to join BOC in competing for yuan-clearing services. This will add to the yuan's liquidity, though it's likely that unprepared U.S. financial institutions will be shut out of the action.

A New Reality

The U.S. dollar is experiencing a decline as a reserve currency. In fact, the percentage of world currency reserves held in U.S. dollars has declined from 73% in 2001 to 60% in mid-2010. (The euro has also slipped, and now represents just 26% of global reserves.)

While U.S. officials have been more than willing to blame the dollar's declining reserve role on China's actions, it's important to note that other factors have also been at work. For one thing, there's not a finite pool of global capital, despite what central bankers the world over appear to believe. Economic growth creates new capital -- and the fact is that emerging economies have accounted for the bulk of recent growth. That means China (along with India, Brazil and others) is putting more than its share into the increasing worldwide pool of capital -- and its contributions are being made in yuan.

All of these factors are pointing toward the major changes to come in the world currency markets. Given the expanded access to -- and growing acceptance of -- the yuan, here are six changes investors can expect:

  1. Use of the yuan by non-Chinese entities will skyrocket as institutions begin to jump on this trading opportunity. Currently, most big multinational corporations (MNCs) still settle their accounts in U.S. dollars, but this will change very rapidly. McDonald's Corp. (NYSE:MCD) and Caterpillar Inc. (NYSE:CAT), both of which get enormous revenue from China, have already announced new Hong Kong offerings of yuan-denominated bonds, and others will quickly follow.
  2. Major U.S. companies could start listing their shares directly on China's stock exchanges -- perhaps as soon as this year. Companies such as PepsiCo Inc. (NYSE:PEP), Wal-Mart Stores Inc. (NYSE:WMT) and General Electric Co. (NYSE:GE) are widely considered to be logical candidates to do so.
  3. As noted earlier, within five years as much as 30% of all Chinese foreign trade will be settled in yuan. That could translate into a sharp drop in demand for the dollar in the foreign-exchange markets -- something many U.S. officials haven't recognized, much less planned for.
  4. Although they already have massive currency-clearing operations in place, U.S. banks haven't heeded any of the warnings about the growing influence of the yuan and appear to have been caught flat-footed. As such, they'll largely be cut out of the action as the four state-owned Chinese banks operating in the U.S. market become the de facto choice for yuan clearing.
  5. Fed officials claim that inflation is in check. But we know better. Inflation will edge higher in the U.S. economy as the yuan begins to appreciate. That appreciation in the yuan will take place as demand for it escalates and prices for everything in China start climbing. This will likely prompt Chinese companies to pass the increases on to American consumers who buy made-in-China products. Add in higher domestic U.S. prices due to falling-dollar values and the situation will worsen -- and likely persist -- for years to come.
  6. Fixed-income guru William Gross, who manages the PIMCO Total Return Fund as well as other bond funds with assets of more than $1 trillion, recently said the U.S. dollar "almost certainly will depreciate relative to other, stronger currencies in developing countries that have lower levels of debt and higher growth potential." I agree. China and the yuan definitely head the "stronger currencies" list to which Gross refers. That's why, within five years, you can expect to see the yuan become a store of value on par with the U.S. dollar, the Japanese yen and the euro, all of which will continue to lose value because of the huge sovereign debt risks they face, as well as the unwillingness of their politicians to realistically deal with it.

Moves to Make Now

Recognizing this, how can you get on board for the trading opportunity of the century? Here are some potential routes to early profits:

  • Buy the yuan itself: As the old investment adage tells us, "He who has the gold makes the rules." Even without the new currency policy, China has years of high growth ahead of it, despite any of the half-dozen or so challenges (including the real estate bubble) that so many Westerners seem fixated on. And it also has the "gold," in the form of the $2.8 trillion in foreign reserves that we cited. As investors, we want to go with who has the most cash -- and that's definitely China. The new currency policy figures to make that total grow substantially.
    As for an investment vehicle, I'd skip the new U.S. access to the yuan market for now and instead go with a deposit at EverBank, instructing the online institution to put your funds in its yuan-denominated WorldCurrency AccessSM Deposit Account. As an alternative, you might also consider shares in the exchange-traded WisdomTree Dreyfus Chinese Yuan Fund (NYSEARCA:CYB), whose recent price was $25.32.
  • Focus on resources: Energy, infrastructure-related products and raw materials for manufacturing will all see big increases in demand as China's economy grows and the yuan gets stronger. That will add to the price increases those assets will see as other global currencies continue to weaken. High-demand agricultural products will also be a good choice as the global population continues to increase, and as middle-class incomes increase on a worldwide basis.
    If you're aggressive and have ample funds, consider making your resource plays directly into the futures markets. Otherwise, focus on the best ETFs; there's now at least one for virtually every commodity (and country or region if you prefer backing producers instead of products). A good source of information on the various sector ETFs, as well as on individual funds, is the ETF Trends newsletter.
  • Do business with the firms that do business with China: Fully 40% of the companies comprising the U.S. Standard & Poor's 500 derive a major chunk of their earnings from overseas. So if you don't want to invest in China-based companies directly, you can make your play with stocks that derive a bunch of their revenue from that market. Some good examples include the aforementioned McDonald's, recent price $73.43, or co-fast-food purveyor Yum Brands Inc. (NYSE:YUM), $47.48. Other solid candidates include equipment suppliers such as Caterpillar, $97.95, and ABB, $23.98.
  • Assume the dollar is doomed: If you're a committed member of the gloom-and-doom crowd, and are also financially aggressive, go ahead and begin shorting the U.S. dollar. Understand, however, that Washington is full of slow learners. So for the near term, at least, you'll have U.S. Federal Reserve Chairman Ben S. Bernanke, and all of "Team Fed," playing against you.