Good Time to Buy Chinese Currency: Follow the 'Hot Money'

Includes: CAF, CNY, FXI, PGJ
by: Macro Monitor

For years, China pegged its currency to the dollar, thereby manipulating traditional economic theory. My classical economics textbook states that:

Currencies of economies with large current-account deficits should depreciate relative to those of countries with surpluses. A currency depreciation will stimulate exports and throttle imports, thereby helping to restore balance to trade gaps.

China gave into economic theory (at least partially) in July of 2005 when it allowed the renminbi to float against a basket of currencies. Since then, the yuan has appreciated by approximately 16%. However, I think the currency remains largely under-valued. Let me explain.

Despite China’s efforts to reduce its foreign-exchange reserves, its coffers are overflowing. It’s estimated that China’s reserves have exceeded $1.8 trillion and are accumulating at a rate of $100 million per hour. The Economist recently highlighted this phenomenon, noting that “hot money” is pouring into China at a break-neck pace. The article points out that “China’s trade surplus and foreign direct investment [FDI] explain only 30% of [the total rise in foreign-exchange assets in 2008]!” It’s estimated that $170-$200 billion in hot money has flowed into China within the first five months of 2008, leaving the People’s Bank of China [PBOC] stymied.

Immense capital inflows are fueling inflation in China. In fact, for the first five months of this year, inflation stood at 8.1%. You know it’s bad when one of China’s most respected economists publicly states the risk of stagflation. Such an occurrence took place last week. While I was kicking back at a barbecue celebrating our country’s founding, Li Yining, one of China’s top economists, issued a statement highlighting that China is facing a pressing challenge of preventing inflation from turning into stagflation. Clearly, inflation is a problem and PBOC needs to take action.

That being said, the PBOC has not been idle. In an effort to curb money-supply growth, the PBOC has raised banks' reserve requirements 16 times, from 9.0% to 17.5%. But reserve requirements cannot be raised forever. Sooner or later, the PBOC’s erstwhile monetary stance will have to change to successfully combat inflation.

With China’s foreign-exchange reserves swelling and inflation escalating, I think an outright reprising of the renminbi is not out of the question. Only after inflation eases will the yuan’s appreciation slow.

If the expectation of higher appreciation wasn't enough, even the interest rate differential between the renminbi and dollar is favorable. Yuan deposits are currently paying 4%, whereas dollar deposits are paying a paltry 2%. I think this higher yield, combined with the expectation of appreciation, provides an ideal investment opportunity. No surprise that $200 billion in “hot money” has poured into China since the start of the year.

The only problem is trying to figure out how to get some of my own hot money into China.