China's Currency: Revaluation or Slight Appreciation?

Includes: CNY, CU, CYB, OIH
by: Brian Rezny
After long pressing China to allow their currency to strengthen (because a weak currency gives them an “unfair” trade advantage), the Obama administration's wish has been granted…sort of. Speaking Sunday after the G20 summit, President Obama said, “…the renminbi is going to go up and it’s going to go up significantly”. We’ll see.
The renminbi (yuan) has been pegged at 6.83 to the dollar since July 2008. Before that, between 2005 and 2008, China allowed the currency to strengthen 21% (in a managed float). But the financial crisis changed that, and the central bank set a fixed exchange rate to protect their exports. Then, on June 19th, the People’s Bank of China announced that they will loosen their peg against the dollar. On the surface, that sounds like good news. But in reality it’s not likely to amount to any material change for the global economy.
First of all, just how much China will allow their currency to strengthen remains to be seen; in its announcement the central bank said that there is no basis for a “large-scale appreciation”. Not to mention that any major strengthening wouldn’t be “in China’s interest”. At the end of the day, we can expect China’s exchange rate to be “basically stable”.
And the central bank’s announcement shouldn’t be seen as a blueprint for action, but more as a statement of principal and intent, according to UBS economist Larry Hathaway (Forbes). The value of the yuan will still be determined by the government, not by the foreign exchange markets: China has a .5% daily trading band within which the currency can float, so any moves will be controlled and gradual.
Just how much will the yuan appreciate? According to Bloomberg, a survey of economists suggests a gain of 1.9% this year. That’s hardly a change, considering that analysts estimate the yuan is undervalued somewhere between 20 to 40%. The bottom line: any strengthening will likely be too slight to have a major impact in rebalancing the global economy.
That’s not to say there won’t be any effect. A stronger yuan will boost Chinese consumer demand. As their currency strengthens, imports became cheaper, giving Chinese consumers more purchasing power for foreign goods. The result: China could become less dependent on exports, and more dependent on growing consumer demand. And slowing exports will calm China’s rapid growth (and slow the risk of inflation). That’s a good thing.
And there is some concern that China’s demand for Treasuries could taper off. After all, if a stronger yuan narrows China’s trade surplus, they will have fewer dollars to invest in Treasuries. But again, any appreciation will be slow and deliberate, and probably won’t equal a sweeping change in China’s demand for Treasuries. And besides, China wouldn’t want that anyway. If the yuan were to strengthen too much, the value of China’s foreign exchange reserves ($2.5 trillion) would be diminished: a 20% yuan revaluation would equal a loss equivalent to $500 billion (in yuan terms), according to High Frequency Economics economist Carl Weinberg.
But here’s the real problem: we are making a dangerous assumption. All of this conjecture is based on the conclusion that, allowed to float, the yuan will gain against the dollar. But it’s entirely possible that the currency could depreciate. If the euro continues to slide, then the yuan would also weaken relative to the dollar.
If anything, the People’s Bank of China’s policy change looks like a political play: at the G20 summit over the weekend (appropriately held in Canada), the focus shifted away from China as leaders discussed global imbalances and deficits. The bottom line: China’s policy isn’t going to result in a dramatic change in the economic landscape.
Still, some sectors stand to benefit as imports become cheaper for China (the country is the largest importer of industrial commodities). China is the world’s largest copper consumer, and second largest oil consumer.
As far as investing, look at Merrill Lynch Oil Services HOLDRs (NYSEARCA:OIH): this ETF is focused on the oil service sector, with holdings in offshore drilling, equipment and exploration.
There’s also First Trust ISE Global Copper Index (NASDAQ:CU): this ETF tracks the ISE Global CopperTM Index.
While these may be opportunities for future growth, based on technical indicators, I wouldn’t recommend adding equity positions until the market signals a trend back up.
Disclosure: Rezny Wealth Management does not hold investments in above mentioned securities; positions can change at any time.