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Yuan Revaluation -- A Chinese Tale

On Saturday, China announced it will increase the flexibility of its exchange rate, effectively ending its 2-year peg with the US dollar. The move, which caught most by surprise, aimed to defuse pressure from the US Congress (which was mounting quickly) and to take the subject of the Yuan out of the G-20 agenda.  So far it seems to be succeeding in both counts.

In typical Chinese style, little detail was provided but the People’s Bank of China (PBOC) statement signaled that if there were to be an appreciation, it would be a slow one. Nouriel Roubini pointed out that a stronger yuan can not be taken for granted given that it has appreciated significantly already specially against the euro. Further euro depreciation could mean that the yuan also depreciates. We agree. Update on 06/22: The Yuan fell marginally on tuesday as Chinese banks were buying dollars.

The PBOC is now gaining some independence in its monetary policy. Interest rate changes will now be more effective in the fight against the real estate bubble and the massive increase in borrowings during the last twelve months. Both issues need to be addressed soon.

China’s manufacturing sector is already facing tectonic changes as recent measures to increase minimum wages will hit its profit margins primarily for low-end manufacturers. The salary increases tried to appease a growing number of striking workers. As we all know, China’s social stability is a balancing act. Tens of millions of workers move to the coastal areas every year and the government through it pro-growth policy tries to create the jobs necessary to avoid social unrest (and a challenge to the central authorities in Beijing).

In our view it is unlikely that China will in practice allow significant pressure to its manufacturing sector, hence if there is an appreciation it would be very modest. Even if the appreciation were more important, let’s say 5% over the next twelve months, its impact will be small. Let’s look at the composition and price-elasticity of China’s imports. Most are exported after some labor-intensive process is added to it and the price elasticity is low, given how little things changed when the currency revalued between 2005 and 2008.

It is in our view mostly about politics and geopolitics. A triumph for the Obama administration (or at least perceived as such today). Mr. Geithner went to China not long ago to push for this move, so he now probably avoided being fired before the elections. It is primarily a major plus for Ms. Clinton who has been trying to get support from China to add pressure to North Korea and Iran while asking then for a change in its FX policy. China wants to stay in the good side of US politicians.

In our view this political move will have little substance so that world imbalances will remain. Let’s change things so that nothing changes -- this is just a Chinese tale. The news should not be construed as a reason to purchase stocks. Today’s equity rally and treasury sell off will probably fade quickly.

Jorge A. Piedrahita

Disclosure: Short the indexes