Profiting from the Yuan

George is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As China's hegemony grows, it is faced with an interesting dilemma concerning its currency manipulation policies. The Chinese government has long kept the value of the yuan at artificially low levels to give its exports a significant competitive advantage in their host countries, a development which has helped catalyze the rise of China as the world's top exporter.

However, the hubris and increasing confidence with which the Chinese government is beginning to assert its power has led to a growing conundrum. Chinese leaders have recently shown desire to implement policies that would aim to eventually turn the yuan into the reserve currency of the world. This development contrasts completely with the current Chinese currency policy: in order for the yuan to displace the dollar as the world's reserve currency, it needs to become convertible. Currency convertibility leads to looser government controls, which in turn would erase much of the advantage of the artificially low yuan in the international stage. 

China's currency policy of artificial devaluation has proven, over the years, to be extremely successful. This devaluation allows Chinese goods a competitive advantage in the area of affordability, an attractive advantage which has lured consumers in these times of economic hardship. Moreover, the inexpensiveness of Chinese products and labor has attracted billions of dollars to China in terms of foreign direct investment: in 2009, the total amount of FDI used in China topped $90 billion, and the total accumulated amount of FDI used in China from 1979 to 2007 is $943 billion. Huge conglomerates such as Wal-Mart (NYSE: WMT) depend on Chinese labor and Chinese suppliers to keep their products cheap, while corporations such as Apple (NASDAQ: AAPL) depend on Chinese labor and Chinese suppliers to keep their profit margins wide. In fact, over 60% of Chinese exports are produced by foreign-invested enterprises producing in China, a phenomenon which has been made possible, in large part, by the weakness of the yuan.

China, as a communist country, has the ability to control its currency to an extent that is unparalleled by the other G8 countries. However, despite China’s stringent control of its currency and frequent rhetoric from the U.S. and other countries lambasting China’s “currency manipulation,” China has started to subtly shift its yuan policy and the yuan has started to grow stronger. Some analysts point out this is due to the success of increasing pressure piled on China to appreciate its currency. However, the true catalyst behind the strength of the currency is due to the Chinese government’s loosening of controls on the yuan, which it views as necessary to achieve its ultimate goal: to make the yuan the dominant mode of currency that replaces the U.S. dollar as the international reserve currency.

Recently the Chinese central bank allowed the yuan to reach a record high on April 27, while in mid-April, Chinese officials pledged in a five-year plan running through 2015 to keep loosening controls on currency flows.  The objective of the five-year plan is to eventually transform the yuan into a convertible currency, one which can be readily bought or sold without government restrictions. Moreover, Chinese regulators recently raised quotas for foreigners buying onshore stocks and bonds to $80 billion from $30 billion, increased the amount of yuan held offshore that can be invested locally, and lifted a 6.5 year ban on locals holding long positions on the yuan. On April 14, China also widened the trading band for the yuan to 1% from 0.5%, which allows the yuan increased flexibility to fluctuate and is considered a major step toward paving the way for the yuan to eventually float freely.

The shifting policies of the Chinese government have strengthened the yuan relative to most other currencies. This strength is apparent when the performance of China's yuan is analyzed compared to the currencies of its top 6 import/export partners: the EU, USA, Japan, ASEAN, Hong Kong, and South Korea. We can expect the euro, the U.S. dollar, the Japanese yen, the Hong Kong dollar, and the South Korea won to most accurately reflect the impact of China's currency policies (for the sake of comparison ASEAN is excluded because it has no universally accepted currency). From a 1-year time span, the yuan has increased 14.13% against the euro, 2.89% against the US dollar, 2.16% against the yen, 8.94% against the South Korean won, and 2.81% against the Hong Kong dollar. Much of the gains may not seem extraordinary, but they are significant considering the tight control the Chinese government exerts over the yuan performance.

If the Chinese government has indeed started to shift to advocacy of a stronger yuan, international conglomerates such as Walmart and Apple that have significant operations in China will definitely feel the pinch. As noted earlier, the main attraction of maintaining factories in China is inexpensive labor; if the yuan gets stronger, then operations in China for these companies will undoubtedly become more expensive. Thus, this shift in yuan policy is counterintuitive to the FDI appeal of China, as companies will start to search for more inexpensive alternatives to continuing their operations in China.

There are several avenues for investors to profit in light of China's recent policies.  For one, the Guggenheim Yuan Bond ETF (NYSEMKT: RMB) follows the AlphaShares China Yuan Bond Index and also holds bonds in yuan denomination. PowerShares Chinese Yuan Dim Sum Bond (NYSEMKT: DSUM) is also a similar ETF that invests in yuan-denominated bonds and tracks the Citigroup Dim Sum Bond Index. Finally, the WisdomTree Dreyfus Chinese Yuan ETF (NYSEMKT: CYB) seeks "to achieve total return reflective of both money market rates in China available to foreign investors and changes in value of the Chinese yuan relative to the U.S. dollar." These three ETFs have direct exposure to yuan fluctuations and will be positively affected by the strengthening of the yuan to its true value, which in turn will be catalyzed by increased convertibility. I heavily recommend investors keep a close eye on these ETFs as well as the Chinese government's continually evolving yuan policy. 




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