In a recent Investment Outlook, Bill Gross suggested that China may abandon its dollar peg within six months’ time. While we are not willing to wager aggressively on the precise timing of such a move, we agree that the current regime is unsustainable. As such, PIMCO’s bets that China will ease controls on its currency are likely among the best in emerging markets.
In just the past few weeks President Hu Jintao has politely ignored requests from President Barack Obama, the president of the ECB and the managing director of the IMF to adjust its currency. While most of the developed world harps on China for alleged currency manipulation, we believe it is entirely possible (if not likely) that the Chinese have already begun a multi-year process that will accelerate toward the free float of the yuan in the intermediate term. (We also believe this would occur much quicker if foreign policy makers quit their nagging.) Perhaps it is because the existing peg has served China so well (through turbo-charged exports) that those of us in the developed world find it so difficult to envision China abandoning it?
However, the next phase of the Chinese Growth Miracle cannot be achieved using the same old tricks. For China, the peg (and accompanying dollar depreciation) translates into rising prices for energy, food and a number of other essentials. As we’ve discussed previously, China cannot readily combat this inflation through traditional measures of monetary policy since the existing peg effectively cedes control of monetary policy to Ben Bernanke & Co. To make matters worse, as Helicopter Ben pursues an ongoing easy-money, debauch-the-dollar policy in the wake of recurring financial catastrophes, China faces even greater inflationary risks. Monetary and fiscal stimulus pumped into the government-controlled Chinese economy on a scale that dwarfs even our own unprecedented stimulus efforts, assures the return of uncomfortable inflation as we turn the calendar. (A number of economic variables we monitor already point to double digit increases in Chinese CPI next year.)
A stronger yuan would help rebalance China’s economy, making it less dependent on exports and putting future growth on a more sustainable path. But Chinese policymakers understand that there is no free lunch in capital markets. While concerns of an export sector collapse are overblown, the dollar price of Chinese goods would certainly increase. And the largest losses would undoubtedly come in China’s vast dollar-denominated bond portfolio. But importantly, reductions in the yuan price of oil and other imports would more than offset these losses. Hence, an accelerated depegging would alleviate many of China’s inflation problems, as oil and other commodities would decline in yuan terms, relieving pressure on Chinese consumers and improving the cost structure of Chinese manufactures.
There is no way to know precisely how undervalued the yuan is, but most indications point to a free float at levels much stronger than today’s consensus expectations. Twelve month yuan non-deliverable forwards currently suggest that traders expect the yuan to strengthen 3% in a year, while the Economist’s Big Mac Index (burgers are much better forecasters than traders) points to a near 50% undervaluation.
We don’t believe that today’s expectations accurately reflect the yuan’s true trajectory. To effectively dampen China’s underlying inflationary pressures, exchange rates would have to rise substantially more than levels implied by the market today. A 50-100% revaluation is even plausible if trends in commodity prices persist, and as history suggests, China overshoots in policy accommodations. If such a move seems extreme in light of forecasts made by mainstream blue chip economists, consider that in 1976-1978 and again in 1985-1987, Japan (then the fast-growing, pre-eminent Asian exporter) allowed the yen to double to endure a diving dollar and rising import prices.
China allowed its currency to appreciate 21% in the three years after they replaced a pure dollar peg with a basket of currencies in July 2005, but has kept its currency pegged at about 6.83 per dollar since July 2008 to help sustain exports. As PIMCO has suggested, “A market-based currency would shift the focus of China’s growth to domestic demand from exports, more efficiently allocate resources and reduce the risk of asset bubbles.”
The introduction and tremendous growth of Exchange Traded Funds (ETFs) provides a cost-efficient opportunity for individual investors to gain exposure to the Chinese yuan through an ETF. The Wisdom Tree Dreyfus Chinese Yuan Fund (CYB) seeks to achieve total returns reflective of money market rates in China as well as changes in the value of the Chinese yuan relative to the U.S. dollar.
Disclosure: At the time of publication, the author was long WisdomTree China Yuan Fund, although positions may change at any time.