Will China allow its currency to appreciate?
April 18, 2005

Central to the thesis that the gold price will continue to rise on the back of a falling US dollar, is the premise that China will forego its policy of supporting the dollar in favor of letting its own currency, the renminbi, appreciate. Both China and Japan are accumulating massive amounts of dollars as a result of their trade surpluses with the United States. But instead of selling those trade dollars into the foreign exchange markets, they, and other countries, are hoarding the dollars and investing them in US Treasury securities. As a result the US dollar is currently trading at a much higher exchange rate than it should versus the renminbi, the yen, other Southeast Asian currencies and, in fact, most currencies.

Many people have argued that China will not allow the renminbi to appreciate against the dollar because it needs US consumption to drive its fledgling economy. But pressure is mounting from Europe, the United States, the World Bank and the IMF for China to let its currency appreciate.

The contention is that Chinese exports have an unfair advantage in the world because the renminbi is undervalued in foreign exchange markets. The undervaluation is a direct result of China’s dollar-hoarding policy, since it keeps the trade dollars that China receives every day off the market.

Support is growing in the US Senate for taking tariff action against China. The US trade deficit with China totaled $29.12 billion for only January and February of this year. That is a fifty percent increase from last year. The US trade deficit with China is now the largest of any country and almost double the size of the trade deficit with Japan, which is second.

The appointment of a new US trade representative is being blocked until Senate leaders vote on anti-subsidy laws against non-market economies such as China. In addition, a wide coalition of senators is backing legislation to impose a 27.5% tariff on all Chinese products entering the US if Beijing does not agree to raise the value of its currency.

If China does not allow its currency to appreciate against the dollar, and if the US goes ahead and implements the tariffs, all Chinese goods will become 27.5% more expensive for US consumers. On the other hand, if China allows its currency to appreciate, let’s say by the same amount, 27.5%, then its goods would be no more expensive to US consumers than if tariffs were imposed. However, the cost of all China’s imports would fall by 21.6% if it allowed its currency to appreciate by 27.5%. So what do you think China is more likely to do? Give the US government a revenue stream equal to 27.5% of the value of all Chinese imports to the US, or reduce the cost of its own imports by 21.6%?

The Chinese have always struck me as intelligent and practical. I suspect that China is going to let its currency appreciate. This not only means that the US dollar is going to fall, it also implies that US interest rates are going to rise because if the Chinese (and Japanese) no longer have to keep their trade dollars off the market to prevent the US dollar from falling they will also not need to buy as many US Treasuries as they have in the past.

It’s all starting to come together. The next big upward move in the gold price will occur when China and Japan allow their currencies to appreciate and the dollar to fall. I have no idea whether it will be this year, or next, but I do believe the current decline in gold and gold related equities represents an opportunity.

I’ll be speaking at next month’s investment conference in New York. Visit my website www.paulvaneeden.com for details.

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com) or contact his publisher at (800) 528-0559 or (602) 252-4477.

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