THE REPERCUSSIONS FROM THE YUAN’S REVALUATION

By Dr. Richard S. Appel              July 27, 2005 www.financialinsights.org

July 24, 2005 –After nearly a decade-long fixed exchange rate, it was announced Thursday that the Chinese yuan was to be severed from its seemingly steadfast link to the U.S. dollar. Instead, it is to be allowed to “float” against a yet to be named basket of currencies. These are said to include the yen, the euro, the dollar and a number of other Asian monetary units. Further, when the contents of the basket is set, the yuan will be managed and the basket kept within a 3% daily trading band. It remains to be seen how the various currencies in this basket will be weighted, and whether this is the first step in a series of similar yuan devaluations, or the last.
The Chinese government has been the object of an ongoing, escalating attack for the past few years. As the world’s various major economies have begun to stall, China has become the global scapegoat for this condition. It has been repeatedly charged that the Chinese have kept their currency artificially undervalued in order to maintain an economic advantage over its trading partners. This in turn generated greater employment in China while simultaneously depriving workers in other lands of their jobs. Allegedly for this reason, and in order to curry favor from their suffering constituents, the politicians of a number of major countries have chastised the Chinese government.
The yuan was first pegged to the dollar in 1994. Through a series of modest increases it rose in value until in 1997, it was fixed to it. The recently announced upward valuation of the yuan was a mere 2.1% increase against the dollar. This is a token amount that I believe was arrived upon to primarily quiet the Chinese government’s antagonists. To my mind, it will have little if any impact upon the balance of trade between China and the United States. It can, however, impact some marginal Chinese exporters who primarily supply their products to the United States. Many of these primarily nascent companies may find themselves out of business or approaching the government for subsidies.
The yuan’s revaluation cheapens dollar denominated goods and services offered in China, thereby making them more affordable to their local consumers. Simultaneously, it makes more dear those items that originate in China and find their way into U.S. markets. In the end, the yuan’s revaluation will likely be insufficient to alter the flow of business between the two nations, affect prices in the U.S., or impact business conditions in either country.
Do not be led astray from recognizing the true implications and importance of this monumental announcement! I am confident that this will be the first in a series of sporadic incremental increases in the yuan’s value. They will be against the U.S. dollar and likely to a lesser extent the currencies of their other major trading partners. This will allow China to gradually gain a stronger foothold in the world economic arena, which in the not too distant future they may greatly influence, and even dominate.
Throughout history nations with strong currencies have typically not only been highly influential in the world’s marketplace, but have often taken leadership roles in both politics and the military. When one country’s monetary unit was greatly desired by those living in other domiciles, it meant that they offered goods and services that were either highly desirable or were more reasonably priced than those of their global competitors. Further, under the gold and gold-exchange standards it indicated that the country was also fiscally responsible. The stability and strength of their monetary units attracted large capital inflows due to the perceived safety that their countries and currencies afforded. I believe that the recently announced revaluation of the yuan is China’s first step toward achieving these goals.
If the yuan is allowed to continue to appreciate, it will benefit a number of conditions within China. It will lessen their cost of imported commodities such as oil, iron ore, cotton and copper. These are priced in dollars and are greatly consumed by their industrial and manufacturing bases. This can act to maintain or even reduce their general price levels. Further, they will be capable of purchasing American-made products at a discount due to their stronger currency.
China’s benefits may be huge. Over time, as their medium of exchange further appreciates, it will act to stem the influx of dollar credits entering China. This will result because the cost of their exports will become more prohibitive to Americans and fewer purchases will be made. This will limit the increase in their money supply thereby reducing their inflation rate. Further, it will simultaneously help to shore up their banking system and tend to moderate their overheated economy. Additionally, the average Chinese citizen will experience an enhanced standard of living. This will result from the lowered local prices of both U.S. imports as well as their commodity laden domestic goods.
The major negative effects of China’s announcement will be upon the United States and our dollar. First, by severing its tie to the dollar, it somewhat distances itself from its dependency upon our currency and will simultaneously increase the yuan’s reliance on the currencies of the “basket” countries. Thus, the dollar’s status and desirability as the premiere global monetary unit will suffer. Next, as the yuan rises against the dollar it will act to export inflation to our nation.
One of the prime reasons that prices have been subdued in the U.S. was due to not only the cheap Chinese import prices, but to the affect that it has had upon our local manufacturers. They have been forced to absorb much of their cost increases in order to remain competitive with Chinese imports. Now, they will be able to raise their prices in sync with the yuan’s upward adjustments. Also, American bond prices will likely weaken. This will result from the reduction of Chinese purchases of our Treasuries as their dollar inflow subsides.
Our nation has been hemorrhaging dollars through our ongoing current account and trade deficits. During the past few years the Chinese have been the second largest dollar acquirer. They used many of these to purchase U.S. Treasuries and presently hold about one quarter of a trillion dollars of our debt. If the Chinese move away from the dollar in favor of other currencies, the support that they have given our bond market will dwindle. And, with it, U.S. bond prices can plummet causing our interest rates to soar.
The U.S. housing market and economy rest on fragile ground. Any rise in our interest rates has the potential to knock the legs out from under them. This can cause home prices to fall precipitously which in turn can shock consumers into withdrawal, and damage our business sector.
On a positive note, if the yuan significantly appreciates against the dollar, it will positively impact our manufacturing base. This may act to reverse its decade long decline, and may even stimulate it to expand, thereby increasing our employment rate.
Finally, gold has the potential to be a major beneficiary of a sustained rise in the yuan. Given the fact that the dollar has heretofore been seen as the world’s primary monetary safe haven, it has attracted great demand. If the dollar loses its prominence in the world’s eyes, gold will be the likely entity that will fill that void and most benefit.
All of the major economies have been aggressively inflating their money supplies. This has sent tens of billions of dollars of the primary currencies searching for safety. A floundering dollar is surely destined to cause a redirection of much of this money to gold. Given the fact that the yellow metal recently broke through major overhead resistance in the euro, yen and Swiss franc, further strength in these currencies should attract substantial gold buying from these nations.
A negative consequence that a rising yuan may have in China is damage generated by a potential influx of speculative money. Given the yuan vs. dollar revaluation, hedge funds and other speculators are carefully assessing their future exchange rate potential. It is likely that when the composition and weightings of the soon to be announced “basket of currencies” becomes public, the currency pirates may shortly act. They will be better able to evaluate the accuracy of the parities between the yuan and the currencies of its trading partners in the basket.
More importantly, this group will recognize that we have not yet seen the last increase in the yuan vs. dollar parity. If a substantial amount of these hedge funds and traders arrive at the same conclusion their buying of renminbi in anticipation of this event, can force a sharp upward revision in its value. They may act, as George Soros did over a decade ago against the British pound. They will not drive it far lower as they did with the pound, but may instead carry it decidedly higher.
When dollars enter China most are exchanged by their central bank for newly created yuan, thereby increasing their money supply. This is the prime reason for their present level of inflation. The received dollars are then used to purchase U.S. Treasuries. If speculators and hedge funds feel confident that the yuan’s rise over time will produce important profits, a substantial inflow of dollar credits may enter their country. They will buy yuan with the expectation of selling them later when they are worth more for a profit. In this event, the Chinese government may be forced to capitulate and quickly revalue the yuan in order to prevent further internal damage. While this occurrence is far from assured, Chinese officials must be vigilant.
No one knows how the yuan’s subsequent rise against the dollar will unfold. Further, we do not yet know the composition of the Chinese basket of currencies against which its currency will float. As Richard Russell (dowtheoryletters.com) opined after the announcement, it might even include gold! If this is destined, gold will quickly be thrust back into the limelight of the world’s monetary system. But, what we do know is that the dollar’s hold on the throne of global currency domination has been deeply shaken, and is now in jeopardy.

ADDENDUM

The above was excerpted from the July 24, issue of Financial Insights, and was completed last weekend. Yesterday, Tuesday, the Chinese People’s Bank released a statement denying that they had plans to further revalue the yuan against the dollar. This brought to mind a situation of which I learned during the 1960's, and that was not an uncommon occurrence.
Governments have forever done their best to defend their currencies. “Jawboning” was a commonplace term used during the 1970's and earlier. It referred to a government’s attempt to apply pressure and frighten market participants who were trying to drive lower their currencies. One method that was often utilized, and frequently occurred just prior to a devaluation, was an official statement that they would not devaluate.
I cannot say with certainty that the recent revaluation of the renminbi will be followed by another as I would have expected during the earlier era. However, the immediate Chinese response to the numerous statements that the yuan will decline over time, gave me pause. I now must wonder if the currency pirates have already begun an attack. In any event, I believe that China’s Central Bank is quite concerned, and may act in this regard far faster than many onlookers believe.

The above was excerpted from the August 2005 issue of Financial Insights © July 24, 2005.

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FINANCIAL INSIGHTS is written and published by Dr. Richard Appel and is made available for informational purposes only. Dr. Appel pledges to disclose if he directly or indirectly has a position in any of the securities mentioned. He will make every effort to obtain information from sources believed to be reliable, but its accuracy and completeness cannot be guaranteed. Dr. Appel encourages your letters and emails, but cannot respond personally. Be assured that all letters will be read and considered for response in future letters. It is in your best interest to contact any company in which you consider investing, regarding their financial statements and corporate information. Further, you should thoroughly research and consult with a professional investment advisor before making any equity investments. Use of any information contained herein is at the risk of the reader without responsibility on our part. Past performance does not guarantee future results. Dr. Appel does not purport to offer personalized investment advice and is not a registered investment advisor. The information herein may contain forward-looking information within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the statements contained herein that look forward in time, which include everything other than historical information, involve risks and uncertainties that may affect the company's actual results of operations. © 2005 by Dr. Richard S. Appel. All rights are reserved. Parts of the above may be reproduced in context, for inclusion in other publications if the publisher's name and address are also included for credit.