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Friday July 22, 2005 - 11:11:41 GMT
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Be careful what you wish for...


“’Contrariwise,’ continued Tweedledee, ‘if it was so, it might be; and if it were so, it would be: but as it isn’t, it ain’t. That’s logic.”

Lewis Carroll

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The announcement by China to “revalue” or “re peg” or “dirty float” the yuan by 2.1% against the US dollar was as clear as mud yesterday. The implications and fallout could be significant. We can conjecture until the cows come home—it makes for a lot of good stories. But we just don’t know how it will play out. Already, much ink has been spilled on the revaluation. We will take a look at a couple of the potential implications we are thinking about this morning.

Will the revaluation lead to higher US interest rates?

Most believe it is only a first step that will lead to a continuing freeing of the Chinese currency. Already we have seen other Asian currencies rise sharply in value. This is because their main competitor on the export front is China—a rising Chinese currency allows them to let their own currencies appreciate accordingly.

If Asian countries are no longer concerned, or at least less concerned, about capping the value of their currencies relative to China—effectively relative to the US dollar—by implication it means they will not need to hold as many US dollar reserves. This is why many are concerned US interest rates could move higher—no longer will the Asian region need to hold as many, or purchases as much, US Treasury paper going forward.

Is this a tiny first step to an eventual free-floating Chinese currency?

So far, that seems the consensus. Already, J.P. Morgan Chase predicted the yuan will gain a further 5% by year-end, according to The Wall Street Journal. But, China must be careful. It is why they only moved 2.1% instead of 10% + the US Treasury was pushing for. And way below the 40-50%, which some believe the yuan is undervalued against the dollar.

Why so careful? Why not a move to free floating and be done with it? Beneath the bullish view of many, China is dealing with some significant problems within its economy—excess capacity in key industries, falling profits for companies in those industries, a slowdown in the property market, banks that are still simply central government conduits, and growing social tension. China needs to employ a lot of people to maintain social stability. With the problems mounting within its economy, a one off large revaluation could lead to money pouring out of China, draining liquidity at precisely the wrong time.

“We believe that the investment-driven cycle will come under the pressure of its own weight - overcapacity, unfavorable pricing, reduced cash flow and shrinking margins (see Andy Xie’s report “Overcapacity — Blaming Whom?”, July 8, 2005). Deteriorating profitability and corporate cash flow are set to force a slowdown in capex, bringing down the unsustainably strong economic growth,” according to Morgan Stanley.

With a small one time move, China maintains the anchor aspect of a fixed rate currency, while at the same time it keeps the music playing.

“The capital inflows continued to buoy monetary and investment growth, in our view. Rmb loans increased by Rmb465.3 bn in the month of June, up 65% YoY, reversing the declines seen in the past few months. YoY growth in outstanding Rmb loans also picked up to 13.3%, after dipping for five straight months (12.4% in May). Broad money M2 growth picked up above the official target (15%) in June, at 15.7% YoY, accelerating for the fourth straight month. Fixed investment has been accelerating noticeably in 1H05. Urban capex rose 28.8% YoY in June (averaging 27.1% in 1H), up from 28.2% in May, 26.5% in April and 25.3% in 1Q05, while total fixed investment grew 25.4% YoY in 1H05, up from 22.8% in 1Q,” according to Morgan Stanley.

So, whether we see a continued appreciation in the yuan or not probably doesn’t matter. The expectation is now that it will appreciate. This means the speculative juices will flow smoothly in the minds of the investor class—with the expectation of more revaluation to come, why not get more and more money domiciled in Chinese assets. In other words, this move could significantly increase the already massive hot money flow into China. Policy makers in China seem to have made it clear they prefer to deal with financial excess than see a significant slowdown in Chinese investment. Is it time to buy more Chinese real estate and jump back on the commodities train?

What is the basket of currencies that China will supposedly use to fix the yuan’s value and how are the currencies within this basket going to be weighted?

So far, the basket contents are “secret.” The make-up of this basked could be significant to the value of the yuan going forward.

Here’s a scenario: Let’s say the basket is made up of equal parts $, euro, yen, for example. What if the dollar continues to appreciate against the euro and yen—after all, the fundamentals in the US haven’t changed and the yield differential favoring the dollar is set to grow? In this scenario, it would mean the relative value of the yuan declines against the dollar. Now wouldn’t that be interesting! That would make Chinese goods appear even cheaper on the world market. WalMart would be happy, but we don’t imagine Capitol Hill would be.

Could this be the “careful what you wish for it may come true” scenario for US financial markets? Maybe! Stay tuned.

Jack Crooks
Black Swan Capital


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