It is the biggest unknown hanging over global financial markets: When will China finally loosen an 11-year-old peg that keeps the value of the yuan steady against the dollar and let it appreciate? Washington, Tokyo, and London have been blasting the Chinese for months to overhaul its currency regime. In return, China has insisted that reform is coming at some point -- though only when the country is good and ready.
That has left global investors baffled about the timing of a rising yuan and its implications for China's $600 billion a year global export machine. American investors stand to benefit if the yuan moves up. That's because it would sweeten the dollar value returns of yuan-denominated investments. At the same time, fears of a currency-driven economic slowdown in China have helped push down stock prices on its two domestic exchanges to six-year lows. And the Hang Seng China Enterprise Index of "H-Shares," which tracks Hong Kong-listed mainland stocks and is more accessible to global investors, is down 0.56% this year. Many investors worry about the impact on Chinese exporters that compete on price. "When it comes to picking [Chinese] stocks, there's still a lot of risk," says Mark Headley, president of San Francisco-based Matthews Asian Funds and co-manager of the Matthews China Fund (MCHFX).
Given the murky accounting standards of publicly listed mainland Chinese companies, some advise avoiding these shares altogether. But investors with a high tolerance for risk might consider pure China plays listed in Hong Kong or New York. China Mobile (CHL) is one. It boasts the biggest mainland market share in cellular phone services and is considered relatively safe from a currency adjustment since it doesn't export.
There's also CNOOC Ltd., a unit of China National Offshore Oil Corp. (CEO), which is widely viewed as the most experienced and well-run Chinese oil producer. Even better, it could gain from a yuan strengthening, since oil is priced in dollars, which would make it cheaper to import. However, Merrill Lynch & Co. (MER) cut its rating on the stock from "buy" to "neutral" on June 9 after CNOOC said it may bid for El Segundo (Calif.)-based Unocal Corp. (UCL), citing possible strains on the company's finances and credit ratings.
Another way to play a possible revaluation is to invest in domestic retailers such as Shanghai-based Lianhua Supermarket Holdings. It stands to profit from rising consumer demand -- and the potential for lower import prices. "If you're a retail store in China, a stronger yuan could help -- as long as it's not too much of a drag on the economy," says Headley of Matthews Asian Funds.
Finding the right China stock picks is trickier now than a year or two ago when China's economy was firing on all cylinders. Now, most economists expect China to slow down from nearly 10% growth rates in 2004 to about 8.5%. A sharp rise in the yuan could slow it further. But Beijing is likely to opt for more modest currency reform, probably the creation of a currency basket including the dollar, euro, and yen. Most forecasters see a 5% or so rise in the yuan against the dollar. That would crimp margins at Chinese exporters, but hardly be a disaster for them.
Companies based elsewhere in Asia that have significant exposure to China can be a less risky way to play a possible revaluation. Among the favorites are multinationals such as Honda Motor (HMC), which is bolstering its car-manufacturing base in southern China -- and uses lots of parts imported from Japan. A stronger yuan would also be good news for Korean shipbuilders like Hyundai Heavy Industries Co. that compete head-to-head with Chinese rivals on price.
Investing in China will remain a difficult proposition for global investors. But the picture should become a little clearer when Beijing finally bends to international pressure and frees its currency from its rigid dollar peg.
By Brian Bremner and Chester Dawson