Will "Hot Money" Chase the Yuan?


By Palash Ghosh After strong pressure from its trading partners, China revalued the yuan and removed the currency's decade-long peg to the U.S dollar on July 21. According to Beijing, the value of the yuan, also called the renminbi, will now link to a basket of currencies of China's main trading partners.

The new exchange rate will start at 8.11 yuan per dollar, vs. an 8.28 peg that had been in place since 1994. The yuan will now trade within a 0.3% band against that basket of foreign currencies.

"STILL PEGGED." The U.S. has long pressured China to depeg its currency because of the belief that the yuan has been kept artificially undervalued, providing Chinese exporters with an unfair advantage. In fact, the U.S. had threatened to impose heavy tariffs on Chinese imports if the government didn't adjust its currency (See BW Online, 7/21/05, "The Yuan: A Baby -- but Key -- Step").

Romeo Dator, co-manager of the U.S. Global China Region Opportunities Fund (USCOX), doesn't see much of an immediate impact. "For the moment, the yuan is not really that much more flexible than it was prior to the depegging," he says. "The immediate impact is an appreciation of the yuan of about 2.1%, but the trading band is so rigid that, in reality, the yuan is still pegged to the U.S. dollar."

A stronger yuan will obviously benefit U.S. companies exporting to China, but Dator thinks the revaluation will likely not hurt Chinese exports because of the labor cost advantage in China. Indeed, Dator says, those Chinese companies that import raw materials denominated in dollars "will be helped as the cost of those raw materials will be lower, thus helping their profit margins."

REVERSE FLOW? Frederick Jiang, manager of the Ivy Pacific Opportunities Fund/A (IPOAX), believes the long-term impact of the yuan's revaluation will be "very, very positive" for China and other Asian nations, as well as U.S. investors. "Asian stocks have been undervalued because their currencies have been undervalued," he says. "Now, as the currency strengthens, the value underlying these assets will show up, and that will benefit U.S. investors."

However, the key question is whether this revaluation is a "one-off event" or a harbinger of further revaluations, Jiang says. "If it is an isolated event, a lot of the hot money into Asia will likely flow out," he says.

Paresh Upadhyaya, senior vice-president and portfolio manager at Putnam Investments, thinks China is following Singapore's model, and that it will probably decline to reveal the weights or the composition of the basket of currencies it will use. "China will now have a more flexible exchange rate, but they will still maintain a degree of control over their currency," he predicts.

BOOST FOR ASIA. Upadhyaya, who works with Putnam's global currency team, believes the move is the first step and that China will likely enact a series of small revaluations in the coming years.

Lei Wang, a co-manager of the Thornburg International Value Fund/A (TGVAX), says he expects more mutual fund flows into Asia as investors seek increased exposure to Asian assets. He also believes that Asia's consumer-related sectors -- such as retailers, airlines, banks, toll-road companies, and refiners -- will benefit from the yuan's revaluation.

"This symbolic and small move may invite more speculation on further moves, which may lead to more hot money flowing into the country or region, adding more difficulties to China's monetary policy," Wang notes. He cautions that "from a micro level, Chinese companies need to prepare themselves for this new currency regime."

BROADER PERSPECTIVE. Dator also thinks the Chinese government could revalue the yuan even further, but certain issues they face, such as the financial condition of the banks and employment, would "probably prevent them from moving to a free-floating currency immediately."

On a macro level, Standard & Poor's believes China's plan to revalue its currency will likely trim the U.S. trade gap with China in the longer term, as the increased cost of imported goods eventually reduces demand. In the short run, however, the U.S. trade gap may actually widen, as the cost of goods will rise more rapidly than the attempt to secure less-expensive substitutes.

The revaluation is also likely to improve the competitiveness of U.S. goods against more expensive Chinese goods (if the U.S. still produces goods that are in direct competition with Chinese goods, that is).

PRESSURE ON TECH. On the other hand, China may decide to reduce the cost of the exported items to offset the effect of the stronger yuan. The revaluation also reduces the threat of trade sanctions imposed by the U.S. Congress on Chinese imports, and may stem the tide of U.S. job losses overseas. It is likely to weaken the value of the U.S. dollar because of a reduced need to peg the yuan to the dollar.

On the negative side, Standard & Poor's believes the revaluation will probably raise the cost of Chinese imports, thus putting pressure on margins for retail and tech companies.

In turn, these rising costs could increase the threat of higher inflation in the U.S. And gold prices could rise in response to the possibility of higher U.S. inflation.

FUNDS TO WATCH. Below is a list of mutual funds and exchange-traded funds tracked by Standard & Poor's that focus on China and Hong Kong. While investors have flocked to China funds in recent years to seek gains from the country's growing economy, they can be subject to sharp losses and high volatility, evidenced by the variability of their returns.

That alone would make them more suitable for investors willing to ride them out for the long term, given corporate governance issues and China's growing pains.

China funds

Fund

1-Year Return (%)

3-Year Return (Annualized, %)

3-Year Standard Deviation (%)

Expense Ratio (%)

AllianceBernstein Greater China 97/A (GCHAX)

18.77

16.56

19.99

2.38

Columbia Newport Greater China Fund/A (NGCAX)

26.81

15.68

17.35

1.89

Dreyfus Premier Greater China Fund/A (DPCAX)

9.68

11.77

17.99

2.09

Eaton Vance Greater China Growth/A (EVCGX)

27.22

15.41

16.28

2.67

Fidelity China Region (FHKCX)

27.79

14.67

15.38

1.22

Gartmore China Opportunities/A (GOPAX)

21.35

N.A.

N.A.

1.95

Guinness Atkinson China & Hong Kong (ICHKX)

20.61

18.85

16.96

1.67

iShares FTSE/Xinhua China 25 Fund (FXI)

N.A.

N.A.

N.A.

0.74

iShares MSCI Hong Kong Index Fund (EWH)

31.62

15.44

17.53

0.8

Matthews China Fund (MCHFX)

14.21

14.36

17.85

1.43

PowerShares Golden Dragon Halter USX China (PGJ)

N.A.

N.A.

N.A.

0.6

US Global Investors China Region Opportunities (USCOX)

21.44

17.36

19.89

2.25

Ghosh is a reporter for Standard & Poor's Fund Advisor


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