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Faster than expected, here's comes the yuan--and I've got some suggestions for ways to play the rise of China's currency
04/24/2012 8:30 am EST
For liquidity, for the depth of its markets, for its ease of transfers and payments, the dollar was relatively strong because the competition was relatively weak. The dollar was a global currency without real competition. That’s been critical to allowing U.S. Treasury prices to rally and U.S. yields to fall even as the country lost its AAA credit rating.
The dollar isn’t without long-term competitive threats, however. The most obvious of those has long been the Chinese renminbi or yuan. (China’s currency is named the renminbi. The units of the renminbi are the fen, jiao, and yuan. It takes 10 fen to make a jiao and 10 jiao make a yuan. It’s as if the U.S. currency was named the dollar, but its units were called the George, the Alexander, and the Benjamin.) But that threat, while acknowledged as real, has always seemed very, very distant.
Well, I think it’s time to at least take one of those “very”s off the timeline. China is moving more quickly than expected to turn its currency into a true global alternative. It still remains to be seen if the Beijing government can fully bring itself to give up the kind of control over its currency that would be necessary to turn the renminbi into a real alternative to the dollar. China’s economic policies are so grounded in the government’s ability to control not just the exchange rate but the flow of its currency in and out of the country that the renminbi may never gain the currency market share that China’s economy and reserves could command. But the global financial crisis—and the damage suffered by the euro, which had looked like a true alternative to the dollar before the euro debt crisis—have pushed Beijing into action faster than projected even just one or two years ago.
Any real challenge to the dollar from the renminbi isn’t going to come tomorrow, but I don’t think investors should take the long-term supremacy of the dollar for granted. The likelihood of slippage in the dollar’s global role has implications for global stock and bond markets, for U.S. interest rates, and for U.S. economic growth rates that you should at least consider in formulating any long-term investment plan.
The latest move—announced just last week and planned to take effect in the third quarter of the year—is to me a bombshell that indicates just how surprisingly fast the currency game is changing for the renminbi. (And it even suggests a few stocks you might want to consider for your portfolio to take advantage of the long-term currency trend.)
What happened last week?Hong Kong Exchanges and Clearing (388.HK in Hong Kong or a very thinly traded HKXCY in New York), the company that owns and operates the stock and futures exchanges in Hong Kong and related clearing houses, announced plans to launch the first yuan-denominated futures in the third quarter of 2012. The new product would allow investors to trade against the dollar in contracts priced in U.S. dollars at $100,000.
Nothing new there. Lots of markets offer futures based on the U.S currency. But this is new and an important change: The contracts will require delivery in dollars by the seller and payment in yuan. In essence then, the futures allow for the convertibility of dollars and yuan.
The move is another step in China’s project of creating a global offshore market for trading the renminbi, which really got up to speed with the creation of an offshore market for the renminbi in Hong Kong in mid-2010. Until then, the buying and selling of yuan had been largely limited to mainland China under the government’s strict currency controls. From July 2010 to January 2011 daily trading in Hong Kong grew from 0 to $400 million. Still a drop in the global bucket, but China wasn’t set to stop there.
In January 2011, for example, the state-controlled Bank of China allowed customers to trade yuan in the United State. The move was an endorsement of the expansion of yuan trading by Beijing but it came with the typical truckload of restrictions. Businesses can convert any amount of currency, as long as they are engaged in international trading, but U.S.-based individual customers were limited to $4,000 a day.
In August 2010 McDonald’s (MCD) became the first foreign non-financial company to sell yuan-denominated bonds in Hong Kong. Since then Caterpillar (CAT) and Volkswagen have joined a parade of companies raising capital in yuan-denominated bonds in Hong Kong. In spite of a slump in issuance in the fourth quarter of 2011, the value of new so-called dim sum bonds reached $16.4 billion (104 billion yuan) in 2011. That’s almost triple the offerings in 2011.
In December 2011 China and Japan agreed to conduct future bilateral trade directly in yuan. (In 2011 trade between China and Japan amounted to $350 billion.) Before the agreement Japanese companies, like those from most other countries, had to convert payments into dollars and then into yuan. Each conversion imposed trading costs and exposure to currency fluctuations.
The real big bang, though, is scheduled for 2014, according to the People’s Bank. That’s when China will roll out a system that would let countries settle payments for Chinese goods in yuan instead of dollars. With higher volumes will come lower costs—in the current system it currently costs more to do cross-border transfers in yuan than in dollars. That cost differential isn’t likely to persist for long given the volume of China’s global trade. International trade settled in yuan was just $371 billion in 2011.
I can see three consequences of this trend that investors need to take into account in building their long-term portfolio strategies.
First, the current move by the world’s central banks to include the yuan in their basket of reserve currencies will accelerate. In September 2011, for example, the Banco Central de Chile, the country’s central bank, reported that, for the first time, it had some of the country’s currency reserves in yuan. The figure was just $91 million or about 0.3% of the reserves, but Chile’s central bank has said it plans to increase its yuan holdings.
The slow effect of this move is to reduce the premium the dollar gets as the best of the world’s big liquid currencies. As the renminbi becomes an increasingly attractive alternative with the increase in liquidity, the decline in transaction costs, and the easing of restrictions on convertibility, then the relative attractions of the dollar fall. That means a falling dollar exchange rate against a basket of currencies belonging to U.S. trading partners even if the Chinese retain some kind of link to the dollar from their currency. More yuan purchased or held in reserve mean fewer dollars purchased or held in reserve. Less demand results in a falling price for the dollar.
The rate and size of that decline will depend on how the United States handles its budget deficit in the coming years, on how the Chinese handle the mountain of bad debt in their official and unofficial banking systems, and on how good a job the Chinese do at building the mechanisms required by a world class currency market. And then, of course, there’s the political issue of exactly how much control China’s political leadership is prepared to give up over its currency and economy. I think it’s safe to conclude, that however these factor play out, the rise of the renminbi as a viable global currency alternative is one more factor pushing down the price of the dollar and pushing up U.S. interest rates.
Second, the rise of the renminbi as a global currency is likely to give a boost to China’s stock markets and, especially in the Shanghai market, reduce volatility. Simultaneously, albeit very slowly, with the easing of restrictions on the renminbi and the opening of markets and the creation of products for trading that currency, China has been opening its mainland financial markets to foreign investors.
For example, on April 4, 2012, the China Securities Regulatory Commission announced a roughly $8 billion increase (to 70 billion yuan from 20 billion) in the quota that non-mainland fund companies can invest in China’s mainland stock market through the country’s Renminbi Qualified Foreign Institutional Investor program. The program allows yuan accumulated in Hong Kong to be invested in mainland stock markets. The goal, Beijing has made clear, is to create new Hong Kong-listed ETFs that will track the A-shares index in Shanghai and Shenzhen. The hope is that this will encourage stable, long-term foreign equity investment. If the plan—and further steps like it—succeed, it will mean more overseas money flowing into Shanghai and Shenzhen. That would have the effect of pushing prices in those markets higher and also of diminishing the volatility of markets dominated by domestic investors who frequently buy and sell based on attempts to read shifts in government policy.
Third, the rise of the renminbi means the rise of the markets that capture the renminbi-denominated trade and that create new products for that trade. Right now I’d give Hong Kong, Singapore, and London the edge in that race. Most of Beijing’s recent moves are clearly intended to foster Hong Kong as the main market for renminbi-denominated trading. London’s trading infrastructure is ahead of Hong Kong’s at the moment and the London market has an incumbent’s advantages in defending its central role in the global currency market. But London’s City sees the current government of Prime Minister David Cameron as 1) hostile to the financial industry and 2) unable to defend the interests of the City against encroachments from Paris and Frankfurt based on a rejiggering of the European Community’s financial rules (and tax and fee policy.) That’s why London/Asia powerhouses such as HSBC (HBC), Prudential (PRU.LN in London or PUK in New York), and Standard Chartered (STAN.LN in London) have all made noises recently about moving all or part of their operation to Hong Kong. Singapore has the advantage of being near China and attuned to China but not in China. China has demonstrated a disconcerting legal arbitrariness that plays to Singapore’s strengths.
One of the most promising ways to invest in these big picture trends is by buying shares in the companies that run these markets or that will sell the new products.
If I were going to buy one market place operator to profit from this trend, I’d pick Hong Kong Exchanges and Clearing (388.HK in Hong Kong and a very thinly traded HKXCY in New York). The company was created in 2000 though the merger of the Hong Kong Stock Exchange, the Hong Kong Futures Exchange, and the Hong Kong Securities Clearing Company to spearhead China’s drive into the global financial markets. The big story here isn’t the growing number of shares traded in Hong Kong but the huge increases in volumes for futures and derivatives. The average daily value of shares traded in Hong Kong rose just 1% from 2010 to 2011. But the average number of derivative contracts traded daily climbed by 22% and the average daily number of stock options contracts traded climbed by 23%.
To diversify take a look at Singapore Exchange (SGX.SP in Singapore). The operator of the Singapore Stock Exchange just reported that profit for the three months ended on March 31 rose by 16%.
The traditional London financial powers with a foot (and maybe two some day soon) in Asia would be another way to build your portfolio’s exposure to the globalization of the renminbi. According to a study by the City of London Corporation, London accounts for 26% of the global offshore yuan spot foreign exchange market. Recently the City and Hong Kong have been making noises about cooperation rather than competition: since currency traders want 24-hour market access to a global renminbi why not work together to provide that, the two markets have started to wonder. Whether any gesture toward cooperation would survive a bid by Hong Kong Exchanges for the London Metal Exchange is another issue. The South China Morning Post has reported that Hong Kong Exchanges is lining up bank financing for a bid. Expected competition will come from the CME Group (CME), NYSE Euronext (NYX) and IntercontinentalExchange (ICE.)
My favorites among the London/Asia powers are HSBC (HBC) and Standard Chartered (STAN.LN)
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Hong Kong Exchanges and Clearing, Prudential, Singapore Exchange, and Standard Chartered as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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