Is the Yuan the New Dollar?
04/24/2012 9:00 am EST
As China’s currency becomes easier and easier to trade, and as its economy grows, it is becoming an alternative to the greenback. Here’s how investors can play the trend, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.
Throughout the global financial crisis—even as the problem changed its focus (and name) from the US mortgage-backed securities crisis to the Eurozone debt crisis—the United States could find solace in the strength of the dollar.
It may not have been a currency backed by the largest gold reserves or a well-run fiscal policy, but it needed only to be less bad than its global competitors. And up against a euro that threatens to come apart and a yen backed by a Tokyo government with an even bigger debt problem than Washington has, the dollar looked good enough.
For liquidity, for the depth of its markets, and 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 US Treasury prices to rally and yields to fall even after 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 ten fen to make a jiao, and ten jiao make a yuan. It’s as if the US 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 "very" off the timeline. China is moving more quickly than expected to turn its currency into a true global alternative.
How Far Can It Go?
It remains to be seen if the Beijing government can 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 the exchange rate, and 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 otherwise 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 European debt crisis—has pushed Beijing into action faster than projected even just a year or two 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 US interest rates, and for US economic growth rates that you should at least consider in formulating any long-term investment plan.
The latest move—announced just last week and set to take effect in the third quarter of the year—is, to me, a bombshell that indicates just how quickly the currency game is changing for the renminbi. (It also suggests a few stocks you might want to consider for your portfolio to take advantage of the long-term currency trend.)
But first: What happened last week?
The Yuan on the Block
It trades as 388.HK in Hong Kong, but Hong Kong Exchanges and Clearing (HKXCY) is very thinly traded in New York.
The company, which owns and operates the stock and futures exchanges in Hong Kong and related clearinghouses, 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 at $100,000.
Nothing new there. Lots of markets offer futures based on the US 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 renminbi, which really got up to speed with the creation of an offshore market for 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 zero to the equivalent of $400 million. Still a drop in the global bucket, but China didn’t stop there.
In January 2011, for example, the state-controlled Bank of China allowed customers to trade yuan in the United States. 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 US-based individual customers were limited to $4,000 a day.
In August 2010, McDonald’s (MCD) became the first foreign nonfinancial company to sell yuan-denominated bonds in Hong Kong. Since then, Caterpillar (CAT) and Volkswagen (VLKAY) 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 104 billion yuan—$16.4 billion. That’s almost triple the offerings in 2011.
In December 2011, China and Japan agreed to conduct future bilateral trades 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 allow countries to settle payments for Chinese goods in yuan instead of dollars.
With higher volumes will come lower costs—in the current system it 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 its China’s global trade. International trade settled in yuan was just $371 billion in 2011.
3 Ways Investors Can Profit
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 baskets 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%. 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—the relative attractions of the dollar decrease.
That means a falling dollar exchange rate against a basket of currencies belonging to US trading partners, even if the Chinese retain some kind of link to the dollar from their currency. More yuan purchased or held in reserve means 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.
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 factors play out, the rise of the renminbi as a global currency alternative is one more factor that will push down the price of the dollar and push up US interest rates.
Second, the rise of the renminbi as a global currency is likely to boost 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, the China Securities Regulatory Commission announced a roughly $8 billion increase (to 70 billion yuan from 20 billion yuan) 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 exchange traded funds 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) succeeds, it will mean more overseas money flowing into Shanghai and Shenzhen. That would push prices in those markets higher, and also diminish 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 renminbi-denominated trade and that create new products for that trade in renminbi.
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 London’s financial world has an incumbent’s advantages in defending its central role in the global currency market.
But London’s financial community, often called simply the "City"—sees the current government of Prime Minister David Cameron as hostile to the financial industry and unable to defend its interests against encroachments from Paris and Frankfurt based on a rejiggering of the European Community’s financial rules and policies.
That’s why London/Asia powerhouses, such as HSBC (HBC), Prudential (PUK), and Standard Chartered (STAN.LN in London), have all made noises recently about moving all or part of their operations to Hong Kong.
Singapore has the advantage of being near and attuned to China, but not in China. China has demonstrated a disconcerting legal arbitrariness that plays to Singapore’s strengths.
Buying the Market Makers
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 marketplace operator to profit from this trend, I’d pick Hong Kong Exchanges and Clearing. The company was created in 2000 through the merger of the Hong Kong Stock Exchange, the Hong Kong Futures Exchange, and the Hong Kong Securities Clearing Co. 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 derivatives contracts traded daily climbed 22%, and the average daily number of stock options contracts traded climbed 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 first three months of the year rose 16%.
The traditional London financial powers with a foot in the door of this trend (and maybe two someday soon) 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, 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 matter. 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 and Standard Chartered.