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An undervalued Chinese currency is bad for the world but could be profitable for you

posted on November 17, 2009 at 8:30 am
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Friends, readers, and countrymen, lend me your eyeballs. I come not to bury the fixed dollar-renminbi peg but to praise it. (Yeah, it doesn’t roll off the tongue but have you ever seen Shakespeare’s first draft of Anthony’s speech?)

If you’re running the global economy (don’t we wish), there’s a whole lot wrong with China refusing to let its currency appreciate against the U.S. dollar. The peg is killing the exports of China’s Asian competitors who are seeing their won and yen appreciate against a renminbi that’s falling in price along with the dollar. The peg is delaying any real rebalancing of the huge trade deficit between the U.S. and China. And it’s feeding into soaring asset prices, bad loans, and run-away investment in unnecessary manufacturing capacity in China.

But if you’re an individual investor looking to put money to work, the dollar-renminbi peg is a gift. And you’d better put it to work for you now because it ain’t going to be here forever.

(For my take on how long the peg will last, see my post http://jubakpicks.com/2009/11/12/talk-is-cheap-especially-at-6-8-renminbi-to-the-dollar-but-a-re-valuation-of-chinas-currency-is-coming/ )

Step back for a moment and assume that instead of a master of the universe you’re just a humble investor looking for someplace to put some cash. The world’s emerging markets appeal to you—these economies look set to grow faster than the United States, Europe, and Japan for a decade or more—but these stocks have had a huge run. Forget getting in through the back door either: The commodity-dominated markets of countries like Australia and Canada have run away from you too.

Heaven forbid that you sold something and want to put the money back to work, or, even worse, that you’re coming late to the game and have cash on the sidelines that you want to invest.

You ready for the final straw? The currencies of many of these countries are hugely stronger against the dollar than they were at the beginning of 2009. Not only are emerging market and commodity economy stocks more expensive in their own currencies than they were when this rally started on March 9, but theyre extra, super-duper expensive to any investor who needs to buy them with U.S. dollars.

Want to buy Telkom Indonesia (TLK)? The Indonesia rupiah is 17% more expensive against the U.S. dollar than it was at the beginning of 2009. How about Banco Itau (ITUB)? The Brazilian real is up 35% against the dollar in 2009? Or Australian iron miner BHP Billiton (BHP)? The Australian dollar is inching toward parity with the U.S. dollar. It’s up about 33% in the last 12 months.

Not for the Chinese renminbi and the U.S. dollar, though. Back in July 2008 when China re-pegged its currency to the dollar it traded at 6.8 to 6.85 renminbi to the dollar. Today it trades at 6.8 to 6.85 renminbi to the dollar.

I won’t pretend that Chinese stocks are cheap now. The iShares FTSE/Xinhua China 25 Exchange Traded Fund is up 88.5% since the start of the current rally on March 9, 2009. That’s significantly more than the itself stunning 60.6% gain on the U.S. Standard & Poor’s 500 in that period.

But it’s less than the 122.7% appreciation—in dollar terms–in the iShares MSCI Brazil Index ETF (EWZ) in the same period.

Most of the difference in the gains in the China ETF and the Brazil ETF—from the perspective of a U.S. investor tracking the world in dollars—is due to the 35% appreciation in 2009 of the Brazilian real against the dollar versus the 0% appreciation of the renminbi against the dollar.

Think about that for a moment. First, it means that U.S. investors just putting money into the Chinese market don’t have to pay the penalty for 2009’s incredible sinking dollar. Second, it means that these investors actually have the future appreciation of the renminbi to look forward to.

No one should expect that the Chinese government and the People’s Bank of China will go all Milton Friedman on us and let the renminbi soar against the dollar when they relax the peg. But it is fair to say that because of the peg, the renminbi has a lot of future appreciation against the dollar curled up inside it like a tightly compressed spring. I wouldn’t be surprised to find that three years after China relaxes the peg that the renminbi has gained 20% against the dollar. That’s how much the renminbi gained against the dollar in the three years before the peg was put back in place in July 2008.

Right now the futures market is pricing in 3% appreciation in the renminbi against the dollar in the next 12 months. Not much perhaps. But I’ll put my money into a market where the trend, even a 3% trend, is running in my favor any day.

But you can’t take advantage of this trend if you don’t play.

Here are five ways that you could make the current dollar-renminbi peg your friend and put the future appreciation of the Chinese currency to work for you.

  • You could by an actively managed mutual fund. I personally own shares in Matthews China (MCHFX). The Matthews funds have a long history of kicking the tires in Asia and I think there’s good value to an investor in paying the 1.23% expense ratio to get that expertise. Here’s a link to their web site http://www.matthewsfunds.com/
  • You could buy an ETF (exchange traded fund). I’d suggest the iShares FTSE/Xinhua China 25 (FXI). With one buy you get exposure to the big boys of China’s economy such as China Mobile (CHL), China Life (LFC), and Petrochina (PTR).
  • You could buy a big hunk of the growing market for consumer financial products by buying shares of China Life. The company has about 50% of the still very young insurance market in China. But as China gets wealthier and older—by 2050 a higher percentage of China’s population will be 60 or over than in the United States—more people will look to consumer financial products such as life insurance to provide for old age and to provide security to the next generation.
  • You could buy into the continued emergence of a consumer economy in China by buying shares of   Ctrip.com (CTRP), the largest online travel company in China. On November 11 the company reported an 80% increase in third quarter profits on a 41% jump in hotel reservations and a 45% gain in flight bookings.
  • And, finally, you could buy into China’s huge need for water and water infrastructure by buying shares of Duoyuan Global Water (DGW), a supplier of water treatment equipment. On November 9 the company reported that third quarter revenue had climbed 31% from the third quarter of 2008, that gross margins had climbed to 49.5% from 46.8% a year ago, and that operating income was up 31.1%. The company divides its business into three product lines: wastewater treatment equipment, circulating water treatment, and water purification equipment.

You probably have other China stocks that you like. Just remember that to get the biggest bang out of the eventual end of the dollar-renminbi peg, you should look for Chinese companies that do the bulk of their business inside China in renminbi.

When do you want to buy these plays on the dollar-renminbi peg?

China is a volatile emerging market capable of dropping like a stone at a word from Beijing. The iShares FTSE/Xinhua China 25 ETF, for example, fell 10% from August 3 through August 31.

Ideally, you’d like to buy into a drop like that.

And you’d like to avoid the kind of runaway enthusiasm that greeted Ctrip.com’s recent earnings report. The stock climbed 7.4% on that earnings news on November 12.

I think that it’s worth waiting a few days right now to see if the dollar strength that took most global stocks and commodities down on November 12 makes another guest appearance. It was a bounce in a dollar that had fallen too far, too fast that caused the 6% drop in the Standard & Poor’s 500 stock index in late October into early November.

I don’t think the peg is going to end tomorrow. You’ve got a few months to time your buying in this market.

Full disclosure: I own shares of Matthews China in my personal portfolio.

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4 comments

  • richard.bready@gmail.com on 18 November 2009

    In 1933, the US depreciated the dollar by 40 percent, to the benefit of its trade balance and economy, and to the dismay of Britain, Germany, and France. In 1985, the US depreciated the dollar by 51 percent against the yen, creating the Japanese asset bubble and destroying Japanese prosperity. Why should China stop depreciating its currency, in favor of other countries’ economies instead of its own, because the US asks it to? Real political pressure will be required to make this happen, and the political muscle to exert that pressure is not readily visible.

  • nukeage on 18 November 2009

    Thank you for being reasonable yet encouraging, as usual. So, you recommend putting money into a mutual fund that invests in China at this point? I have switched my emerging-market investment from mutual funds to ETF in preparation for “carry-trade-over-then-get-the-hell-out” event you have mentioned elsewhere. I understand there’s a difference, but my brain is NOT cooperating!

  • macpete on 25 June 2010

    “And, finally, you could buy into China’s huge need for water and water infrastructure by buying shares of Duoyuan Global Water (DGW)”

    Jim, any thoughts on this play (DGW)? it’s just about at its year low.

    Tx.

  • aleblanc10 on 3 November 2010

    Jim, what do expect to happen to DGW now that the accounting issues have been brought to light.

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