China To Revalue Yuan Is It Time To Invest?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
July 19, 2005

China To Revalue Yuan – Is It Time To Invest?

IN THIS ISSUE:

1.  Will China At Last Revalue The Yuan? 

2.  Schumer-Graham Tariff Bill On China

3.  A Small Yuan Revaluation Is Not Enough 

4.  The Bigger Picture Problems With China

5.  Is Now A Good Time To Invest In China?

China To Revalue The Yuan At Last?

For the last several years, the Bush administration has been pushing China – directly and indirectly – to decouple their currency (the renminbi, or more commonly referred to as the yuan) from the US dollar and revalue the yuan to a higher level.  Why?  Because our trade deficit – US exports to China versus US imports from China - is exploding.  Our trade deficit with China is expected to rise from a record large $160 billion in 2004 to $200 billion for 2005.

The Chinese government has refused to revalue the yuan for a number of reasons.  First (and obvious), Chinese leaders love the fact that they are running a huge trade surplus with the US.  They do not want to increase the value of their currency, thus making their products more expensive in the US, and possibly shrinking demand by American consumers.

Second, Chinese banks are loaded with non-performing loans – thanks to communist government policies and controls – and monetary officials in China claim that they need more time to prepare their banking system for the stresses of a floating currency.

Third, over half of all Chinese exports to the US are goods and services produced by American multi-national companies that operate large production facilities in China.  These exports to the US – even though they are produced by American companies operating in China – are counted as part of the trade deficit, just like products from home-grown Chinese companies.

China argues this isn’t fair.  They argue that Chinese imports into the US from American multi-nationals operating from China should not be counted as a part of the US trade deficit with China.  And they have a point.  The history of US trade relations with China could fill volumes, but space does not permit.

Yet for reasons cited above and others, the Chinese government has resisted revaluing the yuan against the US dollar for a number of years.  But that may be about to change, or so we are led to believe.

The Schumer-Graham Tariff Bill On China

In early February, Senators Charles Schumer (D-NY) and Lindsey Graham (R-SC) co-sponsored a bill that would impose a 27.5% trade tariff on all imports from China.  Initially, it was assumed that such a protectionist piece of legislation would be widely opposed by Senators on both sides of the aisle.

However, to the surprise of many, in April the Senate voted 67-33 to remove a procedural hurdle that was blocking an up-or-down vote on the Schumer-Graham legislation imposing the across-the-board 27.5% penalty tariffs on all Chinese imports - unless China revalues its currency. 

Fearing the erection of protectionist trade barriers, the Bush administration decided to take a tougher approach in its public comments against China and in favor of currency revaluation.  Reportedly, the Bush administration dispatched some former political heavyweights including Henry Kissinger, Brent Scowcroft and others to deliver a message to the Chinese government that they had better get serious about revaluing the yuan.

Even Fed chairman Alan Greenspan got into the act shortly thereafter with comments that essentially said, the time is now for China to revalue the yuan.

Apparently, it worked.  If the stories we read are correct, China’s President Hu Jintao is scheduled to meet with President Bush in August, at which time it is increasingly expected that he will announce a revaluation of the yuan by 5-10%.

Treasury Secretary Snow reportedly met with Senators Schumer and Graham, and we are told they have agreed to delay any action on their China tariff bill pending the outcome of the meeting with Bush and Jintao in August.

Yet 5-10% Is Not Nearly Enough

I have read dozens of analyses on what it will take to make a meaningful dent in our trade deficit with China.  Almost all of the analyses I have read agree that it will take an upward revaluation of the yuan of 40-50% against the US dollar to stem our trade deficit with China.  Do an Internet search with the words “China yuan” or “US-China trade deficit” and you will find countless stories and analyses on the problem.     

Don’t get me wrong - I am not saying that an initial 5-10% revaluation is a bad place to start.  But a single revaluation of only 5-10% (if we get that much) will not mean much if anything.  Most analysts actually believe that Chinese exporters to the US will simply “eat” most of a 5-10% upward revaluation in the yuan, and prices to US consumers will not change much.

Only if China agrees to, and sticks to, a multi-stage plan to revalue the yuan over several years will we see any meaningful drop in the trade deficit with China.  I think it is safe to assume China will not agree to that this year.  This raises the odds that the Senate will revive the Schumer-Graham protectionist legislation to slap large tariffs on Chinese imports again next year.

In any event, it now looks very likely that China will agree later this year, perhaps in August, to revalue the yuan by 5%-10%; my guess is it will be closer to 5% than 10%.  The Bush administration, members of Congress and the media will claim victory.  And this is just one more reason why the stock markets could break out of the recent trading range to the upside.

Never mind that a 5%-10% upward revaluation of the yuan will be largely absorbed by Chinese manufacturers (many of them US-based), so that American consumers will not see much, if any, noticeable increases in the prices of Chinese goods at home.  Never mind that the spiraling trade deficit with China will continue to increase.

Bigger Picture Complications With China

The Bush administration (actually any administration) will welcome even a modest deal with China on currency valuations, even if it is not nearly enough, and even if there are no further commitments for additional revaluations.  Any deal will make for positive media coverage.  Yet we will continue to run a huge trade deficit with China in any event for years to come.

In the bigger picture, that means we will continue to fund China’s nuclear buildup.  You don’t hear anything in the media about this, but we are continuing to feed China’s rapid military and nuclear expansion.  In my view, there is no question that China will be the equivalent of the Soviet Union, in terms of a nuclear threat, within the next decade.

[I cannot help but point out that it was the sharing of highly sensitive information during the Clinton administration that vaulted China years ahead in the development of long-range rockets, missile guidance systems and nuclear technology.   I have written extensively about this in the past in my monthly newsletters.  There is plenty of information on these sensitive technology transfers during the Clinton administration on the Internet.]

In the bigger picture, the US remains very dependent on China for help in checking North Korea’s nuclear buildup.  The US cannot afford to alienate China at this point in our effort to keep pressure on N. Korea to limit its nuclear program.  As a result, the US is likely to welcome whatever currency deal China puts on the table.

Also, don’t forget that China is using its enormous dollar trade surplus to invest in US Treasury securities.  China, like our other Asian trading partners, is investing much of its huge dollar surplus in US Treasury bonds and notes every year.  The US cannot risk taking a really hard line against the Chinese for fear that they will decide to stop buying Treasury securities, much less unload their vast holdings.  We are not in a good spot, and the Chinese know it.   

So, we will continue to run large trade deficits with China.  If China concedes to a minor revaluation of their currency against the dollar, the Bush administration will welcome it.  The media will make a big hoopla out of it.  It will be portrayed as a huge “win-win” for both sides.   All of this could be good for China.  Which raises the question….

Is Now A Good Time To Invest In China?

Americans have been salivating over investing in China for several years now.   And why not?  The Chinese economy has grown at a blistering rate of 8%-10% for the last several years, and most analysts agree that this juggernaut could continue for another 3-5 years, barring some bizarre accident.

If China steps forward and agrees to even some limited currency reforms, the media will go wild and the interest in investing in China will heat-up even further (another reason for China to make a deal).  More investor money will be looking for a way to invest in the China juggernaut.  What follows are my thoughts on investing in China. 

First, whenever you invest in a foreign country, you have more than just market risk.  You also have “currency risk.”  You may be correct that stocks in a foreign country will go up.  But even if they do go up, you also have the risk that the currency of that country may go down.  The currency may go down more than your potential gains in their stocks.  With that said, here are some options for investing directly in China.  On some of the investment products that follow, you will need to contact a broker with connections to those markets.

If you want to invest in Chinese company stocks directly, you might first look at the so-called “H shares” and “red chips,” Chinese companies listed on the Hong Kong exchange.  Most of these companies are in fact real businesses, even though they are controlled in varying degrees by the Chinese government.

Then there are the “A shares” and “B shares” of companies listed on China’s domestic stock markets in Shanghai and Shenzhen. The problem is, the A shares are tough to buy and the B shares offer a limited selection. [Some experts agree that this barrier may be good since China’s legal, accounting and regulatory systems are still not well developed.]

If you want to buy China in the US and avoid the hassle of dealing directly with global accounts, foreign taxes, currency fluctuations, etc., you can buy American Depositary Receipts (ADRs) of Chinese companies listed in New York.  Companies available through ADRs are generally thought to be of higher quality, but they also may offer lower returns.

You should also note that if you buy ADRs, you may not be buying actual stock in a Chinese company, but perhaps the stock of some offshore entity that has only a contractual relationship with a Chinese company to buy its stock.  In that case, you have to hope that the contractual relationships in China, and the companies in China survive until the time you want to get out.

Obviously, most of us are not going to invest directly in stocks traded on Chinese exchanges, and most investors don’t trade in ADRs.  That leaves us with investing in mutual funds that invest in Chinese stocks and other securities.  Be advised that many of these mutual funds charge higher expenses.  Higher fees are not always a bad thing, but just be aware that it is harder to evaluate fees and expenses on mutual funds that invest in foreign securities, since you may not understand all the terminology.

You can also have an exposure to China by investing in passive index funds or exchange-traded funds (ETFs) that seek to duplicate any of a number of Chinese market indices.  These investments provide a lower-cost alternative to an actively managed mutual fund, but also carry the risk of potentially higher volatility.  Before investing in any index fund or ETF, be sure to research the index it is seeking to duplicate so you know exactly what types of securities are being included.  For example, there is a world of difference between stocks of actual Chinese companies, American companies doing business IN China, and American companies doing business WITH China.

Fad Investing Rarely Pays Off

While I see the potential long-term benefits of investing in China through one of the structures discussed above, I also see that many of the opportunities being presented to investors today are nothing more than investments cobbled together to take advantage of the China “fad.”  In my July 13, 2004 E-Letter, I discussed the pros and cons of investing in China, and the risks of putting your money in “fad” investments.   It was good advice then, and even better advice now that the fad has grown even larger, so I have repeated my advice from that E-Letter below.

As an investment professional for almost three decades, I have seen many fad investments that have boomed and then burst.  Each time, investors are wooed by siren songs of large profits and can’t-miss opportunities.  All too often, the reality is one of poor returns and even financial ruin.

There’s an old saying in investing: if everyone is starting to invest in something, that’s probably the best time to get out.  One of the most recent examples of this was the flight into tech stocks in the 1990s.  While it’s true that many people made money in tech stocks, most investors didn’t.  That’s because most investors caught onto the fad late in the game, and invested in late 1999 or early 2000, just in time to ride the market down 70% or more.

There are several characteristics of fad investing that I think will help you to determine whether it’s best for you to invest in China or not:

Halbert’s Observations On Fad Investing

1.    Fad investment promoters will seek to validate their claims by saying how the “smart money” is also involved in this investment.  That’s right, but what they don’t tell you is that the “smart money” invested in the latest craze long ago, and did so only after extensive research. 
I recently received a promotion for an investment newsletter that justified its existence by stating that the Carlyle Group has decided to make extensive investments in China.  While that may be a good reason to invest through the Carlyle group, it’s not necessarily a good reason to trust the advice of this newsletter promoter.  The “smart money” has a presence on-site in China, usually staffed by experts who were born there and know the language, customs and business environment.
2.    Speaking of newsletters, it seems that for every fad there is a proliferation of newsletters and E-Letters claiming expertise in whatever new fad is popular.  This happened during the Internet fad, more recently in the gold fad, and is now very evident in the China fad.  However, simply going to China doesn’t make you an expert in Chinese investing any more than going to Yellowstone makes you a Park Ranger.
On several occasions I have written about how newsletter writers are not required to publish both winners and losers, as registered investment professionals are required to do.  Sure, they may have a recommendation that made 600% just as they claim, but they may have also had five more that lost everything. 
No regulation requires them to disclose the losers.  So, if you are interested in a particular newsletter, ask for a complete list of all of their recommendations and their results.  Or better yet, check with the Hulbert Financial Digest where newsletter writers’ recommendations are independently tracked.  Of course, not all investment newsletters provide such information to Hulbert.  You can check out Hulbert’s service at:
http://cbs.marketwatch.com/commerce/hfdProduct.asp?pname=hfd
3.    Many times, fads woo investors by presenting a reasonable sounding business plan with unrealistic projections.  For example, a Chinese investment promoter may try to get you excited by saying how if a certain percentage of the 1.3 billion Chinese population buys a product, the company will be wildly successful.  Remember that a vast majority of the Chinese population lives in the rural interior where poverty abounds.  These people won’t be buying cars, TVs or other trappings of modern life for a long, long time.
4.    Another observation I have made is that the investors who make the good money in markets that turn out to be fads are those that get in early and get out early.  The problem with getting in early is that this requires that you know about the opportunity long before it is highlighted on the financial news shows and the subject of e-mails and direct-mail offers.  By the time you hear of an opportunity by direct-mail, you probably should assume it’s too late to get in for any decent profits.
5.    Finally, it has been my observation that those that do best in new investment opportunities are those that turn the decisions over to professionals.  This one is somewhat related to my #4 point above, in that professional money managers generally know about new opportunities before individual investors.  You may get tired of my saying that this is the best way to invest, but I firmly believe it.  While I do not represent any investment professionals who specialize in Chinese investments, I still believe that you should only invest in China under the direction of an investment professional who is subject to US securities regulations.

Don’t get me wrong, I think that there is additional upside potential for certain Chinese investments.  However, as we all learned from the 1990s tech stock experience, not every company that claims to have a sure-fire business plan is going to be successful.  The problem was then, and is now, trying to separate the eventual winners from the losers. 

Conclusions

It is clear from a number of credible sources that there are a large number of potential business opportunities (and potential investment gains) in China.  However, there are also many challenges, not the least of which is that its economy is centrally controlled by a COMMUNIST government.  Thus, you should consider any Chinese investment to be a speculative part of your portfolio, and should be limited accordingly.  You should also only invest with seasoned investment professionals who not only know the business potential of an investment, but also the political implications of investing in China as well.

In the bigger picture, there is presently a tenuous interdependence between China and the US.  The US government wants China to continue to buy and hold Treasury securities to finance our trade deficit, while China depends upon US consumer demand to fuel its continued growth.  American corporations also depend upon China’s cheap pool of labor for profitability, while China depends upon American business for expertise and technological support.

At the same time, around the edges of the US/China relationship stand more ominous implications in the form of a Chinese desire to acquire US companies and a military buildup that includes nuclear weapons.  Neither of these issues is likely to cause major problems in the short-term because of the interdependency between our two countries, but will very likely become serious policy considerations in the not-too-distant future. 

The problem is that actions necessary to avoid these future problems should have been addressed years ago, and need to be addressed now, not when they reach a crisis in the future.  Unfortunately, with the US running increasingly large trade deficits, I doubt that there’s anything that will be done to counter these potential future threats anytime soon.

My advice is to keep your eye on Taiwan.  This is likely to be the flashpoint at such time when China decides that it is no longer dependent upon the US for its economic well being.

Very best regards,

Gary D. Halbert

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Rove Rage - even the liberals at Slate.com believe
that the case current against Rove is a witch-hunt.
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Revising American History (one of my pet peeves).
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Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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